Skip to main content

Full text of "General explanation of the Tax reform act of 1976 : (H.R. 10612, 94th Congress, Public law 94-455)"

See other formats 


GENERAL  EXPLANATION 

OF  THE 
TAX  REFORM  ACT  OF  1976 

(H.R.  10612,  94TH  CONGRESS,  PUBLIC  LAW  94^55) 


PREPARED  BY  THE 
STAFF  OF  THE 

JOINT  COMMITTEE  ON  TAXATION 


DECEMBER  29,  1976 


GENERAL  EXPLANATION 

OF  THE 
TAX  REFORM  ACT  OF  1976 

(H.K.  10612,  94TH  CONGRESS,  PUBLIC  LAW  94-455) 


PREPARED  BY  THE 
STAEF  OF  THE 

JOINT  COMMITTEE  ON  TAXATION 


DECEMBER  29,  1976 


U.S.  GOVERNMENT  PRINTING  OFFICE 
79-667  O  WASHINGTON  :   1976  JCS-33-76 


For  sale  by  the  Superintendent  of  Documents,  U.S.  Government  Printing  Office 
Washington,  D.C.  20402 


Stock  No.  052-070-03860-1 


CONGRESS  OF  THE  UNITED  STATES 

(94th  Cong.,  2d  sess.) 

Joint  Committee  on  Taxation 
Senate  House 

RUSSELL  B.  LONG,  Louisiana,  Chairman        AL  ULLMAN,  Oregon,  Vice  Chairman 
HERMAN  E.  TALMADGE,  Georgia  JAMES  A.  BURKE,  Massachusetts 

VANCE  HARTKE,  Indiana  ,  DAN  ROSTENKOWSKI,  Illinois 

CARL  T.  CURTIS,  Nebraska  HERMAN  T.  SCHNEEBELI,  Pennsylvania 

PAUL  J.  FANNIN,  Arizona  BARBER  B.  CONABLE,  Jr.,  New  York 

Laurence  N.  Woodworth,  Chief  of  Staff 
Herbert  L.  Chabot,  Assistant  Chief  of  Staff 
Bernard  M.  Shapiro,  Assistant  Chief  of  Staff 

(ID 


LETTER  OF  TRANSMITTAL 


Congress  of  the  United  States, 

Joint  Committee  on  Taxation, 
Washington,  D.C.,  December  29,  1976. 

Hon.  Russell  B.  Long,  Ohmrman, 

Hon.  Al  Ullman,  Vice  Chairman,  Joint  Committee  on  Taxation, 
U.S.  Congress,  Washington,  D.C. 

Dear  Messrs.  Chairmen  :  While  committee  reports  explain  the  posi- 
tion of  the  House  Committee  on  Ways  and  Means,  or  the  position  of 
the  Senate  Committee  on  Finance,  they  do  not  in  all  cases  explain 
the  tax  legislation  as  finally  passed  by  the  Congress.  This  becames  par- 
ticularly important  in  the  case  of  major  legislation  where  there  are 
many  changes  between  the  bill  as  passed  by  the  House,  or  as  passed  by 
the  Senate,  and  the  bill  which  finally  becomes  public  law.  The  Tax 
Reform  Act  of  1976,  because  of  its  comprehensive  scope  and  because  of 
the  many  changes  which  were  made  in  this  legislation,  both  by  the  Sen- 
ate and  subsequently  by  the  conferees,  is  an  illustration  of  where  the 
differences  were  especially  significant. 

This  document  represents  the  effort  of  the  staff  of  the  Joint  Com- 
mittee on  Taxation  to  provide  an  explanation  of  the  Tax  Reform  Act 
of  1976  as  finally  enacted  and  is  comparable  to  a  number  of  similar 
documents  prepared  by  the  staff  on  other  revenue  acts  in  recent  years. 
For  the  most  part,  where  provisions  which  were  unchanged  in  confer- 
ence were  described  in  either  tlie  House  or  Senate  report,  that  explana- 
tion is  carried  over  in  this  document.  No  attempt  is  made  here  to  carry 
the  explanation  further  than  is  customary  in  the  case  of  committtee 
reports  and  therefore  it  does  not  deal  with  issues  which  are  customar- 
ily explained  in  regulations  or  rulings. 

The  first  major  part  of  the  document  contains  a  summary  of  and  the 
reasons  previously  given  for  the  various  provisions.  The  second  part 
contains  the  revenue  estimates  on  the  legislation  as  finally  enacted  and 
the  third  part  is  a  general  explanation  of  the  provisions  appearing  in 
the  order  in  which  they  appear  in  the  public  law. 

This  material  has  been  prepared  by  the  staff  of  the  Joint  Committee 
on  Taxation  after  the  Tax  Reform  Act  of  1976  was  passed.  It  has  not 
been  reviewed  by  the  tax  committees  and  therefore  only  reflects  the 
staff's  view  as  to'the  intent  of  Congress.  It  is  hoped  that  this  document 
••will  be  useful  in  gaining  a  better  understanding  of  the  Tax  Reform  Act 
of  1976. 

•    Sincerely  yours, 

Laurence  N.  Woodworth, 

Chief  of  Staff. 

(in) 


LEGISLATIVE  HISTORY  OF  THE  ACT 

The  Tax  Eeform  Act  of  1976  was  the  result  of  over  two  years  of 
legislative  deliberations  largely  during  the  94th  Congress,  although 
some  of  the  provisions  were  originally  considered  by  the  House  Ways 
and  Means  Committee  during  the  93rd  Congress.^  Consideration  of  the 
Act  in  the  94th  Congress  proceeded  on  the  following  schedule : 

June  23  through  June  25, 1975 :  Panel  Discussions  before  the  House 
Committee  on  Ways  and  Means. 

July  8  through  July  31,  1975 :  Hearings  before  the  House  Commit- 
tee on  Ways  and  Means. 

November  12, 1975 :  Bill  (H.R.  10612)  reported  by  the  House  Com- 
mittee on  Ways  and  Means  (House  Report  94-658) . 

December  3  and  4, 1975 :  Bill  considered  and  passed  by  the  House  of 
Representatives. 

March  17  through  April  13,  1976;  July  20  through  22, 1976:  Hear- 
ings before  the  Senate  Committee  on  Finance. 

June  10,  1976 :  Bill  reported  by  the  Senate  Committee  on  Finance 
(Senate  Report  94-938)  :  Supplemental  report  filed  by  Senate  Com- 
mittee on  Finance  on  July  20,  1976  (Senate  Report  94-938,  Part  2). 

June  16-18,  21-25,  28-30,  July  1-2,  20-23,  26-30,  and  August  3-6, 
1976:  Bill  considered  and  passed  by  the  Senate. 

September  13,  1976:  Committee  on  Conference  submitted  Confer- 
ence Report  (House  Report  94-1515;  Senate  Report  94-1236). 

September  16,  1976:  Conference  report  (and  House  Concurrent 
Resolution  751)  approved  by  the  House  and  Senate. 

October  4,  1976:  Tax  Reform  Act  of  1976  (Public  Law  94-455) 
signed  by  the  President. 

1  The  Ways  and  Means  Committee  did  not  report  a  tax  reform  bill  in  the  93rd  Congress 
but  did  hold  extensive  discussions  (February  5-28,  1973)  and  hearings  (March  5 
through  May  1,  1973)  on  the  subject.  The  Ways  and  Means  Committee  also  held  legisla- 
tive markup  sessions  on  tax  reform  late  in  the  2nd  session  (1974),  but  had  only  made 
tentative  decisions  prior  to  the  end  of  the  93rd  Congress.  In  addition,  H.R.  17488,  The 
Energy  Tax  and  Individual  Relief  Act  of  1974,  reported  by  that  committee  on  November 
26,  1974  (House  Report  93-1502),  Included  provisions  relating  to  real  estate  invest- 
ment trusts  and  the  taxation  of  foreign  Income,  much  of  which  was  later  Included  in 
the  Tax  Reform  Act  of  1976. 

(V) 


CONTENTS 


Page 

Transmittal  Letter iii 

Legislative  History  of  the  Act v 

I.    Summary  and  Reasons  for  the  Act 1 

A.  Tax  Revision 2 

B.  Tax  Simplification 7 

C.  Extension  of  Tax  Reductions 8 

D.  Capital  Formation 10 

E.  Administrative  Provisions 11 

F.  Estate  and  Gift  Tax  Provisions 12 

II.  Revenue  Effects  of  the  Act 15 

III.   General  Explanation  of  the  Act 25 

A.     Tax  shelter  provisions 25 

1.  Real  Estate 25 

a.  Capitalization  and  Amortization  of  Real   Property 

Construction  Period  Intei  est  and  Taxes  (Sec.  201) .  25 

b.  Recapture  of  Depreciation  on  Real  Property  (Sec. 

202) ■ 29 

c.  Five- Year    Amortization    for    Low-Income    Rental 

Housing  (Sec.  203) 32 

2.  Limitation  of  Loss  to  Amount  At- Risk  (Sec.  204) 33 

3.  Farm  Operations 40 

a.  Farming  Syndicates  (Sec.  207) 40 

b.  Limitation  of  Loss  With  Respect  to  Farms  to  the 

Amount  for  Which  the  Taxpayer  Is  At  Risk  (Sec. 

204) 50 

c.  Method  of  Accounting  for  Corporations  Engaged  in 

Farming  (Sec.  207(c)) 51 

d.  Termination    of    Additions    to    Excess    Deduction? 

Accounts  Under  Sec.  1251  (Sec.  206) 57 

e.  Scope  of  Waiver  of  Statute  of  Limitations  in   Case  of 

Activities  Not  Engaged  in  for  Profit  (Sec.  214) 59 

4.  OilandGas i 62 

a.  Limitation  of  Loss  to  Amount  At  Risk  (Sec.  204) 62 

b.  Gain  From  Disposition  of  an  Interest  in  Oil  and  Gas 

Propertv  (Sec.  205) 64 

5.  Motion  Picture  Films 67 

a.  At  Risk  Rule  and  Capitalization  of  Production  Costs 

(Sees.  204  and  210) 67 

b.  Clarification  of  Definition  of  Produced  Film  Rents 

(Sec.  211) 75 

6.  Equipment  Leasing — Limitation  on  Loss  to  Amount  At 

Risk  (Sec.  204) 77 

7.  Sports  Franchises  and  Player  Contracts  (Sec.  212) 82 

8.  Partnership  Provisions 87 

a.  Partnership     Additional     First- Year     Depreciation 

(Sec.  213(a)) 87 

b.  Partnership    Syndication    and    Organization    Fees 

(Sec.  213(b)) 89 

c.  Retroactive   Allocations  of   Partnership   Income  or 

Loss  (Sec.  213(c)) 91 

d.  Partnership  Special  Allocations  (Sec.  213(d)) 94 

e.  Treatment    of     Partnership     Liabilities     Where    a 

Partner  Is  Not  Personally  Liable  (Sec .  2 1 3  (e) ) 96 

(VII) 


VIII 

III.  General  Explanation  of  the  Act — Continued 

A.  Tax  shelter  provisions — Continued  '^"■^^ 

9.     Interest 97 

a.  Treatment  of  Prepaid  Interest  (Sec.  208) 97 

b.  Limitation  on  the  Deduction  for  Investment  Inter- 

est (Sec.  209) 102 

B.  Minimum  and  Maximum  Tax 105 

1 .  Minimum  Tax  for  Individuals  (Sec.  301) 105 

2.  Minimum  Tax  for  Corporations  (Sec.  301) 107 

3.  Maxim.um  Tax  Rate  (Sec.  302) 109 

C.  Extension  of  Individual  Income  Tax  Reductions  (Sees.  401  and 

402) 111 

D.  Tax  Simplification  in  the  Individual  Income  Tax 115 

1.  Revision  of  Tax  Tables  for  Individuals  (Sec.  501) 115 

2.  Alimony  Payments  (Sec.  502) 116 

3.  Retirement  Income  Credit  (Sec.  503) 117 

4.  Credit  for  Child  Care  Expenses  (Sec.  504) 123 

5.  Sick  Pay  and  Certain  Military,  etc.,  Disability  Pensions 

(Sec.  505) 127 

6.  Moving  Expenses  (Sec.  506) 131 

7.  Tax  Simplification  Study  by  Joint  Committee  (Sec.  507) 135 

E.  Business-Related  Individual  Income  Tax  Revisions 136 

1.  Deductions  for  Expenses  Attributable  to  Business  Use  of 

Home  (Sec.  601) 136 

2.  Deduction  for  Expenses  Attributable  to  Rental  of  Vaca- 

tion Homes  (Sec.  601) 141 

3.  Deductions  for  Attending  Foreign  Conventions  (Sec.  602)  _  _  146 

4.  Qualified  Stock  Options  (Sec.  603) 151 

5.  Treatment  of  Losses  From  Certain  Nonbusiness  Guaranties 

(Sec.  605) 156 

F.  Accumulation  Trusts  (Sec.  701) 159 

G.  Capital  Formation 165 

1.  Investment  Tax  Credit — Extension  of    10-Percent   Credit 

and  $100,000  Limitation  For  Used  Property  (Sees.  801 

and  802) 165 

2.  First-In-First-Out  Treatment  of  Investment  Tax  Credits 

(Sec.  802) 166 

3.  ESOP  Investment  Credit  Provisions  (Sec.  803) 167 

4.  Investment  Credit  in  the  Case  of  Movies  and  Television 

Films  (Sec.-804) 176 

5.  Investment  Tax  Credit  in  the  Case  of  Certain  Ships  (Sec. 

805) 186 

6.  Net  Operating  Losses 188 

a.  Net   Operating   Loss    Carryover    Years   and    Carrj'- 

back  Election  (Sec.  806(a)-(d)) 188 

b.  Limitations  on  Net  Operating  Loss  Carryovers  (Sec. 

806(e)) 190 

7.  Small   Commercial  Fishing  Vessel  Construction  Reserves 

(Sec.  807) 205 

H.      Small  Business  Provisions 206 

1.  Extension  of  Certain  Corporate  Income  Tax  Rate  Reduc- 

tions (Sec.  901) 206 

2.  Changes  in  Subchapter  S  Rules 207 

a.  Subchapter   S   Corporation   Shareholder   Rules    (Sees. 

902  (a)  and  (c) ) 207 

b.  Distributions  by  Subchapter  S  Corporations  (Sec.  902 

(b)) 209 

c.  Changes   to    Rules    Concerning   Termination   of   Sub- 

chapter S  Election  (Sec.  902(c)) 211 

I.       Tax  Treatment  of  Foreign  Income 212 

1 .  Exclusion  for  Income  Earned  Abroad  (Sec.  1011) 212 

2.  U.S.  Taxpayers  Married  to  Nonresident  Aliens  (Sec.  1012).  215 

3.  Income  of  Foreign  Trusts  and  Transfers  to  Foreign  Trusts 

and  Other  Foreign  Entities  (Sees.  1013-1015) 218 

4.  Amendments    Affecting    Tax    Treatment    of    Controlled 

Foreign    Corporations    and    Their    Shareholders    (Sees. 
1021-1024) 227 


IX 

III.  Greneral  Explanation  of  the  Act — Continued 

I.       Tax  Treatment  of  Foreign  Income — Continued  Page 

5.  Amendments  to  the  Foreign  Tax  Credit  (Sees.  1031-1037) . .       233 

6.  Exclusion  From  Gross  Income  and  From  Gross  Estate  of 

Portfolio    Investments   in   the    United   States   of    Non- 
resident Aliens  and  Foreign  Corporations  (Sec.  1041)  255 

7.  Changes  in  Ruling  Requirements  Under  Section  367  and 

Changes  in  Amounts  Treated  as  Dividends  (Sec.  1042)  _  _  _       256 

8.  Contiguous    Country    Branches    of    Domestic    Insurance 

Companies  (Sec.  1043) 267 

9.  Transitional  Rule  for  Bond,  Etc.,  Losses  of  Foreign  Banks 

(Sec.  1044) 271 

10.  Tax    Treatment    of    Corporations    Conducting    Trade    or 

Business  in  Possessions  of  the  United  States  (Sec.  1051)    _  272 

11.  Western  Hemisphere  Trade  Corporations  (Sec.  1052)  278 

12.  ChinaTrade  Act  Corporations  (Sec.  1053) 280 

13.  Denial  of  Certain  Tax  Benefits  for  Cooperation  With  or 

Participation  in  an  International  Boycott  (Sees.   1061- 

1064,  1066and  1067) 282 

14.  Denial    of    Certain    Tax    Benefits    Attributable   to    Bribe- 

Produced  Income  (Sec.  1065) 288 

J.       Domestic  International  Sales  Corporations  (Sec.  1101) 290 

K.      Administrative  Provisions 301 

1.  Public  Inspection  of  Written  Determinations  by  Internal 

Revenue  Service  (Sec.  1201) 301 

2.  Disclosure  of  Tax  Returns  and  Tax  Return  Information 

(Sec.  1202) 313 

3.  Income  Tax  Return  Preparers  (Sec.  1203) 345 

4.  Jeopardy  and  Termination  Assessments  (Sec.  1204) 356 

5.  Administrative  Summons  (Sec.  1205) 364 

6.  Assessments  in  Case  of  Mathematical  or  Clerical  Errors 

(Sec.  1206) 371 

7.  Withholding  Tax  Provisions 375 

a.  Withholding  of   State   and   District   Income   Taxes 

for  Military  Personnel  (Sec.  1207(a)) 375 

b.  Withholding  State  and   City   Income   Taxes   From 

the   Compensation  of  Members  of  the   National        '•    ' 
Guard  or  the  Ready  Reserve  (Sec.  1207(b)) 377 

c.  Voluntary    Withholding    of    State    Income    Taxes 

From   the   Compensation   of   Federal   Employees 

(Sec.  1207(c)) 378 

d.  Withholding   Tax    on    Certain    Gambling   Winnings 

(Sec.  1207(d)) _       379 

e.  Withholding    of    Federal    Taxes    on    Certain    Indi- 

viduals Engaged  in  Fishing  (Sec.  1207(e)).-      ._.        380 

8.  State-Conducted  Lotteries  (Sec.  1208) 383 

9.  Minimum  Exemption  from  Levy  for  Wages,  Salary,  and 

Other  Income  (Sec.  1209) __' 384 

10.  Joint  Committee  Refund  Cases  (Sec.  1210) 386 

11.  Use  of  Social  Security  Numbers  (Sec.  1211) 387 

12.  Interest  on  Mathematical  Errors  on  Returns  Prepared  by 

IRS  (Sec.  1212) '.       388 

L.     Tax-Exempt  Organizations 390 

1.  Modification  of  Transitional   Rule  for  Sales  of  Property 

by  Private  Foundations  (Sec.  1301) 390 

2.  New  Private  Foundation  Set-Asides  (Sec.  1302) 391 

3.  Reduction  in  Minimum  Distribution  Amount  for  Private 

Foundations  (Sec.  1303) 394 

4.  Extension    of    Time    To    Conform    Charitable    Remainder 

Trusts  for  Estate  Tax  Purposes  (Sec.  1304)       .   _._       _       396 

5.  Income  From  Fairs,  Expositions,  and  Trade  Shows  (Sec. 

1305) 398 

6.  Declaratory    Judgments    as    to    Tax-Exempt    Status"   as 

Charitable,  etc..  Organization  (Sec.  1306)  _  _ 400 

7.  Lobbying  Activities  of  Public  Charities  (Sec.  1307)       _  407 


III.  General  Explanation  of  the  Act — Continued 
L.     Tax-Exempt  Organizations — Continued 

8.  Tax  Liens,  etc.,  Not  to  Constitute  "Acquisition  Indebted-     Puse 

ness"  (Sec.  1308) 416 

9.  Extension  of  private  foundation  transition  rule  for  sale 

of  business  holdings  (Sec.  1309) 418 

10.  Private  foundations  imputed  interest  (Sec.  1310) 420 

11.  Unrelated  Business  Income  from  Services  Provided  by  a 

Tax-exempt   Hospital   to   Other   Tax-exempt   Hospitals 

(Sec.  1311) 421 

12.  Clinical  Services  Provided  to  Tax-Exempt  Hospitals  (Sec. 

1312) 422 

13.  Exemption    of    Certain    Amateur    Athletic    Organizations 

From  Tax  (Sec.  1313) 423 

M.     Capital  Gains  and  Losses 425 

1.  Deduction  of    Capital    Losses  Against  Ordinary    Income 

(Sec.  1401) 425 

2.  Increase  in  Holding  Period  for  Long-Term  Capital  Gains 

(Sec.  1402) 426 

3.  Capital  Loss  Carryover  for  Regulated  Investment  Com- 

panies (Sec.  1403) 427 

4.  Gain  on  Sale  of  Residence  by  Elderly  (Sec.  1404) 428 

N.     Pension  and  Insurance  Taxation 430 

1.  Individual   Retirement  Account   (IRA)   for  Spouse   (Sec. 

1501) 430 

2.  Limitation  on   Contributions  to   Certain   H.R.    10   Plans 

(Sec.  1502) 431 

3.  Retirement    Deductions   for    Members    of    Armed    Forces 

Reserves,    National    Guard   and   Volunteer   Firefighters 

(Sec.  1503) 432 

4.  Tax-Exempt   Annuity    Contracts   in   Closed-End    Mutual 

Funds  (Sec.  1504) 433 

5.  Pension  Fund  Investments  in  Segregated  Asset  Accounts 

of  Life  Insurance  Companies  (Sec.  1505) 433 

6.  Study  of  Salary  Reduction  Pension  Plans  (Sec.  1506) 434 

7.  Consolidated    Returns    for    Life    and    Mutual    Insurance   ^ 

Companies  (Sec.  1507) 435 

8.  Guaranteed    Renewable    Life    Insurance    Contracts    (Sec. 

1508) 438 

9.  Study  of  Expanded  Participation  in  Individual  Retirement 

Accounts  (Sec.  1509) 439 

10.  Taxable  Status  of  Pension  Benefit  Guaranty  Corporation 

(Sec.  1510) 440 

11.  Level   Premium   Plans   Covering  Owner-Employees    (Sec. 

1511) 440 

12.  Lump-Sum  Distributions  From  Pension  Plans  (Sec.  1512)  _  _       441 
O.      Real  Estate  Investment  Trusts 443 

1.  Deficiency  Dividend  Procedure  (Sec.  1601) 445 

2.  Distributions   of   REIT   Taxable   Income   After   Close   of 

Taxable  Year  (Sees.  1604  and  1606) 449 

3.  Property  Held  for  Sale  (Sec.  1603) 451 

4.  Failure  to  Meet  Income  Source  Tests  (Sec.  1602) 452 

5.  Other   Changes   in   Limitation;   and    Requirements    (Sec. 

1604) 453 

P.      Railroad  and  Airline  Provisions 460 

1.  Treatmentof  Certain  Railroad  Ties  (Sec.  1701(a)) 460 

2.  Limitation  on  Use  of  Investment  Tax  Credit  for  Railroad 

Property  (Sec.  1701(b)) 461 

3.  Amortization    of    Railroad    Grading    and    Tunnel    Bores 

(Sec.  1702) 463 

4.  Limitation  on  Use  of  Investment  Tax  Credit  for  Airline 

Property  (Sec.  1703) 465 

Q.      International  Trade  Amendments 468 

1.  United  States  International  Trade  Commission  (Sec.  1801)  _       468 

2.  Trade  Act  of  1974  Amendments  (Sec.  1802) 469 

R.      "Deadwood"  Provisions 470 


XI 

III.  General  Explanation  of  the  Act — Continued  Pajre 

S.      Estate  and  Gift  Taxes 525 

1.  Unified  Rate  Schedule  for  Estate  and  Gift  Taxes;  Unified 

Credit  in  Lieu  of  Specific  Exemptions  (Sec.  2001) 525 

2.  Increase  in  Limitations  on  Marital  Deductions;  Fractional 

Interest  of  Spouse  (Sec.  2002) 532 

3.  Valuation  for  Purposes  of  the  Federal  Estate  Tax  of  Certain 

Real   Property   Devoted  to   Farming  or   Closely   Held 
Business  Use  (Sec.  2003) 536 

4.  Extension  of  Time  for  Payment  of  Estate  Tax  (Sec.  2004)  _ _  .       543 

5.  Carryover  Basis  (Sec.  2005) 551 

6.  Generation-Skipping  Transfers  (Sec.  2006) 564 

7.  Orphans'  Exclusion  (Sec.  2007) 583 

8.  Administrative  Changes  (Sec.  2008) 584 

9.  Miscellaneous  Provisions  (Sec.  2009) 588 

T.      Miscellaneous  Provisions 598 

1.  TaxTreatmentof  Certain  Housing  Associations  (Sec.  2101).       598 

2.  Treatmentof  Certain  Crop  Disaster  Payments  (See.  2102)-.       604 

3.  Tax  Treatment  in  the  Case  of  Certain  1972  Disaster  Loans 

(Sec.  2103) 605 

4.  Tax  Treatment  of  Certain  Debts  Owed  by  Political  Parties 

to  Accrual  Basis  Taxpayers  (Sec.  2104) 607 

5.  Tax-Exempt  Bonds  for  Student  Loans  (Sec.  2105) 608 

6.  Personal  Holding  Company  Amendments  (Sec.  2106) 610 

7.  Work  Incentive    (WIN)    and   Federal   Welfare   Recipient 

Employment  Incentive  Tax  Credits  (Sec.  2107) 613 

8.  ExciseTaxonPartsfor  Light-Duty  Trucks  (Sec.  2108) 614 

9.  Exclusion   From   Manufacturers'   Excise  Tax  for  Certain 

Articles  Resold  After  Modification  (Sec.  2109) .   __       615 

10.  Franchise  Transfers  (Sec.  2110) 616 

11.  Employer's  Duties  to  Keep  Records  and  to  Report  Tips 

(Sec.  2111) 617 

12.  Treatment  of   Certain   Pollution   Control  Facilities   (Sec. 

2112) 619 

13.  Clarification  of  Status  of  Certain  Fishermen's  Organiza- 

tions (Sec.  2113) 621 

14.  Innocent  Spouse  (Sec.  2114) 622 

15.  Rules  Relating  to  Limitations  on  Percentage  Depletion  in 

Case  of  Oil  and  Gas  Wells  (Sec.  2115) 624 

16.  Federal  Collection  of  State  Individual  Income  Taxes  (Sec. 

2116) 628 

17.  Cancellation  of  Certain  Student  Loans  (Sec.  2117) 630 

18.  Simultaneous     Liquidation     of     Parent     and     Subsidiary 

Corporations  (Sec.  2118) 631 

19.  Prepublication  Expenses  (Sec.  2119) 633 

20.  Contributions  to  Capital  of  Regulated  Public  Utilities  in 

Aid  of  Construction  (Sec.  2120) 635 

21.  Prohibition  of  Discriminatory  State  Taxes  on  Production 

and  Consumption  of  Electricity  (Sec.  2121) 638 

22.  Deduction    for    Cost    of    Removing    Architectural    and 

Transportation   Barriers  for  Handicapped  and  Elderly 
Persons  (Sec.  2122) 639 

23.  Reports  on  High-Income  Taxpayers  (Sec.  2123) 640 

24.  Tax  Treatment  of  Certified  Historic  Structures  (Sec.  2124).       643 

25.  Supplemental    Security    Income    for    Victims    of    Certain 

Natural  Disasters  (Sec.  2125) 645 

26.  Net  Operating  Loss  Carryovers  for  Cuban  Expropriation 

Losses  (Sec.  2126) 645 

27.  Outdoor  Advertising  Displays  (Sec.  2127).    .   _        ._   _   _         646 

28.  Tax  Treatment  of  Large  Cigars  (Sec.  2128) 648 

29.  Treatment    of    Gain    from    Sales    or    Exchanges    Between 

Related  Parties  (Sec.  2129) 651 

30.  Application  of  Section  117  to  Certain  Education  Programs 

for  Members  of  the  Uniformed  Services  (Sec.  2130) 654 

31.  Exchange  Funds  (Sec.  2131) _.       _         656 


xn 

III.  Greneral  Explanation  of  the  Act — Continued 
T.      Miscellaneous  Provisions — Continued 

32.  Contributions  of  Certain   Government  Publications   (Sec.     rage 

2132) 667 

33.  Study  of  Tax  Incentives  by  Joint  Committee  (Sec.  2133)  __  667 

34.  Prepaid  Legal  Services  (Sec.  2134) 668 

35.  Certain  Charitable  Contributions  of  Inventory  (Sec.  2135).  672 

36.  Tax  Treatment  of  Grantor  of  Certain  Options  (Sec.  2136).  673 

37.  Exempt-Interest     Dividends     of     Regulated     Investment 

Companies  (Sec.  2137) 678 

38.  Common    Trust   Fund    Treatment   of    Certain    Custodial 

Accounts  (Sec.  2138) 679 

39.  Support    Test   for    Dependent    Children    of    Separated    or 

Divorced  Parents  (Sec.  2139) 680 

40.  Deferral    of    Gain    on    Involuntary    Conversion    of    Real 

Property  (Sec.  2140) 681 

41.  Livestock  Sold  on  Account  of  Drought  (Sec.  2141) 681 


I.  SUMMARY  AND  REASONS  FOR  THE  ACT 

The  Tax  Reform  Act  of  1976  will  serve  six  major  purposes.  First, 
it  will  improve  the  equity  of  the  tax  system  at  all  income  levels  without 
impairing  economic  efficiency  and  gi'owth.  Second,  the  Act  effects  im- 
portant simplifications  of  the  tax  system  by  modifying  certain  deduc- 
tions and  credits  affecting  individuals,  by  increasing  the  standard  de- 
duction to  encourage  taxpayers  to  switch  from  itemizing  their  deduc- 
tions to  using  the  standard  deduction,  and  by  redrafting  complex 
provisions  of  the  tax  law  and  deleting  obsolete  and  little  used  provi- 
sions. Third,  the  Act  extends  the  fiscal  stimulus  provided  by  the  Tax 
Reduction  Act  of  1975  and  extended  by  the  Revenue  Adjustment  Act 
of  1975,  and  makes  permanent  part  of  these  tax  cuts  foi-  individuals. 
Fourth,  the  Act  encourages  capital  formation  by  extending  the  in- 
creased investment  credit  for  four  years,  by  modifying  the  application 
of  the  credit,  by  extending  and  revising  the  incentive  for  investing  in 
employee  stock  ownership  plans,  and  by  liberalizing  the  net  operating 
loss  carryover.  Fifth,  it  improves  the  administration  of  the  tax  laws  by 
making  it  more  efficient  and  strengthening  taxpayers'  rights.  Sixth,  the 
Act  makes  a  major  revision  in  the  estate  and  gift  taxes.  It  reduces  the 
estate  and  gift  tax  for  small-  and  medium-sized  estates  and  at  the  same 
time  eliminates  tax  avoidance  possibilities. 

In  addition,  the  Act  makes  certain  changes  in  the  operation  of  the 
U.S.  International  Trade  Commission  as  well  as  the  withholding  of 
preferential  trade  treatment  for  countries  who  aid  or  abet  interna- 
tional terrorists. 

(1) 


A.  TAX  REVISION 

While  no  one  contends  that  our  income  tax  system  does  not  need 
improving,  it  is  still  widely  acknowledged  to  be  the  best  in  the  world. 
The  difficulty  faced  in  improving  the  system  is  that  the  American 
people  want  different  things  from  their  tax  system.  On  the  one  hand, 
they  want  every  individual  and  corporation  to  pay  a  fair  share  of 
the  overall  income  tax  burden.  In  a  system  that  depends  heavily  on 
voluntary  compliance  with  the  tax  laws,  as  ours  does,  tax  equity  is 
especially  important.  However,  at  the  same  time,  Americans  do  not 
want  the  income  tax  system  to  interfere  with  economic  efficiency  and 
growth.  This  implies  that  tax  changes  to  promote  equity  should  not 
retard  either  the  current  recovery  from  what  has  been  the  worst  reces- 
sion since  the  1930's  or  impede  the  long-run  growth  of  the  economy.  The 
tax  revisions  in  the  Act  represent  a  careful  balance  between  these  some- 
times conflicting  objectives. 

The  Act  contains  many  tax  revisions,  described  in  more  deta,il  below, 
designed  to  eliminate  tax  abuses  and  make  the  tax  system  more  equi- 
table. 

Tax  shelter  provisions 

Congress  believed  that  changes  were  needed  to  end  the  excessive  tax 
deferrals  provided  by  tax  shelters,  as  well  as  the  opportunity  they 
provide  to,  in  effect,  convert  ordinary  income  into  capital  gains. 
Too  many  investments  have  been  motivated  by  excessive  con- 
cern with  the  tax  benefits  associated  with  them,  not  their  economic 
merits.  In  some  cases,  the  manner  in  which  the  tax  shelters  were  con- 
trived was  questionable  even  under  prior  law.  In  others,  individuals 
were  combining  provisions  of  the  law,  or  leveraging  them  through  non- 
recourse borrowings,  in  a  way  which  multiplied  severalfold  any 
possible  advantages  intended  by  Congress.  Such  activities  reduce 
citizens'  respect  for  the  income  tax  and  represent  an  inefficient  alloca- 
tion of  resources.  The  Act  contains  a  number  of  provisions  designed  to 
curb  these  abuses  without  interfering  with  economically  worthwhile 
investments. 

The  Act  expands  the  use  of  the  so-called  "recapture"  rules  to  prevent 
conversion  of  ordinary  income  into  capital  gains  in  the  case  of  real 
estate,  oil  and  gas  drilling  and  sports  franchises.  For  oil  and  gas  drill- 
ing, farm  operations,  equipment  leasing,  and  film  purchases  and  pro- 
duction, losses  from  accelerated  deductions  are  limited  to  the  amount 
for  which  the  individual  is  "at  risk."  This  is  designed  to  prevent 
leveraging  of  tax  shelter  benefits  through  the  use  of  nonrecourse  loans. 
There  is  also  an  "at  risk"  rule  for  limited  partnerships  in  areas  not 
specifically  dealt  with  by  the  Act,  which  should  discourage  develop- 
ment of  new  leveraged  tax  shelters.  In  addition,  in  the  case  of  farm 
syndicates  (or  passive  farm  partnerships)  and  motion  picture  produc- 
tion companies  (and  companies  producing  books,  records,  etc.), 
certain  costs  are  required  to  be  capitalized  and  written  off  over  the 

(2) 


productive  period  of  the  related  assets,  or  the  writeoff  is  delayed  until 
the  items  involved  are  used.  For  real  estate,  the  Act  also  requires 
capitalization  of  interest  and  taxes  during  the  construction  period. 

The  provisions  relating  to  various  deductions  and  exclusions  in 
the  case  of  partnerships  are  tightened  so  that  the  deductions  or  ex- 
clusions cannot  be  allocated  among  the  various  partnei*s  according  to 
whomever  can  maximize  the  tax  benefits  unless  such  allocation 
has  substantial  economic  effect.  Also,  limits  are  placed  on  the  amount 
of  "bonus"  first-year  depreciation  deductions  of  the  partners.  The 
Act  requires  prepaid  interest  to  be  deducted  over  the  period  to  which 
it  relates  and  requires  use  of  accrual  accounting  by  many  farm  corpo- 
rations. Also,  it  tightens  the  existing  limit  on  deductions  of  excess 
investment  interest. 

Minimum  and  maximum  taxes 

Congress  believed  that  high-income  people  and  corporations  should 
not  be  able  completely  to  escape  liability  for  income  tax.  Prevent- 
ing this  is  a  major  feature  of  the  Act.  It  greatly  reduces  the  incidence 
of  tax  avoidance  by  high-income  people  through  two  related  provi- 
sions— a  stiffer  minimum  tax  on  tax-preferred  income  and  a  revision 
in  the  maximum  tax  designed  to  discourage  use  of  tax  preferences. 

Mininiufn  fax 

The  prior  minimum  tax  for  individuals  was  inadequate.  In  1974  it 
raised  only  $130  million,  down  from  $182  million  in  1973,  which  is 
only  a  small  fraction  of  total  tax-preferred  income.  Also,  the  minimum 
tax  for  individuals  was  largely  a  tax  on  one  preference — the  excluded 
half  of  capital  gains.  The  Act  amends  the  minimum  tax  both  to  in- 
crease its  revenue  yield  and  to  broaden  the  tax  preferences  covered 
by  it. 

The  Act  raises  the  minimum  tax  rate  from  10  percent  to  15  percent. 
In  place  of  the  existing  $30,000  exemption  and  the  deduction  for  regu- 
lar income  taxes,  the  Act  has  an  exemption  for  individuals  equal  to 
one-half  of  regular  income  taxes  or  $10,000,  whichever  is  greater.  These 
changes  reflect  Congress'  view  that  the  effective  tax  rate  on  tax  pref- 
erences should  be  higher. 

Two  new  minimum  tax  preferences  are  added.  To  reduce  the  tax 
benefit  of  shelters  in  oil  and  gas  drilling  and  to  ensure  that  oil  drillers 
pay  some  minimum  income  tax,  the  Act  adds  a  preference  for  intangi- 
ble drilling  costs.  To  impose  some  tax  in  cases  where  there  is  excessive 
use  of  itemized  personal  deductions,  there  is  a  new  preference  for  item- 
ized deductions  (other  than  medical  expenses  and  casualty  losses)  in 
excess  of  60  percent  of  adjusted  gross  income. 

Congress  also  believed  that  the  minimum  tax  on  corporations  should 
be  strengthened  in  order  to  raise  the  effective  tax  rate  on  corporate  tax 
preferences.  However,  because  corporate  income  is  subject  to  both  the 
individual  and  corporate  income  taxes,  Congress  felt  it  was  appropriate 
to  retain  in  full  the  deduction  for  regular  taxes  for  corporations. 

Mammum  tax 
In  1969,  Congress  enacted  a  50-percent  maximum  marginal  tax  rate 
on  income  from  personal  services.  To  reduce  the  incentive  to  invest  in 
tax  shelters,  the  law  provided  that  income  eligible  for  this  maximum 


rate  be  reduced  by  tax  preferences  (as  defined  under  the  minimum 
tax)  in  excess  of  $30,000.  The  Act  extends  this  50-percent  maximum 
rate  to  deferred  compensation  (including  pensions  and  annuities). 

The  "  preference  offset"  in  the  maximum  tax  has  not  l)cen  as  effective 
in  discouraging  investment  in  tax  shelters  as  originally  planned.  The 
expanded  list  of  minimum  tax  preferences  will  make  the  preference 
offset  more  effective.  Also,  the  Act  repeals  the  existing  $30,000  floor 
on  preferences  that  reduce  personal  service  income  eligible  for  the 
maximum  tax. 

Business  expenses  under  the  individual  income  tax  law 

Many  individuals  are  now  claiming  deductions  for  the  business  use 
of  their  home,  for  expenses  related  to  the  rental  of  their  vacation 
homes  for  a  brief  part  of  the  year,  or  for  expenses  of  attending  foreign 
conventions.  While  in  theory  there  is  nothing  wrong  with  appropriate 
deductions  for  business  or  investment  expenses,  in  ])ractice  it  is  often 
extremely  difficult  to  allocate  between  deductible  business  expenses 
and  nondeductible  personal  expenses.  The  result  is  that  many  people 
have  been  deducting  amounts  as  business  expenses  which  in  part 
actually  represent  personal  expenses.  To  deal  with  this  problem,  the 
Act  places  strict  limitations  on  these  deductions. 

The  Act  also  repeals  the  special  tax  treatment  for  qualified  stock 
options.  With  personal  service  income  subject  to  a  maximum  rate  of 
50  percent.  Congress  decided  that  there  is  no  reason  for  not  taxing 
this  form  of  compensation  as  ordinary  income. 

Tax  treatment  of  foreign  income 

The  Act  makes  several  important  changes  in  the  tax  treatment  of 
forei.^rn  i'^come.  Congress  believed  that  it  is  necessary  to  strike  a  deli- 
cate b'hince  between  encouraging  the  free  flow  of  capital  across  na- 
tional b-^rders  and  making  sure  that  the  tax  laws  do  not  provide  exces- 
siv^e  incentives  for  foreign  investment  instead  of  investment  in  the 
United  States.  Congress  decided  to  retain  the  basic  structure  of  the 
taxation  of  foreign  income— namely,  a  foreign  tax  credit  for  income 
earned  abroad  and  deferral  of  tax  on  income  of  foreign  subsidiaries 
(except  in  the  case  of  "tax  haven"  income)  until  returned  to  this 
country.  However,  the  Act  eliminates  virtually  all  other  tax-related 
incentives  for  investment  abroad. 

An  important  change  made  by  the  Act  is  the  repeal  of  the  per- 
country  limitation  on  the  foreign  tax  credit.  The  per-country  limit 
enables  a  firm  with  a  loss  in  one  country  and  a  profit  in  another  to 
deduct  the  loss  against  U.S.  income  and  still  avoid  U.S.  tax  on  the 
profit  through  the  foreign  tax  credit.  Its  repeal  will  eliminate  this 
possibility  and  will  also  greatly  shnplify  this  part  of  the  tax  law.  The 
Act  also  provides  for  recapture  of  foreign  losses  deducted  from  U.S. 
income  when  foreign  profits  are  earned  in  subsequent  years. 

The  Act  repeals  numerous  tax  incentives  which  favor  investment 
in  some  foreign  areas  over  others— those  which  favor  investment  in 
less-developed  country  corporations,  China  Trade  Act  corporations 
and  Western  Hemisphere  trade  corporations.  It  also  substantially  re- 
vises and  improves  the  tax  provisions  relating  to  U.S.  possessions.  Ex- 
cept in  the  case  of  U.S.  possessions,  Congress  felt  that  there  was  no 
longer  any  good  reason  for  favoring  investment  in  one  of  these 
foreign  areas  over  another. 


The  Act,  while  retaining  an  exchision  for  income  earned  abroad  by 
individuals,  eliminates  special  features  of  this  provision  enabling  those 
with  income  above  the  basic  exemption  levels  to  obtain  additional  tax 
benefits  from  the  exclusion  and  reduces  the  maximum  amounts  eligible 
for  the  exclusion.  Congress  did  not  feel  that  the  tax  preference  for 
income  earned  abroad  should  be  as  large  as  it  was  under  prior  law. 

Another  area  of  concern  is  the  DISC  provision  that  permits  defer- 
ral of  tax  for  one-half  of  export  income.  To  make  this  incentive  more 
efficient,  the  Act  limits  DISC  treatment  to  the  excess  of  a  firm's  exports 
above  a  moving  base  period  level. 

Congress  did  not  believe  that  multinational  corporations  should 
benefit  from  tax  incentives  when  they  engage  in  misconduct.  Thus, 
the  Act  denies  the  foreign  tax  credit,  tax  deferral,  and  DISC  treat- 
ment for  income  earned  in  connection  with  participation  in  interna- 
tional boycotts,  such  as  the  Arab  boycott  o,f  Israel.  Similarly,  it  pro- 
vides that  amounts  paid  as  bribes  by  foreign  subsidiaries  will  be  taxed 
to  the  U.S.  parent  corporation. 

To  eliminate  the  possibility  that  oil  companies  which  operate  abroad 
gain  undue  advantage  from  the  characterization  of  their  payments 
to  foreign  governments  as  creditable  taxes,  the  Act  further  limits  the 
extent  to  which  foreign  tax  credits  from  oil  extraction  can  be  used 
while  continuing  the  requirement  that  these  taxes  may  not  reduce  the 
tax  on  other  foreign  oil  income. 

The  Act  also  makes  several  technical  corrections  that  were  consid- 
ered necessary  resulting  from  the  changes  in  the  taxation  of  foreign 
income  made  by  the  Tax  Reduction  Act  of  1975. 

Capital  gains  and  losses 

The  Act  makes  three  important  changes  in  the  tax  treatment  of 
capital  gains  and  losses.  The  holding  period  defining  long-term  capital 
gains,  which  receive  preferential  tax  treatment,  is  raised  (over  a  period 
of  two  years)  from  six  months  to  one  year.  This  should  encourage 
longer  term  investments  as  contrasted  to  short-term  speculative  invest- 
ments. Also,  the  Act  (over  a  period  of  two  years)  increases  the  amount 
of  ordinary  income  against  which  capital  losses  can  be  deducted  from 
$1,000  to  $3,000.  This  change  is  designed  to  provide  relief  to  those  who 
have  capital  losses  in  excess  of  capital  gains,  which  is  not  only  fair  but 
also  should  encourage  individuals  to  make  equity  investments.  Finally, 
the  Act  increases  the  exemption  level  for  capital  gains  on  the  sale  of  a 
principal  residence  by  a  taxpayer  age  65  or  over. 

Other  tax  revisions 

The  Act  makes  a  large  number  of  other  relatively  minor  revisions 
in  the  tax  law.  These  deal  with  inequities  or  technical  problems  that 
have  come  to  the  attention  of  the  Congress. 

There  are  several  provisions  relating  to  tax-exempt  organizations. 
Among  these  is  one  which  sets  the  payout  requirement  (if  larger  than 
actual  earnings)  for  foundations  at  5  percent  of  asset  value  (instead 
of  a  minimum  of  6  percent)  and  provides  that  this  limit  is  not  to  be 
varied  as  interest  rates  generally  change.  A  second  provision  sets  up 
a  court  review  procedure  where  the  IRS  holds  that  an  organization 
does  not  qualify  for  exempt  status.  A  third  change  makes  more  specific 
the  rules  for  lobbying  by  charitable  and  educational  organizations. 


234-120   O  -  77  -  2 


6 

The  Act  includes  a  number  of  provisions  relating  to  pensions.  Prob- 
ably the  most,  important  of  these  is  one  which  expands  the  existing 
provision  for  individual  retirement  accounts  (IRAs)  to  permit  a  work- 
ing spouse  to  set  up  an  IRA  for  a  nonworking  spouse.  This  change 
recognizes  the  contributions  to  the  family  made  by  nonworking 
spouses.  If  an  IRA  is  set  up  for  both  spouses,  a  $1,750  contribution 
limit  applies.  Contributions  can  be  made,  subject  to  that  limit,  to  a 
single  IRA  with  separate  subaccounts  or  two  separate  IRAs.  Another 
pension  provision  permits  an  amount  of  up  to  $750  to  be  set  aside  each 
year  in  an  H.R.  10-type  plan  where  income  is  $15,000  or  under  without 
the  amount  set  aside  being  limited  to  25  percent  of  an  individual's 
earnings. 

There  also  are  a  number  of  changes  relating  to  the  taxation  of 
insurance  companies.  Among  these  is  one  which,  after  a  period  of  five 
years,  will  permit  casualty  insurance  companies  to  file  consolidated 
returns  with  life  insurance  companies  but  in  a  manner  which  does 
not  permit  the  losses  of  the  casualty  companies  to  remove  more  than  a 
limited  amount  of  the  life  insurance  income  .from  taxation. 

There  are  technical  changes  in  the  tax  treatment  of  real  estate  invest- 
ment trusts,  housing  cooperatives  and  condominiums,  certain  franchise 
transfers,  authors  and  publishers,  creditors  of  political  parties,  sub- 
chapter S  corporations,  the  work  incentive  (WIN)  tax  credit,  personal 
holding  companies,  oil  and  gas  producers,  losses  from  disasters,  simul- 
taneous liquidation  of  parent  and  subsidiary  corporations,  gain  from 
sales  or  exchanges  between  related  parties,  and  deductions  for  remov- 
ing architectural  and  transportation  barriers  for  handicapped  and 
elderly  people. 

The  Act  makes  revisions  in  depreciation  rules  designed  to  encourage 
rehabilitation  of  historic  structures. 

Several  tax  provisions  that  have  recently  expired  are  extended  in 
the  Act.  These  include  rapid  amortization  provisions  for  pollution  con- 
trol facilities  and  rehabilitated  low-income  housing.  Pollution  control 
facilities  are  also  given  half  of  the  normal  investment  credit,  which 
differs  from  the  prior  provision  under  which  5-year  amortization  was 
an  alternative  to  the  investment  credit.  Congress  believed  that  since 
Federal  re^ilations  require  installation  of  pollution  contix>l  equipment, 
it  is  equitable  to  reduce  the  cost  of  capital  for  sii.l.  equipment.  Also,  the 
exclusion  from  income  for  certain  forgiven  student  loans  is  extended 
through  1978.  Further,  the  Act  extends  for  a  limited  period  the  exclu- 
sion for  certain  health -related  scholarships  for  members  of  the  uni- 
formed services  for  those  participating  in  1976. 

Tax  exemption  is  provided  for  contributions  by  employers  to  quali- 
fied group  legal  services  plans,  designed  to  encourage  use  of  this  fringe 
benefit. 

To  broaden  the  market  for  State  and  local  government  bonds,  mutual 
funds  are  allowed  to  pass  through  tax-exempt  interest  on  such  bonds 
to  shareholders. 

Also,  the  Act  redefines  income  or  loss  from  writing  options  as  short- 
term  capital  gain  or  loss  in  order  to  limit  the  tax  shelters  that  have 
developed  in  recent  years  in  stock  option  hedges. 

In  addition,  the  Act  makes  certain  small  changes  in  the  excise  tax 
treatment  of  truck  modifications  and  truck  parts  and  accessories,  and 
simplifies  and  revises  the  excise  tax  treatment  of  cigars. 


B.  TAX  SIMPLIFICATION 

Tax  simplification  is  the  second  major  goal  of  the  Act.  Simplifi- 
cation must  be  an  ongoing  process,  and  the  individual  provisions  of  the 
tax  law  must  be  reexamined  periodically  to  see  how  they  contribute 
to  the  complexity  of  the  tax  law.  Unless  this  reexamination  occurs,  the 
tax  law  will  grow  gradually  more  complicated  as  new  provisions  are 
added  to  achieve  new  goals  of  society.  The  Act  repeals  or  restructures 
several  provisions  of  the  tax  lav,',  and  directs  that  a  Congressional 
study  be  made  regarding  further  simplification  of  the  tax  system. 

One  such  provision  concerns  the  use  of  the  income  tax  tables.  The 
Act  eliminates  the  existing  tax  tables  based  on  adjusted  gross  income, 
which  have  been  a  major  source  of  taxpayer  error,  and  substitutes  a 
simpler  set  of  tables  based  on  taxable  income.  It  also  raises  to  $20,000 
the  taxable  income  level  where  these  tax  tables  may  be  used. 

A  second  simplification  concerns  the  retirement  income  credit.  This 
was  originally  designed  to  give  those  who  retire  without  social  security 
a  tax  benefit  similar  to  that  accorded  social  security  benefits.  As  a 
result,  eligibility  for  the  credit  and  its  computation  were  designed  to 
follow  as  closely  as  possible  eligibility  for,  and  computation  of,  social 
security  benefits.  This  required  a  complex  form  that  filled  a  whole 
page,  and  it  is  estimated  that  a  large  fraction  of  the  people  eligible 
for  the  credit  either  did  not  claim  it  or  made  errors  in  computing  it. 
In  response  to  this  problem,  Congress  restructured  the  credit  to  elimi- 
nate virtually  all  the  complexity,  even  though  this  means  breaking 
the  close  link  between  the  retirement  income  credit  and  social  security 
eligibility.  This  new  credit  for  the  elderly  also  will  be  fairer  than  the 
retirement  income  credit  under  prior  law  since  it  will  also  be  applicable 
to  earned  income  for  taxpayers  age  65  or  over. 

Another  complicated  provision  has  been  the  sick  pay  exclusion.  In 
this  case.  Congress  concluded  that  the  exclusion  should  be  allowed  only 
for  persons  who  are  permanently  and  totally  disabled,  since  for  other 
people  there  is  no  reason  why  sick  pay  should  be  treated  more  favorably 
than  wage  income,  particularly  in  view  of  the  deductibility  of 
medical  and  drug  expenses.  For  those  still  eligible  for  the  sick  pay 
exclusion,  the  provision  has  been  considerably  simplified  and  coordi- 
nated with  the  new  credit  for  the  elderly. 

The  Act  makes  major  changes  in  the  treatment  of  child  and  depend- 
ent care  expenses.  Formerly,  these  were  allowed  as  an  itemized  deduc- 
tion, subject  to  some  complicated  limitations.  The  Act  converts  the 
deduction  into  a  20-percent  credit,  so  that  it  will  be  available  to  those 
who  use  the  standard  deduction  as  well  as  to  itemizers  and  so  that  it 
will  provide  the  same  tax  relief  to  taxpayers  in  low  brackets  as  to  those 
in  high  brackets.  The  child  care  deduction  in  prior  law  was  worth, 
for  exampV,  70  cents  for  each  dollar  of  child  care  expenses  for  a  tax- 
payer in  the  70-percent  bracket,  but  only  14  cents  to  a  low-bracket  tax- 
payer who  itemized  deductions  and  nothing  to  someone  who  used  the 
standard  deduction.  The  new  credit  will  be  worth  20  cents  for  each  dol- 
lar of  qualified  child  care  expenses  for  all  taxpayers.  In  addition,  the 
Act  significantly  simplifies  the  child  care  provision  and  broadens  eli- 
gibility for  it. 

The  Act  makes  several  other  changes  that  will  simplify  the  law  or 
make  it  more  equitable,  including  a  revision  of  the  rules  relating  to 


8 

accumulation  trusts  and  the  moving  expense  deduction.  The  alimony 
deduction  is  moved  from  an  itemized  deduction  to  a  deduction  in  deter- 
mining adjusted  gross  income,  so  that  it  can  be  used  by  people  who 
take  the  standard  deduction. 

There  are  some  cases  where  it  is  possible  to  achieve  tax  simplifica- 
tion without  changing  the  substance  of  the  law.  The  Act  includes  the 
so-called  "deadwood  provisions"  which  deletes  obsolete  and  rarely  used 
parts  from  the  Internal  Revenue  Code  and  makes  many  other  changes 
to  shorten  and  simplify  the  language  of  the  Code. 

These  provisions  are  only  the  beginning  of  what  must  be  a  continual 
process  of  tax  simplification.  Congress  plans  further  tax  simplication 
measures  and  has  directed  the  Joint  Committee  on  Taxation  to  conduct 
a  comprehensive  study  of  ways  to  simplify  the  tax  system  (with  a  le- 
port  to  the  House  "Ways  and  Means  and  Senate  Finance  Committees 
due  by  June  30, 1977).  ' 

C.  EXTENSION  OF  TAX  REDUCTIONS 

Economic  conditions 

A  third  major  purpose  of  the  Tax  Reform  Act  of  1976  is  to  ex- 
tend the  fiscal  stimulus  provided  by  the  Tax  Reduction  Act  of  1975 
and  subsequently  extended  for  the  first  half  of  1976  by  the  Revenue 
Adjustment  Act  of  1975.  The  Tax  Reduction  Act  of  1975  provided  a 
tax  cut,  a  tax  rebate  and  increased  expenditures  totaling  $23  billion  in 
1975.1 

The  1975  tax  cut  included  a  temporaiy  increase  in  the  standard 
deduction  and  a  $30  nonrefundable  tax  credit  for  each  taxpayer  and 
dependent,  which  reduced  tax  liability  by  $8  billion  and  was  reflected 
in  lower  withheld  and  estimated  tax  payments  over  the  last  8  months 
of  1975.  There  was  also  an  earned  income  credit  involving  $1.4  billion 
and  a  home  purchase  credit  amounting  to  about  $0.6  billion.  Finally, 
there  were  business  tax  reductions — an  increase  in  the  investment  tax 
credit  and  a  corporate  rate  cut  for  small  businesses — amounting  to  $5 
billion. 

The  1975  increase  in  the  standard  deduction  and  the  $30  credit,  which 
reduced  tax  liability  by  $8  billion,  were  reflected  in  lower  withheld 
and  estimated  tax  payments  over  the  last  8  months  of  1975  at  the 
rate  of  $1  billion  per  month,  or  $12  billion  per  year.  In  the  Revenue 
Adjustment  Act  of  1975,  Congress  decided  to  extend  these  same  with- 
holding rates  for  the  first  half  of  1976  and  to  provide  a  cut  in  tax  lia- 
bility for  1976  approximately  equal  to  this  $6  billion  reduction  in  with- 
holding. Also,  that  Act  extended  the  small  business  tax  cuts  and  the 
earned  income  credit  for  the  first  half  of  1976.  (The  increase  in  the 
investment  credit  had  been  put  into  effect  for  1975  and  1976  in  the 
Tax  Reduction  Act.) 

Congress  analyzed  economic  conditions  again  in  1976  and  believed 
it  was  inappropriate  to  withdraw  the  economic  stimulus  provided  by 
the  1975  tax  reductions.  Due  in  no  small  part  to  the  1975-76  tax  reduc- 


1  This  included  a  rebate  on  1974  individual  Income  taxes  of  $8.1  billion  plus  a  $50  one- 
time .payment  to  social  security  recipients  and  increased  unemployment  compensation 
amounting  to  $2  billion. 


9 

tions,  there  has  been  an  overall  economic  recovery  from  the  1974-75 
recession  in  the  past  18  months.  Output  has  grown  at  a  rate  of  more 
than  6  percent,  and  we  have  exceeded  the  level  of  income  and  produc- 
tion that  existed  at  the  end  of  1973,  prior  to  the  recession.  Since  then, 
however,  the  capacity  of  the  economy  has  grown  and  will  continue  to 
grow,  and  the  economic  forecasts  examined  by  Congress  indicated 
that  there  is  likely  to  be  excess  capacity  in  the  economy  for  at  least 
the  next  year.  While  the  unemployment  rate  had  fallen  from  9  percent 
to  7.8  percent  (at  the  time  of  passage  of  the  Tax  Reform  Act),  the 
existing  unemployment  rate  was  still  considered  to  be  unacceptably 
high.  For  these  reasons.  Congress  agreed  to  extend  the  existing  tax 
cuts  at  least  through  1977  and  to  make  part  of  the  tax  cuts  permanent. 

Congress  did  not  believe  that  a  permanent  extension  of  the  entire 
$20  million  in  tax  reductions  then  in  effect  was  appropriate.  There 
was  imcertainty  about  just  how  much  excess  capacity  there  was  (or  was 
likely  to  be)  in  the  economy,  how  serious  the  inflation  problem  would 
be  in  the  years  ahead,  as  well  as  what  budgetary  requirements  would  be 
necessary  for  the  rest  of  the  decade. 

In  view  of  the  uncertain  economic  and  budgetary  situation,  Congress 
agreed  to  make  part  of  the  $20  billion  tax  reduction  permanant  but 
to  extend  the  rest  only  temporarily.  This  will  afford  Congress  and 
the  Administration  an  opportunity  in  1977  to  review  economic 
conditions  and  the  fiscal  requirements  to  see  what,  if  any,  further 
extensions  or  enlargements  of  these  tax  cuts  should  be  made. 

Individual  tax  reductions 

The  Act  makes  permanent  $4  billion  of  individual  tax  reductions. 
These  result  from  the  increases  in  the  standard  deduction.  The  Act 
extends  through  1977  the  general  tax  credit  adopted  in  the  Revenue 
Adjustment  Act  and  the  earned  income  credit,  which  together  involve 
a  tax  cut  of  $11  billion  for  1977. 

The  Act  permanently  increases  the  minimum  standard  deduction 
(or  low-income  allowance)  from  $1,300  to  $1,700  for  single  returns 
and  to  $2,100  for  joint  returns.  It  increases  the  percentage  standard 
deduction  from  15  percent  to  16  percent.  Also,  it  increases  the  maxi- 
mum standard  deduction  from  $2,000  to  $2,400  for  single  returns  and 
to  $2,800  for  joint  returns.  This  will  reduce  tax  liability  at  an  annual 
rate  of  $4.2  billion  for  1977,  and  will  lower  budget  receipts  in  fiscal 
year  1977  by  $4.1  billion.  This  increase  in  the  standard  deduction  rep- 
resents a  major  simplification  of  the  individual  income  tax,  since  it 
will  make  it  worthwhile  for  filers  of  9  million  tax  returns  to  switch  to 
the  standard  deduction.  Also,  this  change  creates  greater  tax  equity, 
since  itemized  deductions  have  been  free  to  rise  with  inflation,  while 
the  minimum  and  maximum  standard  deductions  stay  constant  unless 
there  is  specific  legislative  action. 

There  is  also  an  extension  of  the  earned  income  credit  through  1977. 
This  is  a  refundable  credit  equal  to  10  percent  of  the  first  $4,000  of 
earnings,  with  a  phaseout  as  income  rises  between  $4,000  and  $8,000. 
It  is  available  only  to  people  with  dependent  children.  It  involves  a 
cut  in  tax  liability  in  1977  at  a  rate  of  $1.3  billion,  and  a  reduction  in 
fiscal  year  1977  budget  receipts  of  $0.7  billion.  The  earned  income 
credit  provides  a  work  incentive  for  those  with  jobs  that  pay  relatively 


10 

low  wages.  It  provides  desperately  needed  tax  relief  to  a  hard-pressed 
group,  who  are  faced  with  high  food  and  energy  prices  and  are  sub- 
ject to  the  payroll  tax. 

The  Act  extends  through  1977  the  general  tax  credit  for  individuals 
adopted  in  the  Revenue  Adjustment  Act,  which  reduces  tax  liability  in 
1977  at  an  annual  rate  of  $10.1  billion.  The  extension  of  this  credit  will 
reduce  fiscal  year  1977  receipts  by  $9.5  billion.  This  credit  equals  the 
greater  of  $35  for  each  taxpayer  and  dependent  or  2  percent  of  the 
first  $9,000  of  taxable  income. 

Together,  the  individual  tax  cuts  amount  to  a  cut  in  tax  liability  in 
1977  at  an  annual  rate  of  $15.6  billion.  They  will  reduce  budget  receipts 
in  fiscal  year  1977  by  $14.4  billion. 

Business  tax  reductions 

In  order  to  provide  sufficient  economic  stimulus  and  to  encourage 
businesses  to  invest,  the  Act  extends  the  business  tax  cuts  provided  by 
the  Tax  Reduction  Act  of  1975.  These  reduce  tax  liability  in  1977  at  an 
annual  rate  of  $5.4  billion  and  will  reduce  tax  receipts  in  fiscal  year 
1977  by  $3.0  billion. 

As  discussed  later  under  Capital  Fcnvnation,  the  Act  extends 
through  1980  the  current  10-percent  investment  credit  (applicable 
previously  through  1976).  This  represents  an  increase  from  the 
previous  7-percent  rate  for  most  businesses  and  from  the  4-percent 
rate  for  public  utilities.  These  changes  will  reduce  tax  liability  by  $3.3 
billion  in  1977,  and  will  lower  budget  receipts  by  $1.3  billion  in  fiscal 
year  1977. 

The  investment  credit  has  proven  an  effective  way  to  stimulate  in- 
vestment in  equipment.  Its  enactment  in  1962  and  its  reenactment  in 
1971  were  followed  by  investment  booms,  and  its  suspension  in  1966 
and  repeal  in  1969  were  followed  by  sharp  declines  in  investment. 
Increased  investment  in  the  U.S.  economy  is  needed  to  improve  our 
standard  of  living  and  to  achieve  energy,  environmental  and  other 
goals ;  and  under  these  circumstances.  Congress  believed  an  extension 
of  the  10-percent  investment  credit  was  appropriate.  The  credit  for 
utilities  is  increased  to  the  same  rate  as  that  for  other  businesses  because 
Congress  believed  they  should  be  able  to  compete  for  capital  on  the 
same  basis  as  other  industries. 

The  Act  also  extends  through  1977  the  small  business  tax  cuts  enacted 
in  1975.  These  increase  the  corporate  surtax  exemption  from  $25,000  to 
$50,000  and  reduce  the  tax  rate  on  the  initial  $25,000  of  corporate 
income  from  22  percent  to  20  percent.  The  reduction  in  tax  liability  is 
$2.1  billion  in  1977,  and  the  reduction  in  budget  receipts  is  $1.7  billion 
in  fiscal  year  1977.  This  change  will  improve  the  competitive  position 
of  small  business, 

D.  CAPITAL  FORMATION 

A  fourth  major  aspect  of  the  Act  is  the  encouragement  of  capital 
formation  through  the  continuation  and  modification  of  certain  in- 
vestment-related tax  incentives.  Congress  was  concerned  that  the  U.S. 
economy  faced  a  severe  shortage  of  capital.  In  1973  and  early  1974, 
there  were  capacity  shortages  in  many  majoi-  industries  because  invest- 
ment in  them  had  been  inadequate  in  the  previous  five  years.  Also,  the 


11 

growth  rate  of  labor  productivity  has  slowed,  again  partly  because  of 
inadequate  capital  investment.  We  have  had  the  most  success  in  stim- 
ulating capital  investment  in  recent  years  by  the  use  of  the  investment 
tax  credit.  There  appears  to  be  a  close  correlation  since  1962  between 
the  presence  of  the  investment  credit  and  purchases  of  equipment.  As 
a  result,  the  Act  extends  the  10-percent  investment  credit  for  four 
years  (or  through  1980). 

The  Act  extends  and  expands  a  provision  enacted  in  1975  allowing 
an  additional  one- percent  investment  credit  if  an  equivalent  amount 
is  placed  in  an  employee  stock  ownership  plan.  These  changes  should 
significantly  increase  the  extent  to  which  the  provision  is  used  by 
business.  Under  the  new  law,  a  credit  of  an  additional  one-half  per- 
centage point  is  also  allowed  if  it  is  matched  with  employee  contribu- 
tions. This  option  is  considered  desirable  in  order  to  broaden  em- 
ployees ownership  in  business  and  thereby  increase  their  interest  in 
improving  productivity.  It  will  also  serve  the  twin  goals  of  increasing 
capital  accumulation  and  creating  a  more  equal  distribution  of 
wealth.  To  make  the  investment  credit  available  to  less  profitable  busi- 
nesses, the  Act  makes  it  available  on  a  first-in,  first-out  basis. 

Another  provision  to  promote  capital  accumulation,  which  will  be 
especially  important  for  new  business,  is  one  that  extends  the  net 
operating  loss  carryforward  period  to  7  years.  By  allowing  more  flexi- 
bility in  averaging  profits  and  losses,  this  will  encourage  risktaking. 
It  will  also  encourage  investment  in  new  businesses.  The  Act  tightens 
the  existing  rules  to  prevent  "trafficking"  in  losses  in  order  to  reduce 
any  tax  incentives  toward  business  mergers.  In  addition,  the  capital 
loss  carryover  period  for  mutual  funds  is  extended  from  5  years  to 
8  years. 

For  railroads  and  airlines,  industries  which  have  had  trouble  gener- 
ating internal  funds  as  a  result  of  the  recession,  the  Act  provides  (for 
a  limited  period  of  time)  a  tax  reduction  through  changes  in  the 
investment  credit  and  in  amortization  rules.  For  similar  reasons,  at 
least  half  investment  credit  is  made  available  to  the  domestic  merchant 
marine  for  funds  withdrawn  from  their  tax-deferred  ship  construc- 
tion fund  to  purchase  ships. 

Finally,  the  Act,  in  order  to  encourage  domestic  production,  makes 
the  investment  credit  available  in  the  future  for  motion  picture  pro- 
ductions only  where  they  are  predominantly  American-produced  films. 
For  the  past,  a  compromise  between  the  Internal  Revenue  Service  and 
the  industry  is  worked  out  as  to  the  appropriate  investment  credit 
intended  under  the  relatively  uncertain  provisions  of  prior  law. 

E.  ADMINISTRATIVE  PROVISIONS 

A  fifth  major  goal  of  the  Act  is  to  improve  the  administration  of  the 
tax  laws.  It  contains  several  provisions  to  improve  efficiency  of  tax 
administration  through  changes  in  withholding  provisions  and  better 
regulation  of  tax  return  preparers.  It  also  makes  significant  admin- 
istrative changes  designed  to  strengthen  taxpayers'  rights. 

The  Act  provides  definitive  rules  relating  to  the  confidentiality  of 
tax  returns,  an  area  where  there  has  been  abuse  in  the  past.  It 
strictly  limits  disclosure  of  information  from  tax  returns.  The  ability 


12 

of  the  Internal  Revenue  Service  to  use  jeopardy  and  termination  assess- 
ments and  to  issue  administrative  summons  also  is  limited  by  providing 
better  court  review  in  these  cases. 

At  the  same  time,  rules  are  provided  for  the  publication  of  pri- 
vate letter  rulings  so  everyone  will  have  an  equal  opportunity  to  know 
the  view  of  the  IRS  on  the  proper  interpretation  of  the  tax  law.  New 
rules  are  also  added  to  aid  the  Service  in  reviewing  the  way  in  which 
tax  return  preparers  carry  out  their  duties. 

In  the  case  of  withholding  tax  provisions,  a  number  of  changes  are 
made,  including  provision  to  withhold  at  the  rate  of  20  percent  on 
income  from  most  wagering  wliere  the  amount  won  is  $1,000  or  over. 
Further,  in  the  case  of  fishing  vessels  where  the  catch  is  shared,  stern- 
men  are  classified  as  independent  contractors  for  tax  purposes.  The 
Act  also  provides  mandatory  withholding  of  State  and  local  income 
taxes  for  members  of  the  Armed  Forces. 

F.  ESTATE  AND  GIFT  TAX  PROVISIONS 

The  estate  and  gift  tax  provisions  provide  a  comprehensive  revision 
of  these  taxes.  In  this  area,  the  Act  provides  substantial  relief  for 
moderate-sized  estates,  farms  and  other  closely-held  businesses,  allevi- 
ates the  liquidity  problem  for  estates  comprised  largely  of  farms  and 
other  closely-held  business,  while  at  the  same  time  it  removes  tax 
avoidance  devices  from  the  present  system.  This  is  accomplished  with 
a  balanced  set  of  provisions  which  in  the  long  run  will  at  least  main- 
tain the  present  level  of  revenues. 

The  Act  substantially  reduces  estate  taxes  for  medium-sized  estates. 
The  existing  $60,000  estate  tax  exemption  was  enacted  in  1942  and 
since  that  time  the  percentage  of  decedents  whose  estates  have  been 
subjected  to  the  Federal  estate  tax  has  increased  from  1  percent  to  8 
percent.  This  increase  has  resulted  from  inflation  and  the  greater 
ability  of  people  to  accumulate  wealth  because  of  the  unprecedented 
economic  prosperity  in  the  post-war  era.  The  Act  increases  from 
$60,000  to  $175,000  the  level  at  which  the  taxation  of  estates  begins. 
It  also  changes  the  exemption  into  a  tax  credit  in  order  to  confer  the 
maximum  possible  tax  relief  on  the  small  and  medium-sized  estates. 

In  addition,  the  prior  estate  tax  imposed  acute  problems  when  the 
principal  asset  of  the  estate  was  equity  in  a  farm  or  small  business. 
Because  assets  are  valued  at  their  "highest  and  best  use"  for  estate 
tax  purposes,  rather  than  on  the  basis  of  the  specific  use  to  which  the 
assets  were  being  put  (and  also  because  these  assets  are  illiquid), 
family  members  have  often  been  forced  to  sell  farms  and  small  busi- 
nesses in  order  to  pay  the  estate  tax.  To  deal  with  these  problems  the 
Act  allows  farms  (and  other  family  businesses)  to  be  valued  (to  the 
extent  of  $500,000)  at  the  value  for  farming  purposes  (or  other  small 
business  use) ,  if  they  remain  in  the  family  for  a  period  of  ten  to  fifteen 
years  after  the  death  of  the  decedent,  rather  than  being  valued  at  the 
"highest  and  best  use"  market  value.  Also,  in  these  cases,  the  Act  ex- 
tends the  time  for  payment  of  estate  tax  liability  and  provides  for 
a  low  4-percent  interest  rate  on  the  tax  on  up  to  $1  million  of  farm 
or  small  business  value.  These  changes  are  intended  to  preserve  the 
family  farm  and  other  family  businesses — two  very  important  Ameri- 
can institutions,  both  economically  and  culturally. 


13 

The  estate  and  gift  tax  structure  is  an  important  part  of  the  Federal 
tax  system  and  as  such  needs  to  be  as  nearly  equitable  as  possible  in 
its  application.  Tax  liability  should  not  depend  on  the  method  used  to 
transfer  the  property  from  one  generation  to  the  next.  Because  of  this, 
a  number  of  steps  Avere  taken  to  reform  the  estate  and  gift  tax  provi- 
sions. This  reform  provides  assurance  that  in  the  long  run  these  pro- 
visions will  not  lose  revenue. 

Two  features  of  prior  law  which  give  rise  to  considerable  variations 
in  estate  and  gift  tax  burdens  for  people  who  transfer  the  same  amount 
of  wealth  were  the  separate  rate  schedule  and  exemption  provision  for 
estates  and  gifts.  There  were  several  tax  advantages  to  lifetime  gifts. 
The  gift  tax  rates  were  75  percent  of  estate  tax  rates ;  and,  unlike  the 
estate  tax,  the  amount  of  the  gift  tax  itself  was  not  included  in  the  tax 
base.  Also,  someone  who  split  his  total  transfers  between  gifts  and 
bequests  achieved  the  advantage  of  "rate  splitting,"  since  the  first 
dollar  of  taxable  bequests  was  taxed  at  the  bottom  estate  tax  rate  even 
where  there  had  been  substantial  lifetime  gifts.  These  opportunities 
for  reducting  the  overall  burden  by  lifetime  giving  were  inequitable, 
especially  since  many  people  are  not  wealthy  enough  to  make  lifetime 
gifts.  The  Act  unifies  the  estate  and  gift  taxes — both  the  exemptions 
(which  have  been  converted  into  a  credit)  and  the  rates — to  deal  with 
these  inequities. 

Another  cause  of  unequal  treatment  of  taxpayers  with  the  sa,me 
amount  of  wealth  transfers  has  been  the  ability  to  use  "generation 
skipping"  trusts.  Wlien  weath  is  bequeathed  from  the  parent  to  his 
child,  then  from  the  child  to  a  grandchild  and  finally  from  the  grand- 
child to  a  great-grandchild,  the  estate  tax  is  imposed  three  times. 
However,  if  the  parent  places  the  wealth  in  a  trust  in  which  the  child 
and  then  the  grandchild  has  the  right  to  the  income  from  the  trust, 
with  the  principal  going  to  the  great-grandchild,  the  parent  will 
achieve  virtually  the  same  result  and,  in  effect,  skip  two  generations 
of  estate  tax.  In  these  cases,  the  estate  tax  could  be  avoided  for  100 
years  or  more  under  prior  law.  Since  such  trust  arrangements  have 
been  used  largely  by  wealthier  people,  this  failure  to  tax  generation- 
skipping  trusts  has  undermined  the  progressivity  of  the  estate  and 
gift  taxes.  The  Act  significantly  limits  estate  tax  avoidance  through 
generation-skipping  trusts  by  imposing  a  tax  at  the  time  of  the 
death  of  the  child  or  grandchild,  in  the  example  cited  above,  of 
substantially  the  same  size  as  would  be  imposed  had  the  property 
passed  directly  from  the  child  to  the  grandchild  and  to  the  great- 
grandchild, although  the  additional  tax  in  this  case  is  payable  by  the 
trust.  However,  an  exception  to  this  rule  is  provided  for  up  to  $250,000 
passing  from  a  child  to  one  or  more  grandchildren. 

Still  another  inequity  in  the  prior  law  resulted  from  the  fact  that 
when  appreciated  property  was  transferred  at  death,  the  basis  of  the 
property  for  the  heirs  (on  which  any  capital  gain  or  loss  is  computed) 
was  the  fair  market  value  at  the  time  of  death  rather  than  the  basis  of 
the  decedent.  This  contrasted  with  the  rule  for  gifts,  where  the  donee 
must  carry  over  the  basis  of  the  donor.  One  unfortunate  result  of  the 
prior  law  has  been  that  people  were  reluctant  to  sell  appreciated  prop- 
erty in  anticipation  of  the  step-up  in  basis  at  death.  Another  result  has 
been  that  assets  accumulated  out  of  savings  from  ordinary  income  bore 


14 

a  heavier  total  tax  burden  than,  those  resulting  from  appreciation  in 
value  where  the  gain  had  not  been  realized.  To  reduce  the  inefficiency 
and  inequity  of  the  prior  system,  the  Act  generally  provides  for  a 
carryover  basis  at  death  but  provides,  however,  that  there  will  continue 
to  be  a  step-up  in  basis  for  appreciation  which  has  occurred  througli 
the  end  of  the  calendar  year  1976. 

G.  INTERNATIONAL  TRADE  AMENDMENTS 

Another  area  of  the  Act  involves  changes  in  the  operation  of  the 
U.S.  International  Trade  Commission  and  amendments  to  the  Trade 
Act  of  1974  regarding  tariff  treatment  of  countries  aiding  or  abetting 
international  terrorists.  ,       , 

The  Congress  concluded  that, the  voting  procedures  of  the  Interna- 
tional Trade  Commission,  needed  reyising  in  order  to  facilitate  the 
functioning  of  the  Congressiorial  override  mechanism  in  cases  where  a 
plurality  of  three  commissioners  reached  agreemeiiit  on  a  particular 
remedy  but,  because  a  majoi'ity  of  the  commissioners  voting  did  not 
agree  on  a  remedy,  there  was  no  "recommendation"'  by  the  Commis- 
sion which  Congress  could  implement  under  the  override  provisions 
(contained  in  the  Trade  Act  of  1974).  Thus,  the  Act  provides  that  if  a 
majority  of  the  Commissioners  voting  on  an  escape  clause  or  market 
disruption  case  cannot  agree  on  a  remedy  finding,  the  remedy  finding 
agreed  upon  by  a  plurality  of  not  less  than  three  Commissioners  is  to 
be  treated  as  the  remedy  finding  of  the  Commission  for  the  purposes 
of  the  Congressional  override  mechanism.  The  Act  also  modifies  the 
rule  for  the  term  of  office  for  a  member  of  the  Commission  so  that  a 
Commissioner  may  continue  to  serve  after  the  expiration  of  the  term 
of  office  until  the  successor  is  appointed  and  qualified. 

In  addition,  the  Act  amends  the  Trade  Act  of  1974  to  add  a  new 
category  of  reasons  for  denying  preferential  tariff  treatment  to  "bene- 
ficiary developing  countries.''  The  new  provision  would  prohibit  pref- 
erential tariff  treatment  to  such  countries  that  aid  or  abet  any  indi- 
vidual or  group  which  has  committed  an  act  of  international  terrorism. 
The  President,  however,  could  waive  this  prohibition  (as  he  may  for 
certain  of  the  other  categories  for  denial  of  preferential  treatment)  if 
a  waiver  is  determined  to  be  in  the  national  economic  interest  of  the 
ITnited  States. 


11.  REVENUE  EFFECTS 

Table  1  gives  the  revenue  effects  of  the  tax  reform,  estate  and  gift 
tax,  and  tax  cut  provisions  of  the  Act,  and  lists  the  revenue  impact  of 
each  title  of  the  Act.  As  the  table  indicates,  the  tax  reform  provisions 

are  estimated  to  raise  about  $1.6  billion  in  revenues  in  fiscal  year 
1977  and  $2.5  billion  by  1981.  The  tax  cut  extension  amounts  to  $17.3 
billion  in  1977.  The  title-by-title  analysis  of  the  table  indicates  that 
$417  million  of  revenue  will  be  raised  from  tax  shelter  provisions  in 
1977,  a  figure  which  rises  to  $527  million  by  1981. 

Table  2  lists  the  revenue  effect  of  each  section  of  the  Act  by  title. 

Tables  3  and  4  give  the  estimated  decreases  in  individual  income  tax 
liability  for  calendar  year  1977  and  1978  under  the  tax  cut  extensions 
contained  in  the  Act. 

TABLE  l.-REVENUE  EFFECT  OF  TAX  REFORM,  ESTATE  AND  GIFT  TAX,  AND  TAX  CUT  PROVISIONS  OF  THE  ACT, 

SUMMARY  AND  BY  TITLE  i 

(In  millions  of  dollars;  fiscal  years] 

1977     1978     1979     1980     1981 

SUMMARY 

Tax  reform -. -       1,593  1,719  2,038  2,118  2,470 

Estate  and  gift  tax _ -728  -921  -1,134  -1,449 

Extension  of  tax  cuts -17,326  -13,776  -7,966  -8,348  -7,212 


Total -15,733    -12,785      -6,849      -7,364       -6,191 


BY  TITLE 

I  l-Tax  shelters 417  395  501  488  527 

III— Minimum  and  maximum  tax 1,095  1,283  1,464  1,603  1,758 

IV— Extension  of  individual  income  tax  reductions -14,350  -9,293  -4,506  -4,731  -4,968 

V-Tax  simplification  in  the  individual  income  tax —409  -442  -457  -478  -499 

VI— Business  related  individual  income  tax  provisions 215  231  273  306  315 

Vll-Accumulation  trusts (2)  (2)  (2)  (2)  (2) 

VIII— Capital  formation -1,457  -3,593  -3,796  -4,000  -2,499 

IX— Small  business  provisions —1,676  —1, 177 .._ 

X— Changes  in  the  treatment  of  foreign  income 150  108  182  197  198 

XI— Amendments  affecting  DISC 468  553  559  598  728 

XII— Administrative  provisions 88  55  55  55  55 

XIII— Tax  exempt  organizations -5  -5  (>)  (')  (2) 

XIV— Treatment  of  certain  capital  losses;  holding  period  for 

capital  gains  and  losses... —6  10  79  73  58 

XV— Pension  and  insurance  taxation -18  -29  -29  —31  -30 

XVI— Real  estate  investment  trusts (2)  (2)  <2)  (2)  (2) 

XVII— Railroad  provisions -87  -139  -118  -98  -80 

XVIII— International  Trade  Amendments 

XX-Estate  and  gift  taxes..-. -728  -921  -1,134  -1,449 

XXI— Miscellaneous  provisions -158  -14  -135  -212  -305 

Total -15,733  -12.785  -6,849  -7,364  -6,191 


>  Does  not  include  Title  I— Short  Title  and  Title  XIX— Repeal  and  Revision  of  Obsolete,  Rarely  Used,  Etc.,  Provisions. 
2  Less  than  $5,000,000. 

(15) 


16 

TABLE  2.-REVENUE  EFFECT  OF  TAX  REFORM,  ESTATE  AND  GIFT  TAX,  AND  TAX  CUT  PROVISIONS  OF  THE  ACT 

BY  TITLE  AND  SECTION' 

PART  I.  TAX  REFORM 

|ln  millions  of  dollars;  fiscal  years] 


1977           1978           1979           1980            1981 
TITLE  II  ~~ 

Tax  Shelters 
Real  estate  provisions: 

Sec.  201— Amortization  of  real  property  construction  period 

interest  and  taxes.  _ 102  126  190  152  149 

Sec.  202— Recapture  of  depreciation  on  real  property 9  is  28  38  56 

Sec.  203—5  year  amortization  of  low  income  housing.  —1  —4  _»  —8  —7 

Farming  provisions: 

Sec.  204— Limitation  on  deductions  to  amount  at  risk m  m  n)  (2)  (i\ 

Sec.  206— Termination  of  additions  to  excess  deductions 
account _ __ (2)  n\  /«  m  px 

Sec.  207— Limitation  on  deductions  for  farming  syndicates..  86  32  32  33  34 

Sec.  207— Accrual  accounting  for  farm  corporations 8  18  18  18  18 

Sec.  214 — Scope  of  waiver  of  statute  of  limitations  In  case 

of  activities  not  engaged  In  for  profit 

Oil  and  gas  provisions: 

Sec.  204— Limitation  on  deductions  to  amount  at  risk 50  18  6  3 

Sec.  205— Gain  from  disposition  of  an  interest  in  oil  and 

.    gas  property 7  14  42  51  65 

Movie  provisions: 

Sec.  204— Limitations  on  deductions  to  amount  at  risk 3  10  14  17  18 

Sec.  210— Capitalization  rules.. 29  19  9  4  4 

Sec.  211— Clarification  of  definition  of  produced  film  rents  O)  (2)  (2)  (2)  m 

Equipment  leasing  provision:  Sec.  204— Limitation  on  deduc- 

tions  to  amount  at  risk 4  14  17  17  14 

Sports  franchise  provisions: 

Sec.  212— Allocation  of  basis  to  player  contracts 14  6  6  8 

Sec.  212— Recapture  of  depreciation  on  player  contracts...  7  6  7  7  7 

Partnership  provisions: 

Sec.  213— Partnership  syndication  and  organization  fees...  (2)  (2)  (2)  (2)  (2) 

Sec.  213— Retroactive  allocations  of  partnership  income  or 

loss (2)  (2)  (2)  (2)  (2) 

Sec.  213— Partnership  special  allocations (2)  (2)  (2)  (2)  (2) 

Sec.  213— Limitation    on    deductible    losses    of   limited 

partners (2)  (2)  (2)  (2)  (2) 

Sec.  213— Limitation  on  additional  first  year  depreciation 

for  partnerships 12  10  10  10  10 

Interest  provisions: 

Sec.  208— Prepaid  interest (2)  (2)  (2)  (2)  (j) 

Sec.  209— Limitation  on  deduction  of  nonbusiness  interest...  100  110  130  140  145 
Other  provisions:  Sec.  214— Scope  of  waiver  of  statute  of  lim- 
itations in  case  of  hobby  loss  elections (2)                 (2)                 (2)                  (2)  (2) 

Total 417  395  501  433  "527 

TITLE  III  ~~        ======== 

Minimum  Tax  and  Maximum  Tax 

Sec.  301— Minimum  tax  for  individuals.- 1,032         1,135         1,249         1,373  1511 

Sec.  301— Minimum  tax  for  corporations 59  124  185  194  '204 

Sec.  302— Maximum  tax 4  24  30  36  43 

Total 1,095         1,283         1,464         1,603  1,758 

TITLE  V  === 

Tax  Simplification  in  the  Individual  Income  Tax 

Sec.  501— Revision  of  tax  tables  for  individuals 

Sec.  502— Deduction  for  alimony  allowed  in  determining  adjusted  

gross  income —7           —44  —49  -54             -59 

Sec.  503— Revision  of  retirement  income  credit -391         -340  -340  -340           -340 

Sec.  504— Credit  for  child  care  expenses —384         —368  —404  —444           —488 

Sec.  505— Changes  in  exclusion  for  sick  pay  and  certain  military, 

etc.,  disability  pensions 380            357  387  417              450 

Disability   payments  for  civilian  Government  em- 
ployees for  injuries  resulting  from  acts  of  terrorism..             (2)               (2)  (2)  (2)                 (») 

Sec.  506— Moving  expenses —7           —47  —51  —57             —62 

Sec.  507— Tax  revision  study  by  Joint  Committee 

Total _409  -442         -457  -478  -499 

See  footnotes  at  end  of  table. 


17 

TABLE  2.-REVENUE  EFFECT  OF  TAX  REFORM,  ESTATE  AND  GIFT  TAX,  AND  TAX  CUT  PROVISIONS  '-  OF  THE  ACT 
BY  TITLE  AND  SECTION  i— Continued 

(In  millions  of  dollars;  fiscal  years] 


1977     1978     1979     1980     1981 


TITLE  VI 
Business-Related  Individual  Income  Tax  Provisions 

Sec.  601— Deductions  for  expenses  attributable  to  business  use 

of  homes,  rental  of  vacation  homes,  etc 207  206  235  268  305 

Sec.  602— Deductions  for  attending  foreign  conventions 0)  O  0)  0)  (') 

Sec.  603— Change  in  tax  treatment  of  qualified  stock  options...  7  20  33  33  5 

Sec.  604— State  legislators' travel  expenses  away  from  home...  (')  0)  (')  (')  (') 
Sec.  605— Deduction  for  guarantees  of  business  bad  debts  to 

guarantors  not  involved  in  business 15  5  5  5 

Total 215  231  273  306  315 

TITLE  VII 
Accumulation  Trusts 

Sec.  701-Accumulation  trusts 0)  (?)  0)  P)  C) 

TITLE  VIII 
Capital  Formation 

Sec.  802— First-in  first-out  treatment  of  investment  credit 
amounts  (for  extension  of  10-percent  credit  see 
Part  III  of  this  table) (0  (')  -5  -20  -40 

Sec.  803— Modifications  in  employee  stock  ownership  plans —107         —257         —303         -332  -189 

Employee  stock  ownership  plan  regulations 

Study  of  expanded  stock  ownership - - 

Sec.  804— Investment  credit  in  the  case  of  movie  and  television 

films *-37        4-18        4-13        * -13  -3 

Sec.  805— Investment  credit  in  the  case  of  certain  ships —13  —12  —15  —18  —23 

Sec.  806— Additional  net  operating  loss  carryover  years;  limita- 
tions on  net  operating  loss  carryovers (0  (0  (2)  y)  y) 

Sec.  807— Small  fishing  vessel  construction  reserves (»)  (0  (')  (?)  P) 

Total - - -157         -287         -336         -383  -255 

TITLE  IX 
Smalt  Business  Provisions 

3 

Sec.  902— Liberalization  of  subchapter  S  rules  governing  num- 
ber of  shareholders (?)  (2)  (')  (')  (*) 

Liberalization  of  other  subchapter  S  shareholder 

rules 0)  0  (»)  (9  (') 

Distributions  by  subchapter  S  corporation (')  (')  (')  (*)  (?) 

TITLE  X 

Changes  in  the  Treatment  of  Foreign  Income  ' 

Part  I— Foreign  tax  provisions  affecting  individuals  abroad: 

Sec.  1011— Income  earned  abroad  by  U.S.  citizens  living 
or  residing  abroad -- 44  38  38  38  38 

Sec.  1012— Income  tax  treatment  of  nonresident  alien 
individuals  who  are  married  to  citizens  or  residents  of 
the  United  States. -1  -5  -5  -5  -5 

Sec.  1013— Foreign  trusts  having  one  or  more  U.S.  bene- 
ficiaries to  be  taxed  currently  to  grantor 12  10  10  10  10 

Sec.  1014— Interest  charge  on  accumulation  distributions 
from  foreign  trusts...- (2)  0)  «  (»)  0) 

Sec.  1015— Excise  tax  on  transfers  of  property  to  foreign 

persons  to  avoid  Federal  income  tax O  Q)  0)  v)  (v 

Part  II— Amendments  affecting  tax  treatment  of  controlled 
foreign  corporations  and  their  shareholders: 

Sec.  1021— Amendment  of  provision  relating  to  investment 
in  U.S.  property  by  controlled  foreign  corporations Q)  Q)  (')  (v  (V 

Sec.  1022— Repeal  of  exclusion  for  earnings  of  less  devel- 
oped country  corporations  for  purposes  of  section  1248..  14  10  10  10  10 

Sec.  1023— Exclusion  from  subpart  F  of  certain  earnings  of 
insurance  companies.. —14  —10  —10  —10  —10 

Sec.  1024— Shipping  profits  of  foreign  corporations. P)  C^)  (v  (v  (?) 

Limitation  on  definition  of  foreign  base  company  sales 
income  in  the  case  of  certain  agricultural  products 

See  footnotes  at  end  of  table. 


18 


TABLE  2.-REVENUE  EFFECT  OF  TAX  REFORM,  ESTATE  AND  GIFT  TAX.  AND  TAX  CUT  PROVISIONS  •  OF  THE  ACT 
BY  TITLE  AND  SECTION  i— Continued 

[In  millions  of  dollars;  fiscal  years] 


Total,  title  X. 


TITLE  XI 

Amendments  affecting  DISC 

Sec.  1101— Amendments  affecting  DISC 

TITLE  XII 

Administrative  provisions 

Sec.  1207— Withholding: 

Withholding  of  Federal  tax  on  gambling  winnings 

Withholding  of  Federal  tax  on  certain  individuals  engaged  in 

fishing'. 

Sec.  1212— Abatement  of  interest  vKhen  return  is  prepared  for 
Taxpayer  by  the  International  Revenue  Service 


Total. 


TITLE  XIII 

Tax  Exempt  Organizations 

Sec.  1301— Disposition  of  private  foundation  property  under 

transition  rules  of  Tax  Reform  Act  of  1969 

Sec.  1302— New  private  foundations  set-asides 

Sec.  1303— IVIinimum  distribution  amount  for  private  foundations. 
Sec.  1304— Extension  of  time  to  amend  charitable  remainder 

trust  governing  instrument 

Sec.  1305— Unrelated  trade  or  business  income  of  trade  shows, 
State  fairs,  etc.: 
Charitable  organizations  not  subject  to  an  unrelated  busi- 
ness income  tax  on  rental  income  from  trade  shows 

County  fairs  not  subject  to  an  unrelated  business  income 

tax _ 

1306— Declaratory   judgments   with   respect  to  section 

501(cX3)  status  and  classification 

Sec.  1307— Lobbying  by  public  charities 

Sec.  1308— Tax  liens,  etc.,  not  to  constitute  acquisition  indebted- 
ness  

See  footnotes  at  end  of  table. 


Sec. 


1977 


TITLE  X— Continued 

Changes  in  the  Treatment  of  Foreign  Income— Continued 

Part  III— Amendments  affecting  treatment  of  foreign  taxes: 
Sec.  1031— Requirement  that  foreign  tax  credit  be  deter- 
mined on  overall  basis _ 

Sec.  1032— Recapture  of  foreign  losses 

Sec.  1033— Dividends  from  less  developed  country  corpora- 
tions to  be  grosses  up  for  purposes  of  determining  United 
States  income  and  foreign  tax  credit  against  that  income. . 
Sec.  1034— Treatment  of  capital  gains  for  purposes  of 

foreign  tax  credit 

Sec.  1035 -Foreign  oil  and  gas  extraction  income......... 

Sec.  1036— Underwriting  income 

Sec.  1037— Third-tier  foreign  tax  credit  when  section  951 

applies.. 

Part  IV— Money  or  other  property  moving  out  of  or  into  the' 
United  States: 
Sec.  1041— Portfolio  debt  investments  in  United  States  of 

nonresident  aliens  and  foreign  corporations 

Sec.  1042— Changes  in  ruling  requirements  under  section 

367;  certain  changes  in  section  1248 _. 

Sec.  1043— Continguous  country  branches  of  domestic  life 

insurance  companies 

Sec.  1044— Transitional  rule  for  bond,  etc.,  losses  of  foreign 

banks.. 

Part  V— Special  categories  of  foreign  tax  treatment: 

Sec.  1051— Tax  treatment  of  corporations  conducting  trade 
or  business  in  Puerto  Rico  and  possessions  of  the  United 

States. 

Sec.  1052— Western  Hemisphere  trade  corporations.. 

Sec.  1053— Repeal  of  provisions  relating  to  China  Trade  Act 

corporations _  _ 

Part  VI— Denial  of  certain  tax  benefits  on  internationai  boycotts 
and  bribe-produced  income 


-4 


468 


88 


-5 


1978 


1979 


-10 


-10 


553 


559 


101  68 

-13  -13 

0)  Q) 


55 


55 


0) 

(n 

(■') 

p) 

(2) 

(2) 

(?) 


-5 


1980 


51 
2 

35 
8 

39 
14 

45 
22 

80 

55 

55 

55 

14 
-6 
0) 

10 
23 
(?) 

10 
50 

10 
50 
(2) 

-10 


598 


68  68 

-13  -13 

Q)  (2) 


55 


(2) 


(') 

(0 

(0 

(') 

o 

o 

(') 

Q) 

0) 

(2) 

o 

0) 

0 

0 

Q) 

(') 

1981 


10 
50 

-10 


-55 

-115 

-125 

-135 

-145 

0) 

Q) 

0) 

O 

P) 

-12 

-8 

-8 

-8 

-8 

(S)  .. 

6 
19 

10 
25 

10 
34 

10 
45 

10 
50 

(') 

O 

0) 

(0 

P) 

(2) 

32 

70 

70 

70 

150 

108 

182 

197 

198 

728 


68 
-13 

55 


(0 


0) 
(») 


0) 
(2) 


19 

TABLE  2.-REVENUE  EFFECT  OF  TAX  REFORM,  ESTATE  AND  GIFT  TAX.  AND  TAX  CUT  PROVISIONS »  OF  THE  ACT 
BY  TITLE  AND  SECTION  i— Continued 

(In  millions  of  dollars;  fiscal  years) 

1977     1978     1979     1980     1981 

TITLE  XI 1 1— Continued 
Tax  Exempt  Organizations— Continued 

Sec.  1309— Extension  of  self-dealing  transition  rules  for  private 

foundations 0)  0)  Q)  (')  0) 

Sec.  1310-lmputed  interest _.- (»)  (')  (»)  0)  (?) 

Sec.  1311— Certain  hospital  services . (0  0  (J)  0)  0) 

Sec.  1312— Clinical  services  of  cooperative  hospitals Q)  Q}  (?)  C)  (") 

Sec.  1313— Exemption  of  certain  amateur  athletic  organizations 

from  tax P)  P)  0)  0  (?) 

Total -5  -5  (')  (') 0 

TITLE  XIV 

Treatment  of  Certain  Capital  Losses;  Holding  Period  for  Capital 
Gains  and  Losses 

Sec.  1461 — Increaseinamountof  ordinary  income  against  which 

capital  loss  may  be  offset -22         -162         -248         -260  -273 

Sec.  1402— Increase  in  holding  period  required  for  capital  gain 

or  loss  to  be  long  term 33  218  377  392  407 

Sec.  1403— Allowance  of  8-year  capital  loss  carryover  in  case  of 

regulated  investment  companies —13  —21  —25  —34  —51 

Sec.  1404— Sale  of  residence  by  elderly -4  -25  -25  -25  -25 

Total -6  10  79  73  58 

TITLE  XV 

Pension  and  Insurance  Taxation 

Sec.  1501— Retirement  savings  for  certain  married  individuals..  —2  —14  —15  —17  —17 

Sec.  1502— Limitation  on  contributions  to  certain  pension,  etc., 
plans 0)  (2)  (2)  (2)  (2) 

Sec.  1503— Participation  by  members  of  reserves  or  national 

guard  in  individual  retirement  accounts,  etc —6  —5  —5  —5  —5 

Participation  by  certain  volunteer  firemen  in  individual  re- 
tirement accounts,  etc (?)  (2)  (2)  (2)  (2} 

Sec.  1504- Certain  investments  by  annuity  plans 0)  (2)  (2)  (2)  (2) 

Sec.  1505— Segregated  asset  accounts 

Sec.  1506— Study  of  salary  reduction  pension  plans 

Sec.  1507— Consolidated  returns  for  life  and  other  insurance 
companies 

Sec.  1508— Treatment  of  certain  life  insurance  contracts  guar- 
anteed renewable (3)  (S)  (»)  (s)  (>) 

Sec.  1509— Study  of  expanded  participation  in  IRA's 

Sec.  1510— Taxable  status  of  Pension  Benefit  Guaranty  Cor- 
poration  

Sec.  1511— Level  premium  plans  covering  owner-employees (2)  (2)  (?)  (?)  (') 

Sec.  1512— Lump-sum  distributions  from    qualifiea  pension, 
etc.,  plans -10  -10  -9  -9  -3 

Total -18  -29  -29  -31  -30 

TITLE  XVI 

Real  Estate  Investment  Trusts 

Sees.  1601— 1608— Real  estate  investment  trusts (2)  (2)  (2)  (2)  (2) 

TITLE  XVII 

Railroad  and  Airline  Provisions 

Sec.  1701— Certain  provisions  relating  to  railroads —29  —66  —65  —53  —41 

Sec.  1702 — Amortization  over  50-year  period  of  railroad  grading 

and  tunnel  bores  placed  in  service  before  1969 —26  —18  —18  —18  —18 

Sec.  1703— Certain  provisions  relating  to  airlines -32  -55  -35  —27  —21 

ToUl -87         -139         -118  -98  -80 

TITLE  XVIII  ~ 

International  Trade  Amendments 

Sec.  1801— United  States  International  Trade  Commission 

Sec.  1802— Trade  Act  of  1974  Amendments 

See  footnotes  at  end  of  table. 


20 

ABLE  2.-REVENUE  EFFECT  OF     TAX  REFORM,  ESTATE  AND  GIFT  TAX,  AND  TAX  CUT  F  RCVISICNS  i  OF  THE  ACT 
BY  TITLE  AND  SECTION  i— Continued 

|ln  millions  of  dollars;  fiscal  years] 


1977     1978     1979     1980     1981 


0) 
—48 
-60 

0) 

-42 
-15 

0) 

—42 
-15  _-. 

0) 

-42 

—42 

{') 

—3 
-3 

o 

-7 
—3 

(?) 

41 

-3 

(2) 

—14 
—3 

(') 
—3 

(?) 

0) 

0) 

0) 

0)  -- 

59 

102 

18 

—70 

-160 

(?) 

(') 

(2) 

C) 

(?) 

(?) 

(?)  ... 

-24 

-10 

—10 

-10 

—10 

(?) 

(') 

e) 

e) 

C) 

(') 

0) 

e) 

C) 

e) 

(2) 

0) 

(2) 

0 

(') 

TITLE  XXI 
Miscellaneous  Provisions 

Sec.  2101— Tax  treatment  of  certain  housing  associations 

Sec.  2102— Treatment  of  certai n  disaster  Payments 

Sec.  2103— Tax  treatment  of  certain  1972  disaster  losses 

Sec.  2104— Tax  treatment  of  certain  debts  owned  by  political 
parties,  etc.,  to  accrual  basis  taxpayers 

Sec.  2105— Tax-exempt  bonds  for  student  loans. 

Sec.  2106— Personal  holding  company  income  amendments 

Sec. 2107— Work  incentive  program  expenses 

Sec.  2108— Repeal  of  excise  tax  on  light-duty  truck  parts 

Sec.  2109— Exclusion  from  excise  tax  on  certain  articles  resold 
after  modification _ _ 

Sec.  2110— Franchise  transfers.. _ 

Sec.  2111 — Employers'  duties  in  connection  with  the  recording 
and  reporting  of  ti  ps _  _ 

Sec.  2112— Treatment  of  certain  pollution  control  facilities 

Sec.  2113 — Clarification  of  status  of  certain  fishermen's  organi- 
zations   

Sec.  2114— Application  of  section  6013(e)  of  the  Internal 
Revenue  Code  of  1954 

Sec.  2115— Amendments  to     rules   relating    to    limitation  on 

percentage  depletion  in  case  of  oil  and  gas  wells 

Transfers  of  oil  and  gas  property  within  the  same  controlled 
groupor  family.. 

Sec.  2116— Implementation  of  Federal- State  Tax  Collection  Act 
of  1972 

Sec.  2117— Cancellation  of  certain  student  loans.. 

Sec.  2118— Treatment  of  gain  or  loss  on  sales  or  exchanges  in 
connection  with  simultaneous  liquidation  of  a  parent  and 
subsidiary  corporation 

Sec.  2119— Regulations  relating  to  tax  treatment  of  certain  pre- 
publication  expenditures  of  publishers _ 

Sec.  2120— Contributions  in  aid  of  construction  for  certain 
utilities —16  —11  —11  —11  — U 

Sec.  2121 — Prohibition  of  discriminatory  State  taxes  on  produc- 
tion and  consumption  of  electricity 

Sec.  2122— Allowance  of  deduction  for  eliminating  architectural 
and  transportation  barriers  for  the  handicapped — 4  — 10  — 10  — 6 

Sec.  2123— H igh-income  taxpayer  report. 

Sec.  2124— Tax  incentives  to  encourage  the  preservation  of 
historic  structures —1  —3  —8  —12  —16 

Sec.  2125 — Amendment  to  Supplemental  Security  Income  pro- 
gram  

Sec.  2126— Extension  of  carryover  period  for  Cuban  expropria- 
tion losses (2)  (2)  (2)  (2)  (2) 

Sec.  2127— Outdoor  advertising  displays 

Sec.2128— Tax  treatmentof  large  cigars.. —7  —7  —7  —7  —7 

Sec.  2129— Treatment  of  gain  from  sales  or  exchanges  between 

related  parties... (2)  (2)  (2)  (2)  (2) 

Sec.  2130 — Application  of  section  117  to  certain  education  pro- 
grams for  members  of  the  uniformed  services' — 10  — 8  — 8  — 2 

Sec.  2131— Exchange  funds (2)  (2)  (2)  (2)  (2) 

Sec.  2132— Contributions  of  certain  Government  publications (2)  (2)  (')  (2)  (2) 

Sec.  2133 — Tax  i  ncenti ves  study 

Sec.  2134— Prepaid  legal  expenses —5  —8  —16  —21  —33 

Sec.  2135— Special  rule  for  certain  charitable  contributions  of 

inventory  and  other  property — 19  — 22  —22  —24  —24 

Sec.  2136— Tax  treatment  of  the  grantor  of  options  of  stock, 

securities,  and  commodities 3  10  10  10  10 

Sec.  2137— Exempt-interest  dividends  of  regulated  investment 

companies 

Sec.  2138— Common  trust  fund  treatment  of  certain  custodial 

accounts 

Sec.  2139— Support  test  for  dependent  children  of  divorced,  etc., 

parents - 

Sec.  2140— Involuntary  conversionsof  real  property (2)  (2)  (2)  (2)  (2) 

Sec.  2141— Livestock  sold  on  account  of  drought —20  20 

Total —158  —14         —135         —212  —305 

Total  for  Parti,  Tax  Reform T^S         V7i9         2^038         2,118  2,470 

See  footnotes  at  end  of  table. 


21 

TABLE  2.-REVENUE  EFFECT  OF  TAX  REFORM,  ESTATE  AND  GIFT  TAX,  AND  TAX  CUT  PROVISIONS  i  OF  ACT 
BY  TITLE  AND  SECTION— Continued 

PART  II.  ESTATE  AND  GIFT  TAX 

[In  millions  of  dollars;  fiscal  years] 

1977  1978  1979  1980  1981 

TITLE  XX 
Estate  and  Gift  Taxes  ? 

Unified  rates  and  credit -541  -756  -1,012  -1,380 

Marital  deduction -153  -162  -171  -181 

Valuation -14  -15  -16  -17 

Extension  of  time -20  -24  -28  -33 

Unification (*)  (•)  (•)  (•)  (•) 

Generation  skipping (*)  (*) 

Carryover  of  basis (•)  (•)  36  93  162 


Total -728         -921      -1,134       -1,449 

PART  Ml.  ETXENSION  OF  TAX  REDUCTIONS 

TITLE  IV 

Extension  of  Individual  Income  Tax  Reductions 

Sec.  401 — Extensions  of  individual  income  tax  reductions: 

(a)  General  tax  credit -9,509      -3,462  

(b)  Standard  deduction -4,146      -4,481      -4,506      -4,731        -4,968 

(c)  Earned  income  credit —695      —1,350 

Sec.  402— Refunds  of  earned  income  credit  disregarded  in  the 

administration  of  Federal  programs  and  federally  assisted 

programs 

Total... -14,350      -9,293      -4,506      -4,731        -4,968 

TITLE  VIII 

Capital  Formation 

Sec.  801 — Extension  of  $100,000  limitation  on  used  property  for 

the  investment  credit -38         -142         -149         -156  -118 

Sec.  802-Extension  of  10-percent  investment  credit -1,262      -3,164      -3,311      -3,461        -2,126 

Total _. -1,300      -3,306      -3,460      -3,617       -2,244 

TITLE  IX 

Small  Business  Provisions 

Sec.  901— Extension  of  certain  corporate  income  tax  rate 
reductions —1,676      —1, 177 


Totalfor  Part  III,  Extension  of  Tax  Reductions -17,326    -13,776      -7,966      -8,348       -7,212 


Grandtotal,  Partsl.ll.and  III -15,733    -12,785      -6,849      -7,364       -6,191 

'  This  table  has  omitted  Title  I— Short  Title  and  Title  X IX— Repeal  and  Revision  of  Obsolete,  Rarely  Used,  Etc.,  Provisions. 

2  Less  than  $5,000,000. 

3 The  revenue  impact  of  this  provision  will  not  be  very  great;  its  magnitude,  however,  is  not  determinable  because  of 
lack  of  information  regarding  the  practices  of  the  State  legislators  during  the  period  covered  by  the  provision. 

*  Reflects  liability  of  prior  years. 

^  It  is  estimated  that  this  provision  will  decrease  budget  receipts  by  $65,000,000  in  the  aggregate  over  the  next  5  fiscal 
years. 

6  There  is  also  an  estimated  $2,000,000  decrease  in  budget  receipts  for  fiscal  year  1976  under  this  provision. 

'The  long-run  estimates  are  as  follows:  unified  rates  and  credit,  —$1.23  billion;  marital  deduction,  —$153  million; 
valuation,  —$14  million;  extension  of  time,  less  than  $500,000;  unification,  $300  million;  generation  skipping,  $280  million; 
carryover  of  basis,  $1.08  billion;  and  total,  $263  million. 


234-120  O  -  77  -  3 


22 


CO  en  CSICOCsiCNiCMCSJcNjCNJCMCSICMCMCNJ 


ooo      ^  <D  (O '-^  ^  •-4  r^  CM  a>  «r  U7 
corocM       CO  r^ .— •  t£>  ""^  i©  o  <— t  CM  CO .— < 

I     '     '  rS^'^  ^CM  CO  ^"irTr-T 

OOOOcocD<^^-«r^.-ir**ir)oooooro 
cM^oor^r^cMr^CMoocoomr-' 
fa*roina>rooocooocMcoif)ooco 

.-<■  ^^  ^CM  CO  WirTpC 

O00U2^^^'**?:?OOOOOOOCD 

OOt^CDt— i^-oooooooooooooooooo 


■S-iiS 


^^^^^^^ 


OoO<nu->..>^r~^r^Sr^o^r^ 


a>cDo><oo^ooaooo 


<  I! 


uj  5 

o.  < 


ke- N  in  oo  CM  CO  .^  lO  •->  u>  r»  a>  ro  ui 


OO^JJJOOtDOOOOOOOOOOOOOOcnS 


2 

a.    S 

E    S 


-O  9 

Q    Q  « 

O   <  o 

<  "^  -2 

H  s  ^ 

oe  i<r  E 

Lu    T  a 


3   C 


5hS 

CQ.'J- 


OO 


2:  u.  o> 

o  o  -o 

1—1—  » 

o  ;:^  9- 

IT   O  a> 

3    UJ  13 

O  Q:  tf 

LU   o  '^ 

Q  r\  ■=" 

Q  2  " 

ii  :: 

<Q  ° 

M  ^  £ 

UJ  n:  i 

►-    UJ  ^ 

a:  g- 

a  u 


Sj2 

Q.-0 


S2rs*S^^"3S??'*o*ooooooo^^ 

o^<^tf>cM^oo^oo^rtooo^oor*. 
coco   I  ^oocM(A'-^(0^cor-.o^o 

I  '  *-r^~cM''.^cvrcM"coirj"t£roo" 


^S^^o^DCMtocsi^toeMtOir) 

CMCOtOO^OOCOOOrOOOOCMtDcM 


cMq>ocsjor-.ooooootiocooooooog 


^2StS2oo^^**^^<fi"^oooooco 

COOOO^CT>^CO^rOir^O>OOi«trt 

-^cMt^a»rooocooocooooicMr*-Ty5 


•-"^-•CM^^CSJCMCOmcDoO 


ooeM^r^cMroa>(oa>c0mc>ooooco 

cMCMOOcoir>r^cMi-^cM*-iror^cocoW 

^•—•^CsTc^TcMCMCO  ^in  to  oo" 


tftr**r;rg.-<oooooooooc> 

gCM  ^OOIAOOOOOOOOOOOOOOOOOOOO 


^  to  CO  ^  ro  •— <  (D  CO  <o  to  ^  LO  r**  « 

*^COlOO>COOOCOO>COO>tOC>y3^ 


■tr-^CMCMCsJCMCOirnOOOc 


coo)00ooooa>^^-^^^-oocoincM*-« 
•"T^r-TcNi'cocM'co'co'irrto'ooo" 


£^ 


t5  « 
5  2 


ooooooooooo 

OOOCfOOCOOOO^OOOO 
^OOC3^ 

fr9^  «>^  fc^  ^  t-^- «^  fc<»>  «p9>  »^  «9- V>  6^  *^  < 


»% 


23 


S       o 


5^ 


a>    -in 


=>«r> 


S.o 


•oqJ^ 


■OoJ'd- 


^5 


OOOOCslOOOOO^OO^^ 


^,— ir^r^cvjoocoomp*. 


jir>CT>cooocsicnir>oo 


^OOOCNjtOtDt-^^DlO^OOOOrO 

csif— ioop^r»».CNioorooif>r»«. 
r^«— *  cJ"***  ^^  u^  r*. 


oooo^tr^too^oooooo 


o  CO  m  <yt  t^  ^  <Tt^  CD  ooooo  CO 


^r-^rotDO^o^^®^^ 


|-O>00  OOOOOr-4 


a>cotD?f)0^?^^i£'^^i'^ 


jroto^<roof5ooo»cM(.DcJ 


OOCSJOi-*eOO^^OOOC3C3 


•— »  ,-i  CM  CNi  CO  '^  t 


OOCNj^r-eNicoO>tDir>000ooro 


Oc0c0<-400000^^00 


fc^«*(CO^o>ir».-«r^cvjootOL 

»-r,-r,-rcNrcncoirru3"oo~< 


cna>ooooooa>'d-'*oocr)Lncvj.-^ 


CDOCiOCSC 


■  OOCDOOOO^O 


OC3  OCD  O 


III.  GENERAL  EXPLANATION  OF  THE  ACT 

A.  TAX  SHELTER  PROVISIONS 

1.  Real  Estate 

a.  Capitalization  and  Amortization  of  Real  Property  Con- 
struction Period  Interest  and  Taxes  (sec.  201  of  the  Act  and 
sec.  189  of  the  Code) 

Prior  law 
Prior  to  the  Act,  amounts  paid  for  interest  and  taxes  attributable 
to  the  construction  of  real  property  were  allowable  as  current  deduc- 
tions except  to  the  extent  the  taxpayer  elected  to  capitalize  these 
items  as  carrying  charges  (sec,  266).^  If  an  election  was  made  to 
capitalize  these  items,  the  amount  capitalized  was  deductible  over  the 
useful  life  of  the  building.  The  deduction  for  taxes  (sec.  164)  includes 
sales  and  real  estate  taxes  paid  or  accrued  on  real  or  personal  property 
during  the  construction  period.  The  deduction  for  interest  during  the 
construction  period  includes  amounts  designated  as  "'points"  or  loan 
processing  fees  so  long  as  these  fees  were  paid  by  the  borrower  prior 
to  the  receipt  of  the  loan  funds  and  were  not  paid  for  specific  services.^ 
(Generally,  construction  period  interest  is  not  treated  as  investment 
interest  for  purposes  of  the  limitation  on  investment  interest  (sec. 
163(d)  ).3 

Reasons  for  change 
Prior  to  the  Act,  the  tax  provisions  relating  to  real  estate  construc- 
tion were  used  by  taxpayers  in  high  marginal  income  tax  brackets  to 
avoid  payment  of  income  tax  on  substantial  portions  of  their  economic 
income.  This  was  principally  achieved  by  allowing  current  deductions 
for  costs  which  many  believe  are  attributable  to  later  years.  For  ex- 
ample, during  the  construction  period  the  interest  paid  on  the  con- 
struction loan  and  the  real  estate  taxes  were  immediately  deducted 
even  though  there  was  no  income  from  the  property.  These  deductions 
resulted  in  losses  which  were  used  by  taxpayers  to  offset  income  from 
other  sources,  such  as  salary  and  dividends.  In  effect,  a  taxpayer  was 
allowed  to  defer  or  postpone  the  payment  of  tax  on  current  income, 
either  by  offsetting  current  income  with  loss  deductions  attributable 
to  real  estate  or  by  receiving  a  tax-free  cash  flow  from  the  real  estate 


1  Interest  paid  or  accrued  during  the  construction  period  was  deductible  under  the 
provisions  dealing  with  the  deductibility  of  interest  in  general  (sec.  163). 

2  See  Rev.  Rul.  68-643  (C.B.  1968-2,  76),  Rev.  Rul.  69-188  (C.B.  1969-1,  54)  and 
Rev.  Rul.  69-582  (C.B.  1969-2,  29). 

3  Construction  period  Interest  also  was  not  treated  as  a  tax  p  °ference  for  purposes  of 
the  minimum  tax  in  computing  the  preference  for  excess  invest,  lent  interest  which  was 
subject  to  the  minimum  tax  until  1972  when  the  excess  investment  interest  limitation 
provision  became  applicable. 

(25) 


26 

project,  or  both.  This  deferral  was  the  equivalent  of  an  interest-free 
loan  from  the  government,  the  economic  benefits  of  which  could  be 
very  significant. 

The  allowance  of  a  deduction  for  construction  period  interest  and 
taxes  is  contrary  to  tlie  fundamental  accounting  principle  of  matching 
income  and  expenses.  Generally,  a  current  expense  is  deductible  in  full 
in  the  taxable  year  paid  or  incurred  because  it  is  necessary  to  produce 
income  and  is  usually  consumed  in  the  process.  However,  some  expendi- 
tures are  made  prior  to  the  receipt  of  income  attributable  to  the  ex- 
penditures and,  under  the  matching  concept,  these  expenditures  should 
be  treated  as  a  future  expense  when  the  income  "resulting"  from  the 
expenditure  is  received  and  the  original  investment  is  gradually 
consumed. 

In  the  case  of  an  individual  who  constructs  a  building  and  subse- 
quently receives  income  in  the  form  of  rents  from  that  building,  the 
accounting  concept  of  matching  income  against  expenses  should  re- 
quire that  the  expenses  incurred  during  the  construction  period  be 
deducted  against  the  rental  income  which  is  received  over  the  life  of 
the  building,  to  the  extent  the  expenses  are  attributable  to  a  depreci- 
able or  wasting  asset.  The  genei-al  construction  costs  of  the  building 
are  trejited  this  way,  being  capitalized  and  subsequently  deducted  as 
depreciation  expenses.  (Similarly,  certain  pre-opening  or  start-up 
expenses  for  a  new  trade  or  business  are  required  to  be  capitalized  for 
tax  accounting  purposes.)  The  interest  and  taxes  paid  during  the  con- 
struction period,  however,  were  not  capitalized  under  prior  law  except 
to  the  extent  that  the  taxpayer  elected  to  treat  these  items  as  carrying 
charges  chargeable  to  capital  account. 

The  allowance  of  a  deduction  for  construction  period  interest  and 
taxes  contributed  to  the  development  of  tax  shelters  in  the  real  estate 
industry.  Real  estate  ventures  which  were  formed  primarily  to  obtain 
tax  shelter  benefits  essentially  represent  a  misuse  of  intended  tax  in- 
centives of  longstanding  and  major  importance.  In  addition,  many 
feel  that  tax  shelters  may  cause  serious  distortions  in  real  estate  values 
and  construction  costs,  resulting  in  investments  being  made  in  projects 
that  are  economically  unsound,  and  interfering  with  the  efficient  allo- 
cation of  the  nation's  resources.  Although  it  has  been  argued  that  the 
provisions  of  prior  law  providing  incentives  are  essential  to  attract 
investment  in  an  industry  already  suffering  from  a  shortage  of  capital. 
the  Congress  concluded  that  allowing  the  full,  immediate  writeoff  of 
construction  period  interest  and  taxes  in  these  cases  was  not  compatible 
with  the  objectives  set  out  above. 

As  a  result  of  the  concern  over  the  tax  sheltering  in  real  estate,  the 
Congress  decided,  after  a  transition  period,  to  require  the  capitaliza- 
tion of  construction  period  interest  and  taxes  and  provide  for  the 
amortization  of  these  items  over  a  10-year  period,  which  deals  directly 
with  tlie  preference  providing  the  shelter  while  retaining  some  of  the 
tax  incentives  for  real  estate  investment  by  providing  a  shorter 
amortization  period  (10-years)  than  the  useful  life  of  the  building. 

Explanation  of  provision. 
lender  the  Act,  in  the  case  of  a  taxpayer  other  than  a  corporation 
which  is  not  a  subchapter  S  corporation  or  a  personal  holding  com- 


27 

pany,*  real  property  construction  period  interest  and  taxes  are  to  be 
capitalized  in  the  year  in  which  they  are  paid  or  accrued  and  amortized 
over  a  10-year  period.  A  portion  of  the  amount  capitalized  may  be 
deducted  for  the  taxable  year  in  which  paid  or  accrued.  The  balance 
must  be  amortized  over  the  remaining  years  in  the  amortization  period 
beginning  with  the  year  in  which  the  property  is  ready  to  be  placed 
in  service  or  is  ready  to  be  held  for  sale. 

The  prepaid  interest  rules  provided  under  the  Act  are  to  be  applied 
first  to  determine  the  period  to  which  the  interest  relates.  If  under  that 
provision,  interest  is  treated  as  allocable  to  the  constiniction  period, 
the  10-vear  amortization  rule  is  then  to  apply  to  tliat  portion  of  the 
interest  (in  effect,  for  the  purposes  of  this  provision  the  interest  is 
treated  as  paid  or  incurred  in  the  year  to  which  it  is  allocated  under 
the  prepaid  interest  rules)  .■' 

Construction  period  interest  includes  interest  paid  or  a-ccrued  on 
indebtedness  incurred  or  continued  to  acquire,  construct,  or  carry 
real  property  to  the  extent  attributable  to  the  construction  period 
for  such  property.  The  construction  period  commences  with  the  date 
on  which  the  construction  of  a,  building  or  other  improvement  begins 
and  ends  on  the  date  that  the  building  or  improvement  is  ready  to  be 
placed  in  service  or  is  ready  to  l)e  held  for  sale.  For  this  purpose,  the 
construction  period  is  not  to  be  considered  to  have  commenced  solely 
because  drilling  is  performed  to  determine  soil  conditions,  architect's 
sket^'hes  or  plans  are  prepared,  or  a  building  permit  is  obtained.  Gen- 
erally the  construction  period  will  be  considered  to  have  commenced 
when  land  preparations  and  improvements,  such  as  clearing,  grading, 
excavation,  and  filling,  are  undertaken.  However,  the  construction 
period  will  not  be  considered  to  have  commenced  solely  because  clear- 
ing or  grading  work  is  undertaken,  or  drainage  ditches  are  dug,  if  such 
work  is  undertaken  primarily  for  the  maintenance  or  preservation  of 
raw  land  and  existing  structures  and  is  not  an  integral  part  of  a  plan 
for  the  construction  of  new  or  substantially  renovated  buildings  and 
improvements.  In  the  case  of  the  demolition  of  existing  structures 
where  the  construction  period  has  not  otherwise  commenced,  the  con- 
struction period  is  considered  to  commence  when  demolition  begins  if 
the  demolition  is  undertaken  to  prepare  the  site  for  construction.  The 
construction  period  will  not  be  considered  to  commence  solely  because 
of  the  demolition  of  existing  structures  if  the  demolition  is  not  under- 
taken as  part  of  a  plan  for  the  construction  of  new  or  substantially 
renovated  buildings  or  improvements.^ 

The  provision  is  not  to  apply  to  any  amount  that  is  capitalized  at 
the  election  of  the  taxpayer  as  a  carrying  charge  (sec.  266).  In  addi- 
tion, the  provision  is  not  to  apply  to  interest  or  taxes  paid  or  accrued 

*  Since,  except  for  subchapter  S  corporations  and  personal  holding  companies,  this 
provision  does  not  limit  the  deductibility  of  amounts  p'ald  or  incurred  by  corporations,  the 
provision  is  not  to  apply  to  corporations  (other  than  subchapter  S  corporations  and  per- 
sonal holding  companies)  which  are  partners  in  any  partnership. 

s  However,  in  anv  case  where  construction  period  interest  is  also  Investment  interest, 
(i.e..  where  the  exception  under  sec.  163(d)(4)(D)  for  construction  period  interest  does 
not  apply),  the  construction  period  Interest  rules  are  to  be  applied  first.  Amounts  allow- 
able under  the  construction  period  rules  for  a  taxable  vear  are  thus  not  to  be  subject  to  the 
investment  Interest  provision  until  that  year  ;  if  disallowed  for  that  year  unde  rthe  invest- 
ment interest  provision,  these  amounts  can  be  deducted  in  succeeding  years  in  accordance 
with   the  carryover  rules  of  the  investment   interest   provision. 

8  For  purposes  of  this  provision  the  growing  of  trees  or  other  crops  is  not  to  be  con- 
sidered an  improvement  in  real  property. 


28 

with  respect  to  property  that  is  not  held  (or  will  not  be  held)  for  busi- 
ness or  investment  purposes  (e.g.,  the  taxpayer's  residence) . 

Separate  transitional  rules  are  provided  for  non- residential  real 
estate,  residential  real  estate,  and  government-subsidized  housing.  In 
the  case  of  nonresidential  real  estate,  this  provision  is  to  apply  to 
property  where  the  construction  period  begins  after  December  31, 1975, 
with  respect  to  amounts  paid  or  accrued  in  taxable  years  beginning 
after  1975.  In  the  case  of  residential  real  estate  (other  than  certain 
low-income  housing),  this  provision  is  to  apply  to  construction  pe- 
riod interest  and  taxes  paid  or  accrued  in  taxable  years  beginning 
after  December  31, 1977,  and,  in  the  case  of  low-income  housing,  to  con- 
struction period  interest  and  taxes  paid  or  accrued  in  taxable  years 
beginning  after  December  31, 1981.  For  this  purpose,  low-income  hous- 
ing means  government  housing  entitled  to  the  special  rules  relating  to 
recapture  of  depreciation  (under  sec.  1250(a)  (1)  (B) ). 

In  addition,  the  length  of  the  amortization  period  is  to  be  phased-in 
over  a  7-year  period.  The  amortization  period  is  to  be  4  years  in  the 
case  of  interest  and  taxes  paid  or  accrued  in  the  first  year  to  which 
these  rules  apply.  The  amortization  period  increases  by  one  year  for 
each  succeeding  year  after  the  initial  effective  date  until  the  amortiza- 
tion period  becomes  10  years  (i.e.,  the  10-year  period  is  fully  phased-in 
for  construction  period  interest  and  taxes  paid  or  acciiied  in  taxable 
years  beginning  in  1982,  in  the  case  of  non-residential  real  estate ;  1984, 
in  the  case  of  residential  real  estate ;  and  1988,  in  the  case  of  govern- 
ment subsidized  low-income  housing).  As  a  special  transition  rule  for 
1976  only,  50  percent  of  the  amount  paid  or  incurred  may  be  deducted 
currently  but,  the  remaining  50  percent  is  to  be  amortized  over  a  3-year 
period  beginning  in  the  year  the  property  is  ready  to  be  placed  in 
service  or  is  ready  to  be  held  for  sale. 

The  application  of  the  general  transitional  rules  and  the  phase-in 
of  the  amortization  period  can  be  illustrated  by  the  following  exam- 
ple. Assume  that  $120,000  of  interest  and  taxes  are  paid  or  accrued  in 
1980  with  respect  to  the  construction  of  residential  real  estate  (other 
than  government  subsidized  low-income  housing)  and  that  the  prop- 
erty is  ready  to  be  placed  in  service  in  1982.  For  taxable  year  1980,  the 
$120,000  must  be  capitalized  under  this  provision,  but  a  deduction  is 
to  be  allowed  for  $20,000  (i^  of  the  amount  capitalized).  The  remain- 
ing $100,000  (i.e.,  %  of  the  total)  is  to  be  deducted  ratably  over  a  5- 
year  period  beginning  in  1982  (the  year  in  wliich  the  property  is  ready 
to  be  placed  in  service).  Thus,  $20,000  is  to  be  allowed  as  a  deduction 
for  taxable  year  1982  and  in  each  of  the  next  succeeding  4  years. 

In  the  case  of  a  sale  or  exchange  of  real  property,  the  unamortized 
balance  of  the  construction  period  interest  and  taxes  is  to  be  added  to 
the  basis  of  the  property  for  purposes  of  determining  gain  or  loss  on 
the  sale  or  exchange.  In  the  case  of  nontaxable  transfer  or  exchange 
(i.e.,  a  transfer  to  a  partnership  or  controlled  corporation,  a  like-kind 
exchange,  or  a  gift),  the  transferor  is  to  continue  to  deduct  the  un- 
amortized balance  allowable  over  the  amortization  period  remaining 
after  the  transfer. 

E-ffective  date 
In  the  case  of  nonresidential  real  estate,  this  provision  is  to  apply 
only  to  property  where  the  construction  period  begins  after  Decern- 


29 

ber  31, 1975,  and  only  with  respect  to  amounts  paid  or  accrued  in  tax- 
able years  beginning  after  1975.  In  the  case  of  residential  real  estate 
(other  than  certain  low-income  housing) ,  this  provision  is  to  apply  to 
construction  period  interest  and  taxes  paid  or  accrued  in  taxable  years 
beginning  after  December  31,  1977,  and,  in  the  case  of  low-income 
housing  to  construction  period  interest  and  taxes  paid  or  accrued  in 
taxable  years  beginning  after  December  31, 1981.  In  each  of  these  cases, 
phase-in  rules  of  the  amortization  period  are  provided,  as  indicated 
above. 

Revenue  effect 
The  revenue  gain  from  this  provision  is  estimated  to  be  $102  million 
for  fiscal  year  1977  and  $149  million  for  fiscal  year  1981. 

h.  Recapture  of  Depreciation  on  Real  Property  (sec.  202  of  the 
Act  and  sec.  1250  of  the  Code) 

Prior  laio 

Generally,  net  gains  on  the  sale  of  real  property  used  in  a  trade  or 
business  (with  certain  exceptions)  are  taxed  as  capital  gains,  and 
losses  are  generally  treated  as  ordinary  losses.  However,  gain  on  the 
sale  of  depreciable  real  property  (buildings)  is  generally  "recaptured" 
and  taxed  as  ordinary  income  rather  than  capital  gain  to  the  extent 
that  the  gain  represents  accelerated  depreciation  allowed  or  allowable 
in  excess  of  the  amount  computed  under  the  straight-line  method  of 
depreciation. 

The  provisions  relating  to  depreciation  recapture  were  first  enacted 
in  1962  to  prevent  deductions  for  accelerated  depreciation  from  con- 
verting ordinary  income  into  capital  gain.  In  general,  the  1962  recap- 
ture provision  (sec.  1245  of  the  code)  provided  that  gain  on  a  sale  of 
most  personal  property  would  be  taxed  as  ordinai-y  incoine 
to  the  extent  of  all  depreciation  taken  on  the  property  after  December 
31,  1962.  In  1964,  recapture  rules  were  extended  to  real  property 
(buildings)  to  provide,  in  general,  that  gain  on  a  sale  would  be  taxed 
as  ordinary  income  to  the  extent  of  the  depreciation  (in  most  cases  only 
the  accelerated  depreciation)  taken  on  that  property  after  Decem- 
ber 31,  1963.  This  provision  (sec.  1250  of  the  code),  however,  had  a 
gradual  reduction  of  the  amount  to  be  recaptured.  If  the  property 
had  not  been  held  for  more  than  12  months,  all  of  the  depreciation  was 
recaptured.  However,  if  the  property  had  been  held  over  12  months, 
only  the  excess  depreciation  over  straight-line  was  recaptured  and  the 
amoimt  recaptured  was  reduced  after  an  initial  20-month  holding 
period  at  the  rate  of  one  percent  per  month.  Thus,  after  120  months 
(10  years)  there  was  no  recapture  of  any  depreciation. 

In  the  Tax  Reform  Act  of  1969,  the  recapture  rules  on  real  property 
were  further  modified  as  to  post-1969  depreciation.  In  the  case  of 
residential  real  property  and  property  with  respect  to  which  the  rapid 
depreciation  for  rehabilitation  expenditures  has  been  allowed,  post- 
1969  depreciation  in  excess  of  straight-line  was  fully  recaptured  at 
ordinary  income  rates  (to  the  extent  of  gain)  if  the  property  has  been 
held  for  more  than  12  months  ^  but  less  than  100  months  (8  years  and  4 

''There  was  no  change  In  the  rule  providing  for  recapture  of  all  depreciation  (including 
straight-line)  if  the  property  Is  not  held  for  more  than  12  months. 


30 

months).  For  each  month  the  property  was  held  over  100  months, 
there  was  a  one  percent  reduction  in  the  amount  of  post-1969  deprecia- 
tion that  was  recaptured.  Thus,  there  was  no  recapture  of  any  deprecia- 
tion if  the  property  was  held  for  200  months  (16  years  and  8  months) . 

In  the  case  of  non-residential  real  property,  all  post-1969  deprecia- 
tion in  excess  of  straight-line  depreciation  is  recaptured  (to  the  extent 
there  is  gain)  regardless  of  the  length  of  time  the  property  is  held. 

In  addition,  in  the  case  of  certain  Federal,  State,  and  locally  assisted 
housing  projects  constructed,  reconstructed,  or  acquired  before  Janu- 
ary 1, 1976,  such  as  the  FHA  221(d)  (3)  and  the  FHA  236  programs, 
the  pre-1969  recapture  rules  on  real  property  were  retained.*  How- 
ever, if  the  property  was  constructed,  reconstructed,  or  acquired  after 
December  31,  1975,  the  regular  post-1969  rules  previously  discussed 
above  with  respect  to  residential  property  were  to  apply  (i.e.,  a  one 
percent  reduction  per  month  after  100  months) . 

Reasons  for  change 

Generally,  deductions  for  accelerated  depreciation  exceed  the  actual 
decline  in  the  usefulness  of  the  property.  Further,  accelerated  methods 
of  depreciation  make  it  possible  for  taxpayers  to  deduct  amounts  in 
excess  of  the  those  required  to  service  the  mortgage  during  the  early 
life  of  the  property. 

When  the  property  is  sold,  the  excess  of  the  sales  price  over  the 
adjusted  basis  was  treated  as  capital  gain  to  the  extent  that  the 
recapture  provisions  did  not  apply.  Under  prior  law,  by  holding 
residential  rental  property  for  16%  years  before  sale,  the  taxpayer 
could  arrange  to  have  all  gain  resulting  from  excess  depreciation 
(which  was  previously  offset  against  ordinary  incx^me)  taxed  at  the 
capital  gain  rates  without  any  recapture.''  The  tax  advan- 
tages for  converting  ordinary  income  into  capital  gain  increase  as  the 
taxpayer's  marginal  income  tax  rate  increases. 

To  reduce  the  opportunities  to  avoid  income  taxes  as  a  result  of 
allowing  accelerated  depreciation  for  real  property  to  convert  ordi- 
nary income  into  capital  gain,  the  Congress  decided  that  it  is  appro- 
priate to  extend  the  application  of  the  present  recapture  rules  on 
residential  real  estate.  Under  the  Act,  when  residential  real  estate  is 
sold,  any  gain  will  be  recognized  as  ordinary  income  to  the  extent  of 
accelerated  depreciation  previously  allowed  or  allowable.  In  the  case 
of  low-income  housing,  however,  the  Congress  decided  that  it  is  not 
desirable  to  require  full  recapture.  In  this  way,  in  incentive  is  pro- 
vided for  owners  of  such  housing  to  retain  their  ownership  and  opera- 
tion of  the  properties  for  longer  periods  of  time. 

In  addition,  it  came  to  the  attention  of  the  Congress  that  certain 
taxpayers  have  taken  dilatory  action  to  postpone  foreclosure  (or  simi- 
lar proceedings)  on  real  property  for  the  principal  purpose  of  reduc- 
ing the  applicable  percentage  of  accelerated  depreciation  that  will  be 
recaptured  upon  foreclosure  (or  similar  proceeding).  As  a  result  of 

^  That  is,  with  respect  to  these  projects,  accelerated  depreciation  will  be  fully  recaptured 
at  ordinar.v  income  rates  onl.v  if  the  property  has  been  held  for  not  more  than  20  months. 
(If  the  property  is  sold  within  12  months,  all  of  the  depreciation  is  recaptured.)  For  each 
month  the  property  is  held  over  20  months,  there  is  a  1  percent  per  month  reduction  in 
the  amount  of  accelerated  depreciation  recaptured.  Thus,  there  will  be  no  recapture  if  the 
property  is  held  for  a  period  of  120  months  (10  years). 

8  In  the  ci\T.Q  of  certain  Federal.  State,  and  locally  assisted  housing  projects  constructed, 
■  reconstructed,  or  acquired  before  January  1,  1976,  there  will  be  no  recapture  if  the  prop- 
erty is  held  for  10  years  before  sale. 


31 

this,  the  Congress  decided  to  make  the  recapture  rules  apply  in  the 
case  of  real  property  from  the  date  foreclosure  proceedings  are  com- 
menced. 

Explanation  of  provisimi 

In  the  case  of  residential  real  estate  (other  than  certain  low-income 
rental  housing),  the  Act  provides  for  the  complete  recapture  of  all 
post-1975  depreciation  in  excess  of  straight-line  depreciation.  (This 
rule  already  applies  in  the  case  of  nonresidential,  i.e.,  commercial  prop- 
erty.) As  under  prior  law,  all  of  the  depreciation  taken,  including 
straight-line  depreciation,  is  recaptured  as  ordinary  income  if  the 
property  is  not  held  for  more  than  12  months.  Under  the  Act,  all  ac- 
celerated depreciation  (depreciation  in  excess  of  straight-line)  at- 
tributable to  periods  after  December  31, 1975,  will  be  fully  recaptured 
to  the  extent  of  any  depreciation  in  excess  of  straight -line  regardless 
of  the  date  the  property  was  constructed.  Special  rules  are  provided 
in  the  case  where  a  portion  of  the  gain  from  the  sale  or  exchange  of 
property  is  subject  to  recapture  under  both  the  former  recapture  rules 
and  the  new  recapture  rules.  Under  these  special  rules,  first,  accelerated 
special  rules,  first,  accelerated  depreciation  attributable  to  periods 
after  December  31,  1975,  will  be  recaptured  (to  the  extent  of  any 
gain)  ;  second,  accelerated  depreciation  attributable  to  periods  after 
December  31,  1969,  and  before  January  1,  1976,  will  be  recaptured 
(to  the  extent  of  any  additional  gain  not  recaptured  under  the  new 
rules)  ;  and  third,  accelerated  depreciation  attributable  to  periods 
after  December  31,  1963,  and  before  January  1,  1970  (to  the  extent  of 
any  remaining  gain  not  recaptured). 

The  new  rules  providing  for  complete  recapture  of  accelerated 
depreciation  do  not  apply  to  4  categories  of  low-income  rental  hous- 
ing: (1)  Federally  assisted  housing  projects  with  respect  to  which  a 
mortgage  is  insured  under  section  221(d)  (3)  or  236  of  the  National 
Housing  Act  (or  housing  financed  or  assisted  by  direct  loan  or  tax 
abatement  under  similar  provisions  of  State  or  local  laws)  ;  (2)  low- 
income  rental  housing  held  for  occupancy  by  families  or  individuals 
eligible  to  receive  subsidies  under  section  8  of  the  United  States  Hous- 
ing Act  of  1937,  as  amended,  or  under  the  provisions  of  State  or  local 
law  authorizing  similar  levels  of  subsidy  for  lower  income  families ; 
(3)  low-income  rental  housing  with  respect  to  which  a  depreciation 
deduction  for  rehabilitation  expenditures  was  allowed  imde'r  section 
167 (k)  ;  and  (4)  Federally  assisted  housing  with  respect  to  which  a 
loan  is  made  or  insured  under  title  V  of  the  Housing  Act  of  1949. 
As  to  these  4  categories  of  real  property,  all  depreciation  will  be 
recaptured  if  the  property  has  not  been  held  for  more  than  12  months. 
However,  if  the  property  has  been  held  for  more  than  12  months,  no 
more  than  the  excess  depreciation  over  straight-time  will  be  recap- 
tured. For  each  month  the  property  is  held  over  100  months,  there  will 
be  a  one  percent  per  month  reduction  in  the  amount  of  accelerated 
depreciation  attributable  to  periods  after  December  31,  1975.  which  is 
recaptured.  Thus,  after  200  months  (16%  years)  there  will  be  no  re- 
capture. 

Special  rules  similar  to  those  discussed  above  are  provided  for 
Federally  assist^  housing  projects  with  respect  to  whicih  a  mortgage 
is  insured  under  section  221  (d)  (3)  or  236  of  the  National  Housing  Act 


32 

(or  housing  financed  or  assisted  by  direct  loan  or  tax  abatement  un- 
der sdmilar  provisions  of  State  or  local  laws)  where  a  portion  of  the 
gain  from  the  sale  or  exchange  of  such  proj^erty  is  subject  to  recapture 
under  both  the  prior  recapture  rules  and  the  new  recapture  rules. 

In  addition,  the  Act  provides  that  where  real  property  is  disposed  of 
by  reason  of  foreclosure  or  similar  proceedings,  the  monthly  pei"cent- 
age  reduction  of  the  amount  of  accelerated  depreciation  subject  to 
recapture  are  to  terminate  as  of  the  date  on  which  such  proceedings 
were  begun.  The  application  of  this  provision  can  be  illustrated  by  the 
following  example: 

Example. — Assume  that  on  June  1,  1976,  the  taxpayer  acquired  cer- 
tain low-incx)me  rental  property  which  qualified  for  the  special  recap- 
ture treatment  discussed  above  (i.e.,  a  one  percent  per  month  reduction 
after  100  months).  On  April  1,  1987  (130  months  after  the  property 
was  placed  in  service)  foreclosure  proceedings  were  instituted  with 
respect  to  the  property  and  on  December  1,  1988  (150  months  after 
the  property  was  placed  in  service)  the  property  was  disposed  of  pur- 
suant to  the  foreclosure  proceedings.  The  applicable  percentage  reduc- 
tion will  be  30  percent  rather  than  50  percent  since  the  percentage 
reduction  would  cease  to  apply  on  April  1,  1987  (the  date  that  fore- 
closure proceedings  were  instituted). 

Effective  date 
The  provisions  relating  to  the  complete  i"ecapture  of  depreciation 
apply  to  accelerated  depreciation  attributable  to  taxable  years  begin- 
ning after  December  31,  1975.  The  provisions  relating  to  the  percent- 
age reduction  in  the  case  of  dispositions  pursuant  to  foreclosure  or 
similar  proceedings  shall  apply  with  respect  to  proceedings  which 
begin  after  December  31,  1975. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in  budget 
receipts  of  $9  million  for  fiscal  year  1977,  and  $56  million  for  1981. 

c.  Five-Year  Amortization  for  Low-Income  Rental  Housing  (sec. 
203  of  the  Act  and  sec,  167  of  the  Code) 

Prior  lm(y 

Under  the  code,  special  depreciation  rules  are  provided  for  ex- 
penditures to  rehabilitate  low  income  rental  housing  (sec.  167 (k)  of 
the  code).  Low-income  rental  housing  includes  buildings  or  other 
structiires  that  are  used  to  provide  living  accommodations  for  families 
and  individuals  of  low  or  moderate  income.  Under  current  Treasury 
regulations  occupants  of  a  dwelling  unit  are  considered  families  and 
individuals  of  low  or  moderate  income  only  if  their  adjusted  income 
does  not  exceed  90  percent  of  the  income  limits  described  by  the  Secre- 
tary of  Housing  and  Urban  Development  (HUD)  for  occupants  of 
projects  financed  with  certain  mortgages  insured  by  the  Federal  Gov- 
ernment. The  level  of  eligible  income  varies  according  to  geographical 
area.^" 

Under  the  special  depreciation  rules  for  low  income  rental  property, 
taxpayers  can  elect  to  compute  depreciation  on  certain  rehabilitation 

!«  Tlie  current  Income  limits  prescribed  by  the  Secretary  of  HUD  for  a  family  of  four 
are  $15,400  In  WashlnRton,  D.C.,  $13,700  In  Chicago,  and  $11,900  In  Los  Angeles.  Thus, 
00  percent  of  these  limits  are  $13,800,  $12,330,  and  $10,710  respectively. 


33 

expenditures  under  a  straight-line  method  over  a  period  of  60  months 
if  the  additions  or  improvements  have  a  useful  life  of  5  years  or  more. 
Under  prior  law,  only  the  aggregate  rehabilitation  expenditures  as  to 
any  housing  which  do  not  exceed  $15,000  per  dwelling  unit  qualified 
for  the  60-month  depreciation.  In  addition,  for  the  60-month  deprecia- 
tion to  be  available,  the  sum  of  the  rehabilitation  expenditures  for  two 
consecutive  taxable  years — including  the  taxable  year — ^must  erceed 
$3,000  per  dwelling  unit. 

Reasons  for  change 
In  the  Housing  and  Community  Development  Act  of  1974,  the  Con- 
gress expressed  its  desire  to  stimulate  construction  in  low-income 
rental  housing  to  eliminate  the  shortage  in  the  area.  However,  the 
special  tax  incentive  for  rehabilitation  expenditures  for  low-income 
rental  housing  under  present  law  expired  on  December  31, 1975.  With- 
out this  incentive  the  remodeling  of  many  high-risk  low-income  proj- 
ects would  have  been  curtailed.  In  order  to  avoid  discouraging  this 
rehabilitation,  the  Congress  believed  that  the  special  depreciation  pro- 
vision for  low-income  housing  should  be  extended. 

Explanation  of  provision 

The  Act  provides  a  two-year  extension  of  the  special  5 -year  deprecia- 
tion rule  for  expenditures  to  rehabilitate  low-income  rental  housing 
and  increases  the  amount  of  rehabilitation  expenditures  that  can  be 
taken  into  account  per  dwelling  unit  from  $15,000  to  $20,000. 

Under  the  Act,  rehabilitation  expenditures  that  are  made  pursuant 
to  a  binding  contract  entered  into  before  January  1,  1978,  would  qual- 
ify for  the  5-year  depreciation  rule  even  though  the  expenditures  are 
actually  made  after  December  31, 1977. 

In  addition,  the  Act  modifies  the  definition  of  families  and  individ- 
uals of  low  and  moderate  income  by  providing  that  the  eligible  income 
limits  are  to  be  determined  in  a  manner  consistent  with  those  pres- 
ently established  for  the  Leased  Housing  Program  under  Section  8 
of  tiie  United  States  Housing  Act  of  1937,  as  amended. 

Effective  date 
The  provisions  relating  to  the  2-year  extension  apply  to  expenditures 
paid  or  incurred  with  respect  to  low-income  rental  housing  after 
December  31, 1975,  and  before  January  1, 1978  (including  expenditures 
made  pursuant  to  a  binding  contract  entered  into  before  January  1, 
1978).  The  provisions  increasing  the  amount  of  expenditures  that  can 
be  depreciated  under  the  special  5-year  rule  apply  to  expenditures 
incurred  after  December  31, 1975. 

Revenue  effect 
It  is  estimated  that  the  provision  will  result  in  a  decrease  in  budget 
receipts  of  $1  million  for  fiscal  year  1977,  and  $7  million  for  1981. 

2.  Limitation  cf  Loss  to  Amount  At-Risk  (sec.  204  of  the  Act  and 
sec.  465  of  the  Code) 

Prior  laio 
Generally,  the  amount  of  depreciation  or  other  deductions  which 
a  taxpayer  has  been  permitted  to  take  in  connection  with  a  property 
has  been  limited  to  the  amount  of  his  basis  in  the  property.  Similar 


34 

statutory  limitation  rules  are  found  in  sections  704(d)  and  1374(c)  (2) 
for  owners  of  partnership  interests  and  shareholders  in  subchapter  S 
corporations  where  the  partners  and  shareholders,  rather  than  the 
entity,  are  taxed  on  the  income  or  loss  of  the  entity. 

The  starting  point  for  determining  a  taxpayer's  adjusted  basis  in 
a  productive  activity  or  enterprise  is  generally  the  taxpayer's  cost 
for  the  assets  used  in  the  activity  or  enterprise  (sees.  1011,  1012).  In 
the  case  of  a  productive  activity  engaged  in  through  a  partnership  or 
subchapter  S  corporation,  the  investor's  adjusted  basis  in  his  stock  or 
partnership  interest  is  generally  based  on  the  amount  of  money  and 
his  adjusted  basis  in  other  property  contributed  to  the  enterprise  (sees. 
722,  358).  The  investor's  basis  in  a  partnership  interest  or  subchapter 
S  corporation  stock  is  increased  by  his  portion  of  the  income  of  these 
entities,  and  decreased  by  his  portion  of  their  losses,  in  recognition  of 
the  fact  that  the  income  and  losses  are  flowed  through  to  the  investor 
for  tax  purposes,  rather  than  being  taxed  to  the  entity. 

The  liabilities  of  a  productive  activity  may  also  have  an  effect  upon 
an  investor's  adjusted  basis  in  the  activity.  Thus,  a  taxpayer's  basis  in 
a  property  includes  the  portion  of  the  purchase  price  which  is  financed 
even  if  the  taxpayer  is  not  personally  liable  on  the  loan  and  the  lender 
must  look  solely  to  the  financed  property  for  repayment  of  the  loan. 

However,  in  the  case  of  a  subchapter  S  corporation,  liabilities  of 
the  corporation  increase  a  shareholder's  adjusted  basis  in  the  stock 
only  to  the  extent  that  the  liability  is  owed  to  that  particular  share- 
holder (sees.  1374(c)(2),  1376). 

In  the  case  of  partnerships,  in  general,  a  partner's  share  of  the  lia- 
bilities of  the  partnership  is  considered  to  be  a  contribution  of  money 
by  him  to  the  partnership  (sec.  752).  Since  a  partner's  contributions 
to  the  partnership  increase  the  adjusted  basis  of  his  partnership  inter- 
est (sec.  705),  the  partner's  adjusted  basis  reflects  not  only  his  contri- 
butions in  money  and  other  property,  but  also  his  share  of  partnership 
liabilities.  This  rule  applies  regardless  of  whether  the  particular  lia- 
bility is  owed  to  one  or  more  of  the  partners  or  to  an  unrelated  party. 

The  rule  is  premised  upon  the  assumption  that  the  partner  may  be 
held  pei-sonally  liable  for  the  debts  of  the  partnership  and  since  he 
may  be  called  on  to,  in  effect,  make  additional  contributions  of  money 
to  cover  these  liabilities,  the  adjusted  basis  of  his  partnership  interest 
should  reflect  this  potential  risk  of  additional  liability. 

However,  a  limifed  partner  in  a  limited  partnership  may  not  be 
held  responsible  for  partnership  debts,  and  his  potential  personal 
liability  is  confined  to  any  additional  amount  he  is  required  to  con- 
tribute to  the  partnership  by  the  partnership  agreement.  Since  a 
limited  partner  does  not  have  unlimited  personal  liability,  the  basis 
of  his  partnership  interest  is  not  usually  increased  to  reflect  borrow- 
ing by  the  partnership.  There  has  been,  however,  an  exception  to  this 
rule.  The  regulations  provide  that  where  none  of  the  partners  have 
personal  liability  for  a  partnership  obligation,  all  of  the  partners, 
including  limited  partners  share  in  the  liability  (Reg.  §  1.752-1  (e)). 
Since  a  limited  partner  is  deemed  to  have  a  share  of  such  nonrecourse 
liabilities,  the  adjusted  basis  of  his  partnership  interest  is  increased 
under  the  generally  applicable  partnership  provisions. 

This  approach  to  nonrecourse  partnersnip  liabilities  ai-ose  from  a 
judicially  developed  principle  known  as  the  Crane  rule.  The  Crane 


35 

rule  was  derived  from  the  Supreme  Court's  reasoning  in  Crane  v.  Com- 
missioner^ 331  U.S.  1  (1947),  where  it  was  held  that  an  owner's  ad- 
justed basis  in  a  parcel  of  real  property  included  the  amount  of  a  non- 
recourse mortgage  on  the  property,  under  which  the  mortgagee-lender 
could  seek  a  recovery  of  its  loan  oiily  from  the  property.  (It  is  because 
of  the  Crane  rule  that  nonrecourse  indebtedness  has  generally  been  in- 
cluded in  an  investor's  adjusted  basis,  as  indicated  above,  in  a  business 
or  productive  property.) 

Also,  in  general,  the  existence  of  protection  against  ultimate  loss  by 
reason  of  a  stop-loss  order,  guarantee,  guaranteed  repurchase  agree- 
ment or  similar  arrangement  does  not  generally  impose  a  limitation 
on  the  amount  of  losses  a  taxpayer  may  deduct  in  the  early  taxable 
years  of  an  activity. 

Reasons  for  change 

The  typical  tax  shelter  has  operated  as  a  limited  partnership  with 
individual  investors  participating  as  limited  partners.  Virtually  all  of 
the  equity  capital  for  the  activity  has  been  contributed  by  the  limited 
partners  with  the  major  portion  of  the  remaining  operating  funds 
(generally  75  percent  or  more  of  the  total  capital)  for  the  partner- 
ship financed  through  nonrecourse  loans. 

When  an  investment  had  been  solicited  for  a  tax  shelter  activity,  it 
had  been  common  practice  to  promise  the  prospective  investor  sub- 
stantial tax  losses  which  could  be  used  to  decrease  the  tax  on  his  in- 
come from  other  sources.  The  opportunity  to  deduct  tax  losses  in  ex- 
cess of  the  amount  of  the  taxpayer's  economic  risk  had  arisen  under 
prior  law  primarily  through  the  use  of  nonrecourse  financing  not  only 
by  limited  partnerships,  but  also  by  individuals  and  subchapter  S  cor- 
porations. The  ability  to  deduct  tax  losses  in  excess  of  economic  risk 
had  also  arisen  through  guarantees,  stop-loss  agreements,  guaranteed 
repurchase  agreements,  and  other  devices  used  by  the  partnerships,  in- 
dividuals and  subchapter  S  corporations. 

Nonrecourse  leveraging  of  investments  and  other  risk  limiting  de- 
vices which  produce  tax  savings  in  excess  of  amounts  placed  at  risk 
substantially  alter  the  economic  substance  of  the  investments  and 
distort  the  workings  of  the  investment  markets.  Taxpayers,  ignoring 
the  possible  tax  consequences  in  later  years,  can  be  led  into  investments 
which  are  otherwise  economically  unsound  and  which  constitute  an 
unproducti  ve  use  of  investment  funds. 

Congress  believed  that  it  was  not  equitable  to  allow  individual  in- 
vestors to  defer  tax  on  income  from  other  sources  through  losses  gen- 
erated by  tax  sheltering  activities.  One  of  the  most  significant  prob- 
lems in  tax  shelters  was  the  use  of  nonrecourse  financing  and  other 
risk-limiting  devices  which  enabled  investors  in  these  activities  to 
deduct  losses  from  the  activities  in  amounts  which  exceeded  the  total 
investment  the  investor  actually  placed  at  risk  in  the  activity.  The 
Act  consequently  provides  an  "^at  risk"  rule  to  deal  directly  with  this 
abuse  in  tax  shelters. 

Explanation  of  provision 
To  prevent  a  situation  where  the  taxpayer  may  deduct  a  loss  in  ex- 
cess of  his  economic  investment  in  certain  types  of  tax  shelter  activi- 
ties, the  Act  provides  that  the  amount  of  any  loss  (otherwise  allow- 
able for  the  year)  which  may  be  deducted  in  connection  with  one  of 


36 

these  activities  cannot  exceed  the  a^^re^ate  amount  with  respect  to 
which  the  taxpayer  is  at  risk  in  eacli  such  activity  at  the  close  of  the 
taxable  year.  This  "at  risk"  limitation  applies  to  the  follovvino^  activi- 
ties: (1)  farming^;  (2)  exploring  for,  or  exploiting,  oil  and  gas  re- 
sources; (3)  the  holding,  producing,  or  distributing  of  motion  picture 
films  or  video  tapes;  and  (4)  equipment  leasing.  The  limitation  ap- 
plies to  all  taxpayers  (other  than  corporations  which  are  not  sub- 
chapter S  corporations  or  personal  holding  companies)  including 
individuals  and  sole  proprietorships,  estates,  trusts,  shareholders  in 
subchapter  S  corporations,  and  partners  in  a  pai-tnei-ship  which  con- 
ducts an  activity  described  in  this  provision.^ 

The  at  risk  limitation  is  to  apply  on  the  basis  of  the  facts  existing  at 
the  end  of  eacli  taxable  year.  The  at  risk  limitation  applies  regard- 
less of  the  method  of  accounting  used  by  the  taxpayer  and  regardless 
of  the  kind  of  deductible  expenses  which  contributed  to  the  loss. 

The  amount  of  any  loss  which  is  allowable  in  a  particular  year  re- 
duces the  taxpayer's  at  risk  amount  as  of  the  end  of  that  year  and  in 
all  succeeding  taxable  yeai-s  with  respect  to  that  activity.'' 

Tosses  which  are  suspended  under  this  provision  with  respect  to  a 
taxpayer  because  they  are  greater  than  the  taxpayer's  investment 
which  is  "at  risk""  are  to  be  treated  as  a  deduction  with  respect  to  the 
activity  in  the  following  year.  Consequently,  if  a  taxpayer's  amount 
at  risk  increases  in  later  years,  he  will  be  able  to  obtain  the  benefit  of 
previously  suspended  losses  to  the  extent  that  such  increases  in  his 
amount  at  risk  exceed  his  losses  in  later  yeare. 

The  at  risk  limitation  is  only  intended  to  limit  the  extent  to  which 
certain  losses  in  connection  with  the  covered  activities  may  be  deducted 
in  the  year  they  would  otherwise  be  allowable  to  the  taxpayer.  The 
rules  of  this  provision  do  not  apply  for  other  purposes,  such  as  the 
determination  of  basis.  Thus,  a  partner's  basis  in  his  interest  in  the 
partnership  will  generally  be  unaffected  by  this  provision  of  the  com- 
mittee amendment.*  However,  for  ]iurposes  of  determining  how  much, 
if  any,  of  his  share  of  a  partnei-ship  loss  from  the  enumerated  activi- 
ties a  partner  may  deduct  in  any  year,  this  provision  of  the  Act  over- 
rides the  existing  partnership  rules  of  section  704(d)  and  related 
provisions,  iiicludino;  regulations  section  1.752-1  (e).^ 

For  purposes  of  this  provision,  a  taxpayer  is  generally  to  be  con- 

1  For  purposes  of  this  section,  the  definition  of  "farming"  Is  the  definition  used  In  the 
farming  syndicate  rules  (discussed  below).  Thus,  the  at  risk  provision  does  not  apply  to 
forestry  or  the  growing  of  timber. 

-  Since,  except  for  subchapter  S  corporations  and  personal  holding  companies,  this 
provision  does  not  limit  the  deductibility  of  amounts  paid  or  incurred  by  corporations, 
the  provision  would  not  apply  to  a  partnership  in  which  all  the  partners  are  corporations 
(other  than  subchapter  S  corporations  or  personal  holding  companies).  Similarly.  If  a 
partnership  is  comprised  of  both  individiml  partners  and  corporate  partners  (other  than 
subchapter  S  corporations  and  personal  holding  companies),  the  at  risk  provision  ap- 
plies to  the  individual  partners  but  not  the  corporate  partners. 

'  The  at  ri.^k  limitation  does  not  affect  a  taxpayer's  utilization  of  the  Investment  credit. 
.\lso.  the  amount  of  investment  tax  credit  claimed  by  a  taxpayer  with  respect  to  an 
activity  does  not  reduce  the  amount  the  taxpayer  is  at  risk  with  respect  to  the  activity. 

*  For  example,  the  basis  of  a  partner's  interest  in  a  partnership  Is  rpduce<l  by  the  full 
amount  of  any  losses  which  would  be  allowable  but  for  this  provision.  However,  upon 
disposition  of  his  interest  in  a  partnership,  a  partner  is  to  be  treated  as  becoming  at  risk 
with  respect  to  the  amount  of  any  gain  from  the  disposition.  As  a  result,  a  partner  will 
be  able  to  deduct  nny  suspended  losses  at  the  time  of  disposition. 

"  If  no  partner  is  personally  liable  to  repay  any  part  of  a  debt  obligation  Incurred  bv 
the  partnership,  no  partner  may  treat  such  part  of  the  debt  as  part  of  his  capital  at  risk 
in  the  partnership  for  purposes  of  this  provision.  Similarly,  even  if  one  or  more  partners 
is  personally  liable  on  part  or  all  of  a  partnership  debt,  other  partners  who  have  no 
personal  liability  may  not  treat  any  part  of  the  debt  as  part  of  their  risk  capital.  In 
the  case  of  a  partnership,  special  allocations  of  deductions  by  agreement  among  the 
partners  may  not  increase  the  amount  of  a  loss  deduction  allowable  to  any  partner  for  a 
taxable  year  beyond  the  amount  which  that  iiartner  is  "at  risk"  in  the  partnership  for  the 
same  vear. 


37 

sidered  "at  risk"  with  respect  to  an  activity  to  the  extent  of  his  cash 
and  the  adjusted  basis  of  other  property  contributed  to  the  activity, 
as  well  as  any  amounts  borrowed  for  use  in  the  activity  with  respect 
to  which  the  taxpayer  has  pereonal  liability  for  payment  from  his  per- 
sonal assets. 

A  taxpayer's  at  risk  amount  is  also  generally  to  include  amounts 
borrowed  for  use  in  the  activity  which  are  secured  by  property  other 
than  property  used  in  the  activity.  For  example,  if  the  taxpayer  act- 
ing as  a  sole  proprietor  (or  partner  or  shareholder  in  a  subchapter  S 
corporation)  uses  personally-owned  real  estate  to  secure  nonrecourse 
indebtedness,  the  proceeds  from  which  are  used  in  an  equipment  leas- 
ing activity,  the  proceeds  may  be  considered  part  of  the  taxpayer's 
at  risk  amount.  In  such  a  case,  the  portion  of  the  proceeds  which  in- 
creases the  taxpayer's  at  risk  amount  is  to  be  limited  by  the  fair  market 
value  of  the  property  used  as  collateral  (determined  as  of  the  date  the 
property  is  pledged  as  security),  less  any  prior  (or  superior)  claims  to 
which  the  collateral  is  subject. 

The  Act  contains  a  special  rule  which  prevents  a  taxpayer  from  in- 
creasing his  at  risk  amoimt  through  collateral  in  cases  where  the  col- 
lateral was  financed  directly  or  indirectly  by  indebtedness  which  is 
secured  by  any  property  used  in  the  activity.  The  intent  of  this  rule 
is  to  prevent  a  taxpayer  from  increasing  his  at  risk  amount  by  cross- 
collateral  izing  property  used  in  the  activity  with  other  property  not 
used  in  the  activity. 

Except  where  the  indebtedness  is  secured  by  property  not  used  in 
the  activity,  a  taxpayer  is  not  to  be  considered  at  risk  with  respect  to 
the  proceeds  from  his  share  of  any  nonrecourse  loan  used  to  finance  the 
activity  or  the  acquisition  of  property  used  in  the  activity.  In  addi- 
tion, if  the  taxpayer  borrows  money  to  contribute  to  the  activity  and 
the  lender's  only  recourse  is  either  the  taxpayer's  interest  in  the  activ- 
ity or  property  used  in  the  activity,  the  amount  of  the  proceeds  of  the 
borrowing  are  to  be  considered  amovmts  financed  on  a  nonrecourse 
basis  and  do  not  increase  the  taxpayer's  amount  at  risk. 

Also,  under  these  rules,  a  taxpaj^er  is  not  to  be  "at  risk,"  even  as 
to  the  equity  capital  which  he  has  contributed  to  the  activity,  to  the 
extent  he  is  protected  against  economic  loss  of  all  or  part  of  such  capi- 
tal by  reason  of  an  agreement  or  arrangement  for  compensation  or 
reimbursement  to  him  of  any  loss  which  he  may  suffer."  Under  this 
concept,  a  taxpayer  is  not  "at  risk"  if  he  arranges  to  receive  insurance 
or  other  compensation  for  an  economic  loss  after  the  loss  is  sustained, 
or  if  he  is  entitled  to  reimbursement  for  part,  or  all  of  any  loss  by 
reason  of  a  binding  agreement  between  himself  and  another  person.^ 


8  The  normal  buy-sell  afrreement  between  partners  which  is  carried  out  when  a  partner 
retires  or  dies  is  not  the  kind  of  agreement  which  prevents  a  partner  from  being  at  risk. 

■'  In  livestock  feeding  operations,  for  example,  some  commercial  feedlots  have  offered  to 
reimburse  Investors  against  any  loss  sustained  on  sales  of  the  fed  livestock  above  a  stated 
dollar  amount  per  bead.  Under  such  "stop  loss"  orders,  the  investor  is  to  be  considered 
"at  risk"  (for  nurposes  of  this  nrovision)  only  to  the  extent  of  the  portion  of  his  capital 
agfainst  which  he  Is  not  entitled  to  reimbursement.  Similarly,  in  some  livestock  breeding 
Investments  carrie'l  on  through  a  limited  partnership,  the  partnership  agrees  with  n 
limited  partner  that,  at  the  partner's  election,  it  will  repurchase  liis  partnership  Interest 
at  a  stated  minimum  dollar  amount  (usually  less  than  the  Investor's  original  capital 
contribution).  In  situations  of  this  kind,  the  partner  is  to  he  considered  "at  risk"  only  to 
the  extent  of  the  portion  of  the  amount  otherwise  at  risk  over  and  above  the  guaranteed 
repurchase  price. 

In  addition  a  limited  partner  who  assumes  personal  liability  on  a  loan  to  tht^  partnership 
(made  by  a  bank  or  other  lender)  but  who  obtains  the  general  partner's  ugreement  to 
Indemnify  him  against  some  or  all  of  any  loss  arising  under  such  personal  liability,  is  at 
risk  only  with  respect  to  the  excess  of  the  amount  of  the  Indebtedness  over  the  maximum 
amount  covered  by  the  indemnity  agreement. 

234-120  O  -  77  -  4 


38 

Similarly,  if  a  taxpayer  is  personally  liable  on  a  mortgage  but  sepa- 
rately obtains  insurance  to  compensate  him  for  any  payments  which 
he  nnist  actually  make  under  such  pei"Sonal  liability,  the  taxpayer  is 
at  risk  only  to  the  extent  of  the  uninsured  portion  of  the  personal  lia- 
bility to  Avhicli  he  is  exposed.*  The  taxpayer  will  be  able  to  include  in 
the  amount  which  he  has  at  risk  any  amount  of  nondeductible  pre- 
mium which  he  has  paid  from  his  pei-sonal  assets  with  respect  to  the 
insurance.  However,  a  taxpayer  who  obtains  casualty  insurance  or 
insurance  protecting  himself  against  tort  liability  will  not  be  con- 
sidered "not  at  risk"'  solely  because  of  such  hazard  insurance  protection. 

In  the  ca,s(^  of  a  pai"tnershii),  a  }>aitiier  is  generally  to  be  treated  as 
at  I'isk  to  the  extent  that  his  basis  in  the  partnership  is  increased  by 
his  share  of  partnership  income.''  The  fact  that  partnership  income  is 
then  used  to  reduce  the  partnership's  nonrecourse  indebtedness  would 
have  no  etl'ect  on  the  partner's  amount  at  risk.  (The  reduction  of  non- 
recoui-se  indebtedness  would  still,  of  course,  reduce  his  basis  in  his 
partnership  interest  for  purposes  other  than  the  at  risk  limitation.)^" 
If  the  j)artnership,  instead  of  retaining  the  income,  makes  actual  dis- 
tributions of  the  income  to  a  partner  in  the  taxable  year,  the  amount 
distributed,  like  any  cash  distribution,  reduces  the  partner's  amount  at 
risk. 

In  general,  in  the  case  of  an  activity  engaged  in  by  an  individual, 
each  motion  picture  film  or  video  tape,  item  of  leased  equipment,  fai-m, 
or  oil  and  gas  property  is  treated  as  a  separate  activity.  However,  in 
the  case  of  a  partnership,  personal  holding  company,  or  subchapter  S 
corporation,  all  of  the  activities  of  the  same  type  (e.g.,  all  motion 
picture  films  and  video  tapes)  are  to  be  treated  as  one  activity."  Thus, 
where  the  partnership  is  engaged  in  oidy  one  type  of  activity  the  loss 
from  the  activity  for  any  partner  is  that  partner's  loss  from  the  part- 
nership and  (assuming  no  stop  loss  orders,  etc.)  his  at  risk  amount  is 
generally  the  amount  of  his  cash  or  other  contribution  to  the  partner- 
ship, plus  his  share  of  any  indebtedness  with  respect  to  which  the 
partner  has  no  limitation  on  liability. 

The  at  risk  limitation  applies  only  to  losses  produced  by  deduc- 
tions which  are  not  disallowed  by  reason  of  some  other  provision 
of  the  Code.  For  example,  if  a  prepaid  interest  expense  is  suspended 
under  the  prei)aid  interest  limitation  (sec.  208  of  the  Act  and  sec. 
461  of  the  Code)   that  expense  will  not  enter  into  the  computation 

?  For  purposes  of  this  rule,  it  will  be  nssnnied  that  ft  loss-protection  guarantee,  repurchase 
acroonieiit  or  insurance  policy  will  be  fully  honored  and  that  the  amounts  due  thereunder 
will  be  fully  paid  to  the  taxpayer.  The  possibility  that  the  party  making  the  guarantee 
to  the  taxpayer,  or  that  a  partnersliip  whidi  agrees  to  repurchase  a  partner's  Interest  at  an 
agn'od  price,  will  fail  to  carry  out  the  agreement  (because  of  factors  sucli  as  Insolvency  or 
other  financial  difficulty)  is  not  to  be  material  unless  and  until  the  time  when  the  taxpayer 
becomes  unconditionally  entitled  to  payment  and.  at  that  time,  demonstrates  that  he 
cannot  recover  under  the  agreement. 

"  However,  bis  at  rislv  amount  must  be  reduced  by  any  personal  nonrecourse  indebtedness 
reflected  in  his  basis  and  any  other  appropriate  stop-loss  orders,  etc.,  which  affect  his 
ri'slc  or  that  of  his  partnership. 

'"For  example,  assume  partner  A's  basis  in  the  partnership  is  .$60X  (consisting  of  $10X 
whidi  is  "at  risk"  aTid  .f.'iflX  wldch  represents  tlie  portion  of  the  partnersliip's  nonrecourse 
loan  \v.hlch  is  allocated  to  partner  A's  basis).  If  the  partnership  has  S.'SX  of  taxable  income 
for  the  taxable  year  which  is  allocated  to  partner  A.  his  total  basis  is  increased  to  .^fi.'iX  (his 
at  Tisl<  l)asis  increases  to  .$ir)X  while  his  l>asis  which  is  not  at  rislc  remains  at  .f.'iOX). 
If  the  partnership  then  makes  a  .f.^X  payment  to  the  bank  on  its  loan,  the  partner's  basis 
is  reduced  to  .fSfiOX  (bis  at  risk  basis  remains  at  .fl.'iX  while  his  basis  which  is  not  at  risk  !s 
reduced  to  .'?45X). 

"  Partnersliips  engaged  in  two  or  more  different  types  of  activities,  such  as  movies  and 
equipment  leasing,  or  movies  and  farming  are  to  be  treated  as  liaving  that  number  of 
activities,  and  the  at  risk  limitation  is  determined  separately  for  each  activity. 


39 

of  the  loss  subject  to  the  at-risk  limitation.  When  the  interest  ac- 
crues and  becomes  deductible,  the  expense  may  at  that  time  be  subject 
to  this  provision.  Similarly,  if  a  deduction  is  deferred  pursuant  to 
the  farming  syndicate  rules  (described  below),  that  deduction  will 
enter  into  the  computation  of  the  tax  loss  subject  to  the  at  risk  limita- 
tion only  when  it  becomes  deductible  under  the  farminjr  syndicate 
rules. 

The  Act  specifically  requires  that  a  taxpayer  not  be  considered  at 
risk  with  respect  to  amounts  borrowed  for  use  in  an  activity  (or 
which  are  contributed  to  the  activity)^'-  where  the  amounts  are  bor- 
rowed from  any  pei-son  who  lias  an  interest  in  the  activity  (other 
than  that  as  a  creditor)  or  who  is  related  to  the  taxpayer  (as  de- 
scribed in  sec.  267(b)).  Persons  having  an  interest  in  the  activity 
include,  in  the  case  of  a  partnership,  all  other  partners  and  any  other 
person  (such  as  a  promoter  or  selling  agent)  who  stands  to  receive 
financial  gain  from  the  activity  or  from  the  sale  of  interests  in  the 
activity.  Those  persons  considered  to  be  related  to  the  taxpayer 
include  the  taxpayer's  spouse,  ancestors  and  lineal  descendants,  broth- 
ers and  sisters,  and  corporations  and  other  entities  in  which  the  tax- 
payer has  a  nO-percent  or  greater  interest.^^ 

E-ffective  dates 

In  general,  the  at  risk  provision  applies  to  losses  attributable  to 
amounts  paid  or  incurred  (and  depreciation  or  amortization  allowed 
or  allowable)  in  taxable  years  beginning  after  December  31,  1975. 
However,  with  respect  to  equipment  leasing  activities,  the  at  risk  rule 
generally  does  not  apply  where  the  i)roperty  was  subject  to  a  net  op- 
erating lease  and  binding  contracts  weiv  finalized  on  or  l)efore 
December  31,  1975,  and  similarly  to  operating  lease  transju'tions  under 
binding  contracts  finalized  on  or  before  A])i-il  80,  1976. 

With  respect  to  motion  i)icture  activities,  the  at  risk  provision  does 
not  apply  to  a  film  purchase  shelter  if  the  principal  photography  began 
before  September  11, 1975,  there  was  a  binding  written  contract  for  the 
purchase  of  the  film  on  that  date,  and  the  taxpayer  held  his  interest  in 
the  film  on  that  date.  The  at  risk  rule  also  does  not  apply  to  production 
costs,  etc.,  if  the  principal  photography  began  bixfore  September  11, 
1975,  and  the  investor  had  acquired  his  inter-est  in  the  film  l.»efore  that 
date.  In  addition,  the  at  risk  provision  does  not  apply  to  film  ])roduced 
in  the  United  States  if  the  principal  photogr-aphy  began  l)efore  Jan- 
uary 1,  1976,  if  certain  commitments  with  respect  to  the  film  had  been 
made  by  September  10, 1975. 

In  applying  the  at  risk  provisions  to  activities  which  were  begim  in 
taxable  years  beginning  before  January  1,  1976  (and  not  exempted 
from  this  pr-ovision  by  the  above  transition  rules),  amounts  paid  or  in- 
curi-ed  in  taxable  years  beginning  prior  to  that  date  and  deducted  in 
such  taxable  years  will  generally  be  treated  as  reducing  first  that  por- 


12  Til p  (imoiints  borrowed  by  tlie  taxpayer  and  then  contributed  to  the  activity  (or  used 
to  purfhnsc  property  which  is  contributed  to  the  activity)  are  "amounts  borrowed  with 
respect  to"  the  activity  (as  referred  to  in  section  465(b)  (l)fB))  and  therefore  are  sub- 
ject fo  the  rules  of  section  465(b)(3)  ei^en  though  such  amounts  (or  property)  are  also 
described  In  section  465  (b)  (1)  (A). 

"  While  this  rule  applies  to  loans  from  a  partner  to  the  partnership  for  purposes  of 
determining  the  at  rlsic  amount  of  the  iitlier  partners  (resulting  from  the  increase  in 
partnership  liabilities),  it  is  not  to  affect  any  possible  allocation  of  basis  and  at  risk  amounts 
which  otherwise  might  be  made  to  a  specific  partner  in  cases  where  that  partner  has 
borrowed  funds  from  the  partnershp   (or  is  otherwise  obligated  to  the  partnership). 


40 

tion  of  the  taxpayer's  basis  which  is  attributable  to  amounts  not  at 
risk.  (On  the  other  hand,  withdrawals  made  in  taxable  years  begin- 
ning before  Januaiy  1,  1976,  will  be  treated  as  reducing  the  amount 
which  the  taxpayer  is  at  risk.)  ^* 

Reverviie  effect 
The  provision  will  increase  budget  receipts  by  $57  million  in  fiscal 
year  1977,  $42  million  in  fiscal  year  1978,  and  $38  million  in  fiscal 
year  1981. 

3.  Farm  Operations 

a.  Farming  Syndicates  (sec.  207  (a)  and  (b)  of  the  Act  and  sees.  278 
and  464  of  the  Code) 

Prior  law 

Under  the  tax  laws,  farm  operations  are  governed  by  special  tax 
rules,  many  of  which  confer  tax  benefits  on  fai'ming  activities  and  on 
persons  who  engage  in  farming.  The  special  tax  rules  available  to 
farmers  have  been  utilized  by  both  full-time  farmers  and  by  high- 
bracket  taxpayers  who  participated  in  farming  as  a  sideline.  Part-time 
farmers  have  been  entitled  to  use  the  special  farm  rules  even  if  they 
were  absentee  owners  who  paid  agents  to  operate  their  farming  activi- 
ties and  regarded  their  own  participation  (such  as  being  limited 
partners  in  a  nationwide  syndicate)  as  a  completely  passive  investment. 

Taxpayers  engaged  in  farming  have  been  allowed  to  report  their 
income  and  expenses  from  farm  operations  on  the  cash  method  of 
accounting,  which  does  not  require  the  accumulation  of  inventory  costs. 
Fanners  have  also  been  allowed  to  deduct  the  cost  of  seed  and  young 
plants  purchased  in  one  year  which  would  be  sold  as  farm  products  in 
a  later  year.^  These  rules  contrast  with  the  tax  rules  applicable  to  non- 
farm  taxpayers  engaged  in  the  business  of  selling  products,  who  must 
report  their  income  using  the  accrual  method  of  accounting  and  must 
accumulate  their  production  costs  in  inventory  until  the  product  is  sold. 

The  special  inventory  exception  for  farmers  was  adopted  by  admin- 
istrative regulation  more  than  fiftv  years  ago.  The  primary  justifica- 
tion for  this  exception  was  the  relative  simplicity  of  the  cash  method  of 
accounting  which,  for  example,  eliminates  the  need  to  identify  specific 
costs  incurred  in  raising  particular  animals. 

The  Treasury  has  also  long  permitted  farmers  to  deduct  currently 
many  of  the  costs  of  raising  or  growing  farm  assets  (such  as  costs 
related  to  breeding  animals,  orchards  and  vineyards)  wliich  are  used  in 
the  trade  or  business  of  farming.-  (In  similar  nonf arming  businesses, 
such  as  manufacturing,  these  costs  generally  are  treated  as  capital 
expenditures  and  are  depreciated  over  their  useful  lives.)  These  assets 


"Increases  in  basis  occurinij  after  December  31,  1975.  as  a  result  of  income  from  the 
discharge  of  indebtedness  attributable  to  property  used  in  an  activity  with  respect  to  which 
substantial  deductions  were  taken  in  taxable  years  beginning  before  January  1,  1976,  are 
not  to  increase  a  taxpayer's  at  rislc  amount  with  respect  to  that  activity. 

1  However,  a  farmer  has  not  been  allowed  to  deduct  the  purchase  price  of  livestock,  such 
as  cattle,  which  he  intended  to  fatten  for  sale  as  beef. 

2  Not  all  costs  relating  to  development  of  farm  assets  have  been  currently  deductible.  A 
farmer  has  been  required  to  capitalize  costs  of  water  wells,  irrigation  pipes  and  ditches, 
reservoirs,  dams,  roads,  trucks,  farm  machinery,  land  and  buildings. 

Thus,  even  prior  to  the  changes  made  by  the  Act.  section  27S  of  prior  law  speclfleally 
required  caoitalization  of  all  amounts  attributable  to  the  planting,  cultivating,  maintain- 
ing or  developing  of  an  almond  or  citrus  grove  during  the  first  four  years  after  the  grove 
was  planted. 


41 

are  used  in  a  taxpayer's  business  and  may  eventually  be  sold  at  a  gain 
which  is  taxed  at  the  lower  capital  gain  tax  rate.  Since  development 
costs  could  be  deducted  before  the  income  is  realized  from  the  sale  of 
livestock  or  crops,  the  development  costs  would  offset  a  farm  investor's 
income  from  other  sources  such  as  salaries,  interest,  professional  fees, 
etc. 

Certain  other  statutory  provisions  allow  specific  types  of  capital 
improvements  to  farmland  to  be  deducted  when  the  taxpayer  pays 
them.  These  costs  include  soil  or  water  conservation  expenditures  (sec. 
175),  fertilizer  costs  (sec.  180),  and  land  clearing  expenses  (sec.  182). 
Similar  capital  expenditures  in  a  nonfarm  business  would  be  added  to 
the  basis  of  the  property  and,  since  land  is  nondepreciable,  could  be 
rex3overed  only  out  of  the  proceeds  when  the  land  is  sold. 

Capital  gain  treatment  is  generally  available  on  the  sale  of  depre- 
ciable assets  used  in  farming  (as  well  as  on  the  sale  of  the  underlying 
farmland  itself),  even  though  these  assets  or  land  may  have  been 
developed  or  improved  by  expenditures  which  were  deducted  against 
ordinary  income.^  In  effect,  a  farm  investor's  income  which  has  been 
initially  sheltered  by  accelerated  farm  deductions  has  been  trans- 
formed into  added  capital  value  of  the  farm  asset  and  taxed  as  part  of 
that  value  when  the  farm  capital  assets  (vineyard,  breeding  animal, 
farmland,  etc. )  are  later  sold. 

After  breeding  animals,  vineyards  or  orchards  reach  maturity  and 
are  held  for  the  production  of  annual  crops,  farmers  and  farm  inves- 
tors continue  to  receive  tax  benefits  through  deductions  for  accelerated 
depreciation.* 

Capital  gain  treatment  on  the  sale  of  farm  asests  held  for  the  pro- 
duction of  income  or  used  in  a  taxpayer's  farm  business  is  not  avail- 
able to  the  extent  that  various  recapture  rules  of  present  law  are 
applicable.  For  example,  section  1251  requires  a  limited  recapture  as 
ordinary  income  (rather  than  capital  gain)  of  previous  farm  tax 
losses  whenever  assets  used  in  a  farming  business  are  sold  or  disposed 
of.  (This  section  of  prior  law  was  amended  by  section  206  of  the  Act.) 

Section  1252  recaptures  amounts  previously  deducted  as  soil  and 
water  conservation  and  land  clearing  expenses  if  farmland  is  sold 
within  5  years  after  acquisition.  If  the  land  is  held  for  a  longer  period, 
the  amount  recaptured  is  reduced  by  20  percent  for  each  year  over 
5  years  that  the  property  is  held.  Thus,  if  the  land  is  held  more  than 
10  years,  no  recapture  is  required  on  a  sale  of  farmland. 

The  holding  period  for  long-term  capital  gain  treatment  of  cattle 
and  horses  held  for  draft,  breeding,  dairy,  or  sporting  purposes  (such 
as  horse  racmg)  is  24  months  (sec,  1231(b)  (3) ).  The  minimum  liold- 

3  Under  section  1231.  a  taxpayer  who  sells  property  used  in  his  trade  or  business  obtains 
a  special  tax  treatment.  All  gains  and  losses  from  section  12.'>1  property  are  afrpreRated 
for  each  taxable  year  and  the  gain,  if  any,  is  treated  as  capital  gain.  The  loss,  if  any. 
Is  treated  as  an  ordinary  loss.  Machinery,  equipment,  buildings  and  land  used  by  a  taxpayer 
In  his  business  are  examples  of  section  12.31  property. 

*  For  example,  an  investor  or  rancher  can  use  200  percent  declining  balance  depreciatiori 
on  the  purchase  price  of  breeding  animals  which  he  originally  purchased  for  the  herd.  If 
the  rancher  purchased  cattle  which  had  been  used  for  breeding  by  a  previous  owner,  the  cat- 
tle can  be  depreciated  on  the  150  percent  declining  balance  method. 

The  offspring  of  purchased  animals  cannot  be  depreciated,  however,  since  the  owner  is 
considered  to  have  no  cost  basis  in  such  animals.  (As  indicated  earlier,  however,  the  cost 
of  raising  such  offspring  can  be  expensed.) 

Accelerated  depreciation  under  a  150-percent  declining  balance  method  is  also  avail- 
able for  new  farm  buildings  and  for  the  costs  of  purchased  vineyards  and  orchards.  The 
capitalized  costs  of  vineyards  and  orchards  planted  by  the  taxpayer  may  be  depreciated 
on  a  200-percent  declining  balance  method. 


42 

ing  period  for  other  livestock  held  for  such  purposes  is  12  months. 
(One  effect  of  this  rule  is  that  many  sales  of  "culls"  from  a  breeding 
herd,  i.e.,  animals  regarded  as  unsuitable,  are  taxable  at  ordinary  in- 
come rates,  since  many  culls  are  sold  within  24  months.)^ 

Section  183  limits  the  current  deduction  of  expenses  in  an  activity 
which  a  taxpayer  conducts  other  than  "for  profit."  Although  not  lim- 
ited to  farming,  this  provision  may  affect  a  variety  of  farm  operations. 
If  an  activity  is  found  not  to  be  engaged  in  for  profit,  expenses  can 
be  deducted  only  to  the  extent  that  income  derived  from  the  activity 
exceeds  deductible  interest,  taxes  and  casualty  losses. 

Reasons  for  change 

Farm  investments  have  offered  an  opportunity  to  defer  taxes  on  non- 
farm  income  where  investors  were  able  to  take  advantage  of  the  special 
farm  tax  rules  to  deduct  farm  expenses  in  a  year  or  years  prior  to  the 
years  when  the  revenue  associated  with  such  expenses  was  earned.  This 
type  of  deferral  could  occur  regardless  of  whether  the  proceeds  from 
the  later  sale  of  the  underlying  products  were  taxed  at  ordinary  income 
or  capital  gain  rates.  Generally,  in  farming  operations  tax  losses  were 
shown  in  early  years  of  an  investment  because  of  (1)  the  opportunity 
to  deduct,  when  paid,  costs  which  in  nonfarm  businesses  would  be  in- 
ventoried and  deducted  in  a  later  year,  (2)  the  ability  to  deduct,  when 
paid,  costs  which  under  general  accounting  principles  should  have 
been  capitalized,  and  (3)  the  ability  to  claim  depreciation  deductions 
which  exceeded  straight-line  depreciation. 

These  tax  losses  were  used  to  offset  income  from  a  taxpayer's  other 
nonfarm  occupations  or  investments  on  which  he  would  otherwise  have 
been  required  to  pay  tax  currently.  ^Vhen  the  income  which  was  re- 
lated to  these  deductions  was  reported,  it  was  not  reduced  by  the 
amount  of  the  deductions  attributable  to  it  (and  was  thus  greater 
in  net  amount  than  it  otherwise  would  be).  This  lack  of  match- 
ing resulted  in  deferral  of  taxes  from  the  years  when  the  initial  de- 
ductions were  taken.  If  the  related  farm  income  was  eventually  real- 
ized as  capital  gain  (as  it  might  have  been  where  breeding  animals  or 
orchards  were  sold),  conversion  of  ordinary  income  (against  which 
the  expenses  were  deducted)  into  capital  gain  also  resulted.  Even 
without  the  possibility  of  conversion,  however,  the  tax  advantages  of 
deferral  alone  were  frequently  sufficient  to  motivate  high-income  tax- 
payers to  engage  in  certain  types  of  farming  activities. 

Even  after  the  Tax  Eeform  Act  of  1969,  high-bracket  taxpayers 
continued  to  use  farm  tax  rules  to  shelter  nonfann  income  because  (ex- 
cept for  citrus  and  almond  groves)  the  restrictions  in  prior  law 
did  not  prevent  the  initial  deferral  of  taxes  on  nonfarm  income  by 
means  of  accelerated  deductions  incurred  in  farm  activities.  Prior  law 
focused  largely  on  recapturing  deductions  which  otherwise  would 
be  used  to  convert  ordinary  income  into  capital  gain,  and  on  limiting 
capital  train  treatment  by  increasing  the  holding  periods  for  farm 
assets.  However,  under  the  cash  method  of  accoimting,  farm  expenses 

s  The  statute  also  prevents  tax-free  exchanges  of  livestock  of  different  sexes  (sec.  1031 
(e)).  Prior  to  the  Tax  Reform  Act  of  1969.  such  exchanges  had  been  used  to  enable  a 
rancher  (or  ranch  investor)  to  build  up  his  herd  free  of  current  tax  by  exchancinp  bull 
calves,  most  of  which  are  not  used  for  breeding  purposes,  for  female  calves  which  could 
be  used  to  increase  the  size  of  the  herd. 


43 

are  still  deductible  as  they  are  paid.  The  time  value  of  deferring  taxes 
on  nonfami  income  remained  a  strong  attraction  for  outside  investors 
to  invest  in  farming  and  to  use  as  much  borrowed  money  as  possible 
to  create  farm  "tax  losses." 

Since  1969,  the  number  and  volume  of  publicly  syndicated 
investments  in  almost  all  areas  of  agriculture  increased  substan- 
tially. Farm  tax  benefits  were  eifectively  packaged  and  sold  to  high- 
bracket  taxpayers  through  limited  partnerships  (and  management 
contracts)  for  investments  in  cattle  feeding  and  breeding,  tree  crops, 
vegetable  and  other  field  crops,  vineyards,  dairy  cows,  fish,  chickens, 
and  egg  production. 

Table  1  sets  forth  the  average  farm  loss  reported  for  tax  purposes 
since  1969  by  individual  taxpayers  in  different  income  brackets.  This 
table  shows  that  average  farm  losses  increased  as  taxpayers'  income 
levels  increased,  and  that  this  trend  remained  consistent  during  the 
four  years  covered  by  the  table.  The  fact  that  the  largest  farm  losses 
were  concentrated  in  income  levels  over  $100,000  suggests  that  high- 
bracket  taxpayers  continued  to  make  use  of  the  special  farm  tax  rules 
to  shelter  their  nonf  arm  income. 

TABLE  1.— NET  FARM  LOSSES  BY  SIZE  OF  ADJUSTED  GROSS  INCOME 


1970 


Adjusted  gross  income 


Returns 

showing 

farm  loss 


Average 
farm  loss 


1971 


Returns 

showing 

farm  loss 


Average 
farm  loss 


1, 234, 092 

($2, 350) 

1,  290, 203 

($2,  540) 

(2,899,513).- 

(3,  277,  548) 

All  returns— total 

Total  net  farm  loss  (thousands) 

Under  $5,000 485,531  (2,659) 

$5,000  under  $10,000 -  379,947  (1,576) 

$10,000  under  $20,000 284,652  rl,669) 

$20,000  under  $50,000 --  63,949  (4,202) 

$50,000  under  $100,000 14,697  (9,473) 

$100,000  under  $500,000 5,012  (21,016) 

$500,000  under  $1,000,000 210  (43, 143) 

$1,000,000  or  more 94  (128,149) 


475, 983 

385,  338 

327, 808 

78,  358 

16,  575 

5,787 

252 

102 


(2, 969) 

(1,  664) 

(1,822) 

(4, 087) 

(9,  527) 

(20,903) 

(52,  516) 

(134, 069) 


1972 


Adjusted  gross  income 


Returns 

showing 

farm  loss 


Average 
farm  loss 


1973 


Returns 

showing 

farm  loss 


Average 
farm  loss 


All  returns-totai 1,171,591  ($2,758)  1,218,962  ($3,343) 

Total  netfarm  loss  (thousands) (3,230,956) (4,074,998) 

Under$5,000 363,492  (3,821)  371,489  (4,323) 

$5,000  under  $10,000 325,492  (1,879)  290,056  (2,365) 

$10,000  under  $20,000 354,754  (1,852)  397,588  (2,123) 

$20,000  under  $50,000 100,840  (3,894)  126,567  (3,907) 

$50,000  under  $100,000 19,642  (9,607)  24,494  (8,970) 

$100,000  under  $500,000 - 6,941  (21,784)  8,390  (23,108) 

$500,000  under  $1,000,000 301  (50,296)  268  (70,451) 

$1,000,000  or  more 129  (170,418)  110  (110,018) 


Source:  U.S.  Treasury  Department,  Statistics  of  Income— Individual  Income  Tax  Returns,  1970, 1971, 1972, 1973  (pre- 
liminary). 


Deferral  shelters. — Some  of  the  more  popular  types  of  farming  oper- 
ations which  have  been  used  as  deferral  shelters  are  set  out  below. 


44 

Cattle  feeding  has  offered  one  of  the  best  known  and,  until  recent 
downturns  in  the  farm  economy,  most  widely  used  deferral  shelters. 
Typically,  the  investment  has  been  organized  as  a  limited  partnership 
or  as  an  agency  relationship  (under  a  management  contract)  in  which 
a  commercial  feedlot  or  a  promoter  has  agreed  to  act  as  an  agent  for 
the  investor  in  buying,  feeding  and  managing  cattle.  After  being  fed  a 
specialized  diet  for  four  to  six  months,  the  fattened  cattle  were  sold 
at  public  auction  to  meat  packers  or  food  companies.  A  cattle  feeding 
venture  of  this  kind  has  typically  been  formed  in  November  or  De- 
cember, using  leveraging  and  the  cash  method  of  accounting  to  per- 
mit taxpayers  with  income  from  other  sources  to  defer  taxes  other- 
wise due  on  that  income  in  that  year  by  deducting  expenses  for  pre- 
paid feed,  interest,  and  other  costs  incurred  in  the  feeding  venture. 
Income  was  realized  in  the  following  year  when  the  fattened  cattle 
were  sold.  At  that  time,  the  bank  loans  were  repaid  and  any  unpaid 
fees  due  the  feedlot  (or  promoter)  were  deducted.  The  balance  was 
distributed  to  the  investors.  Since  feeder  cattle  are  held  for  sale  to 
customers,  sales  of  the  animals  produce  ordinary  income.  If  the  in- 
vestors were  to  reinvest  their  profit  from  one  feeding  cycle  into  an- 
other one,  they  could  theoretically  defer  taxes  indefinitely  on  the 
nonfarm  income  which  they  sheltered  originally. 

Since  most  investors  in  cattle  feeding  shelters  have  typically  bought 
in  at  the  end  of  the  calendar  year,  deductions  for  prepaid  feed  for  the 
cattle  have  been  central  to  the  creation  of  tax  losses  in  that  year." 

Another  deferral  shelter  involved  the  production  and  sale  of  eggs. 
In  egg  shelters,  almost  the  entire  amount  invested  and  borrowed  was 
spent  on  items  for  which  deductions  were  claimed  in  the  first  year. 
These  items  included  poultry  flocks,  prepaid  feed,  and  (to  some  extent) 
management  fees  to  the  persons  who  operated  the  program  for  the  in- 
vestors. Under  prior  law,  amounts  paid  for  egg-laying  hens,  which  are 
commonly  kept  for  one  year  from  the  time  they  start  producing,  have 
been  treated  as  allowable  deductions  in  the  year  the  poultry  was 
purchased.^ 

Deferral  and  conversion  shelters. — A  deferral  and  conversion  shelter 
has  offered  an  investor  an  opportunity  both  to  defer  taxes  and  also  to 
convert  ordinary  income  into  capital  gain.  The  manner  in  which 
these  benefits  were  obtained  was  by  deducting  development  costs  of 
section  1281  property  (breeding  cattle,  orchards,  vineyards,  etc.)  and 
capital  gain  property  (farmland)  from  ordinary  nonfarm  income  and 
by  later  selling  the  developed  assets  after  the  investor  had  held  them 
long  enough  to  qualify  for  long-term  capital  gain  rates.  Since  the  re- 
capture rules  which  apply  to  deducted  development  expenses  (e.g., 
section  1251)  are  much  more  limited  in  scope  than  depreciation  re- 
captui'e  rules  generally,  many  farm  operations  can  be  structured  so 
that  there  will  be  little  or  no  recapture  of  previously  deducted  develop- 
ment costs. 


*  In  recent  years,  the  Internal  Revenne  Service  questioned  deductions  for  prepaid  feed 
claimed  by  taxpayers  usinp  the  cash  method  of  accountinff.  The  Service  (in  Rev.  Rul. 
7.1-152)  prescribed  several  technical  criteria  and  relied  on  its  general  antliority  to  recom- 
pute a  taxpayer's  income  if  deductions  materially  distort  his  Income.  However,  investors 
In  cattle  feeding  shelters,  in  some  cases,  had  still  been  able  to  circumvent  the  administra- 
tive criteria  in  order  to  instifv  deductions  for  prepaid  feed. 

'Rev.  Rul.  60-191,  1960-1  C.B.  78.  The  purchase  cost  of  this  poultry  may  be  deducted 
currently  if  the  farmer  consistently  does  so  and  if  the  deductions  clearly  reflect  his 
income. 


45 

Livestock  breeding  has  offered  taxpayers  the  opportunity  to  defer 
taxes  over  a  period  of  two  or  more  years  and  also  to  convert  ordinary 
income  into  capital  gain.  In  general,  breeding  operations  have  relied 
on  current  deductions  for  prepaid  expense  items;  current  deductions 
for  expenses  of  raising  young  animals  to  be  used  for  breeding,  dairy, 
draft  or  sporting  purposes ;  the  investment  credit ;  accelerated  depre- 
ciation and  additional  first-year  depreciation  on  purchased  animals  and 
equipment;  and  capital  gain  when  the  mature  animals  are  eventually 
sold. 

Although  cattle  has  been  the  most  widely  used  breeding  shelter, 
there  have  also  been  investments  offered  for  the  purchase,  breeding 
and  sale  of  horses,  fur-bearing  animals  (such  as  mink  and  chinchilla) , 
other  types  of  farm  animals  (such  as  hogs),  and  some  kinds  of  fish 
and  shellfish. 

An  investment  in  an  orchard,  vineyard  or  grove  involves  a  "tree 
crop"  as  distinct  from  a  "field"  crop  such  as  vegetables.  The  list  of 
tree  crop  partnerships  has  covered  virtually  anything  grown  in  an 
orchard  or  vineyard  in  the  form  of  trees  or  vines  which  produce 
annual  crops  of  fruits  (e.g.,  grapes,  apples  or  avocados)  or  nuts  (e.g., 
pecans,  pistachios  or  walnuts) .® 

During  the  development  period  of  trees  or  vines,  the  owners  have 
deducted  costs  of  spraying,  fertilizing,  irrigating  and  cultivating  the 
tree  or  vine  to  its  crop-producing  stage.  They  have  also  depreciated 
farm  machinery,  irrigation  equipment,  sprinkler  systems,  wells  and 
fences  w^hich  they  installed  on  the  property.  They  have  also  obtained 
the  investment  credit;  and  deductions  were  often  available  for  interest, 
fees  and  some  prepaid  items.  After  the  trees  start  producing  fruit  or 
nuts,  the  owner  has  depreciated  the  c^sts  of  the  seedlings  and  their 
original  planting.  (These  costs  were  capitalized  when  incurred.)  Such 
depreciation  has  been  used  partly  to  shelter  the  annual  crop  income. 
Income  from  the  crop  sales  is  ordinary  income.  Capital  gain  is  avail- 
able, however,  when  the  underlying  land  and  the  orchard  are  sold 
(except  to  the  extent  that  recapture  rules  come  into  play). 

Use  of  farming  syndicates. — These  special  farm  tax  rules  have  been 
utilized  not  only  by  taxpayers  who  were  actively  engaged  in  farming 
enterprises  with  the  intention  of  making  a  profit,  but  also  by  passive 
investors  whose  motivation,  in  large  part,  consisted  of  a  desire  to  use 
these  farming  rules  to  shelter  income  from  other  sources.  These  pas- 
sive investors  were  frequently  members  of  "farming  syndicates" 
formed  by  a  promoter  or  operator.  In  order  to  offer  attribution  of 
losses  and  limited  liability  to  the  investor,  a  farming  syndicate  has 
generally  been  structured  as  either  a  limited  partnership  or  as  an  agen- 
cy relationship  with  a  management  contract  (and  with  limited  liability 
generally  provided  for  by  nonrecourse  indebtedness,  insurance,  stop- 
loss  guarantees,  etc.).  During  the  51/^  years  betw^een  January  1,  1970, 
and  July  1, 1975,  the  dollar  amount  of  tax  shelter  offerings  in  partner- 
ship form  registered  with  the  National  Association  of  Securities 
Dealers  was  $942,424,000  in  cattle  feeding  and  breeding  ventures  and 
$166,575,625  in  vineyards  and  other  farming  shelters.  (There  have 
been  many  more  private  syndications  which  were  not  required  to  be 
registered.) 


■'' Citrus   fruits   and    almonds  were  generally   not   suited   to    tax   shelter  because  of  the 
cost  capitalization  rule  of  section  278. 


46 

Congress  believed  that  the  special  farm  tax  rules  should  be 
continued  for  most  farmers  who  are  actively  engaged  in  farm  opera- 
tions, but  that  such  special  farm  tax  rules  should  be  severely  curtailed 
for  farming  syndicates  in  which  a  substantial  portion  of  the  interest 
is  held  by  taxpayers  who  are  motivated,  in  very  large  part,  by  a  desire 
to  shelter  other  income,  rather  than  by  a  desire  to  make  a  profit  in  the 
particular  farming  operation. 

CongTess  also  believed  that  reducing  tax  incentives  for  high-bracket 
taxpayers  who  invest  in  syndicated  farming  operations  will  improve 
the  competitive  position  of  full-time  farmers  who  must  look  to  the 
income  generated  from  farm  operations  for  all  or  most  of  the  return 
on  their  investment  in  farm  operations. 

Explanation  of  provisiotis 

In  general,  the  Act  requires  farming  syndicates  to  deduct  expenses 
for  feed,  seed,  fertilizer,  etc.,  only  when  used  or  consumed,  to  deduct 
expenses  of  purchased  poultry  only  over  their  useful  life  (or,  in  the 
case  of  inventory,  only  when  disposed  of)  and  to  capitalize  certain 
cultivation,  maintenance,  etc.,  expenses  of  groves,  orchards  and  vine- 
yards to  the  extent  such  expenses  are  incurred  before  the  grove,  or- 
chard or  vineyard  becomes  productive.^ 

DefnifioTi  of  farming  sj/ndicafe. — For  purposes  of  these  provisions, 
a  "farming  syndicate"  is  defined  as  including  (1)  a  partnership  ^°  or 
other  enterprise  (other  than  a  corporation  wliich  is  not  a  subchapter  S 
corporation)  engaged  in  farming  if,  at  any  time,  any  interest  in  the 
partnership  or  other  enterprise  has  been  offered  for  sale  in  an  offering 
required  to  be  registered  with  a  Federal  or  State  agency  having 
authority  to  regulate  the  offering  of  securities  for  sale,  (2)  a  partner- 
ship or  other  enterprise  (other  than  a  corporation  which  is  not  a  sub- 
chapter S  corporation)  engaged  in  the  trade  or  business  of  farming 
if  more  than  35  percent  of  the  losses  during  any  period  are  allocable 
to  limited  partners  or  limited  entrepreneurs.^^ 

These  categories  include  as  farming  syndicates  many  forms  of  orga- 
nization of  farm  enterprises  such  as  general  partnerships,  sole  pro- 
prietorships involving  agency  relationships  created  by  management 
contracts,  trusts,  and  interests  in  subchapter  S  corporations.^^  If  an 
interest  in  any  such  enterprise  has  been  offered  for  sale  in  an  offering 
required  to  be  registered,  it  is  a  farming  syndicate.  Similarly,  unless 
excepted  by  the  five  specific  exceptions  described  below,  if  more  than 

'  Also,  as  a  general  limitation  on  the  use  of  the  farm  tax  rules.  Congress  provided  that 
tax  losses  incurred  in  farming  are  to  be  allowable  in  any  year  only  to  the  extent  of  the 
amounts  for  which  the  taxpayer  is  at  risk  in  the  business.  This  rule  applies  to  all  types 
of  taxpayers  engaged  in  farming  operations  (sec.  204  of  the  Act). 

10  The  term  "partnership"  is  used  in  the  farming  syndicate  provisions  only  in  a  de- 
scriptive sense  ;  it  is  not  intended  that  this  definition  of  farming  syndicate  operate  to  pre- 
clude the  Internal  Revenue  Service  from  applying  the  regulations  under  section  7701  to 
an  organization  described  in  such  definition  to  determine  its  proper  classification  (as  a 
partnership  or  corporation)  for  Federal  tax  purposes. 

11  Thus,  the  first  category  of  farming  syndicates  includes  limited  partnership  and  other 
tax  shelter  offerings  required  to  be  registered  with  the  Securities  and  Exchange  Commis- 
sion or  with  a  State  securities  or  real  estate  office.  The  second  category  includes  partner- 
ships or  other  enterprises  with  respect  to  which  there  is  no  registration  requirement. 
T^nregistered  offering.^  made  through  a  dealer  who  is  a  member  of  the  National  Association 
of  Securities  Dealers,  through  an  intrastate  broker-dealer,  or  througli  a  real  estate  compan.v, 
as  well  as  interests  in  private  enterprises  which  are  not  sold  by  a  broker-dealer,  or  similar 
jiarty  are  included  in  the  second  category,  if  the  loss  allocation  requirements  are  satisfied. 

12  Corporations  other  than  subchapter  S  corporations  are  not  treated  as  farming  syndi- 
cates since  tax  losses  in  such  corporations  cannot  be  passed  through  to  its  shareholders. 


47 

35  percent  of  the  losses  during  any  year  are  allocable  to  limited  part- 
ners or  limited  entrepreneurs,  the  enterjDrise  will  be  treated  as  a 
farming  syndicate. 

In  general,  a  limited  entrepreneur  means  a  person  who  has  an  in- 
terest, other  than  a  limited  partnership  interest,  in  an  enterprise  and 
who  does  not  actively  participate  in  the  management  of  the  enterprise. 
The  determination  of  whether  a  person  actively  participates  in  the 
operation  or  management  of  a  farm  depends  upon  the  facts  and  cir- 
cumstances. Factors  which  tend  to  indicate  active  participation 
include  participating  in  the  decisions  involving  the  operation  or  man- 
agement of  the  farm,  actually  working  on  the  farm,  living  on  the  farm, 
or  hiring  and  discharging  employees  (as  compared  to  only  the  farm 
manager).  Factoi-s  which  tend  to  indicate  a  lack  of  active  participa- 
tion include  lack  of  control  of  the  management  and  operation  of  the 
farm,  having  authority  only  to  discharge  the  farm  manager,  having  a 
farm  manager  who  is  an  independent  contractor  rather  than  an  em- 
ployee, and  having  limited  liability  for  farm  losses." 

With  respect  to  farming  activities  othar  than  those  conducted  by 
enterprises  in  which  securities  have  been  registered  or  were  required 
to  be  registered,  the  provision  specifies  five  cases  where  an  individ- 
ual's activity  with  respect  to  a  farm  will  result  in  his  not  being  treated 
as  a  limited  partner  or  limited  entrepreneur.  These  cases  cover  situa- 
tions where  an  individual — 

(1 )  has  an  interest  in  a  trade  or  business  of  farming  attributable 
to  his  active  participation  for  a  period  of  not  less  than  5  yeai-s 
in  the  management  of  the  trade  or  business  of  farming  ^* ; 

(2)  lives  on  the  farm  on  which  the  trade  or  business  of  farming 
is  being  carried  on  (but  only  with  respect  to  farming  activities  on 
such  farm)  ; 

(3)  actively  participates  in  the  management  of  a  trade  or  busi- 
ness of  fanning  which  involves  the  raising  of  livestock  (or  is 
treated  as  being  engaged  in  active  management  pursuant  to  one 
of  the  first  two  exceptions  set  forth  above),  and  the  trade  or 
business  of  the  partnership  or  any  other  enterprise  involves  the 
further  processing  of  the  livestock  raised  in  the  trade  or  business 
with  respect  to  which  he  is  (actually  or  constructively)  an  active 
participant ; 

(4)  actively  participates,  as  his  principal  business  activity,  in 
the  management  of  a  trade  or  business  of  fanning,  regardless  of 
whether  he  actively  participates  in  the  management  of  the  ac- 
tivity in  question ;  or 

(5)  is  a  member  of  the  family  (within  the  meaning  of  section 
267(c)  (4) )  of  a  grandparent  of  an  individual  who  would  be  ex- 

1'  In  determining  whether  a  person  has  lliniteil  liability  for  farm  losses,  all  the  facts 
and  circumstances  are  tu  he  taken  into  account.  Generally,  for  purposes  of  this  definition, 
a  person  will  be  considered  to  have  limited  liability  for  farm  losses  if  he  is  protected 
against  loss  to  any  significant  degree  by  nonrecourse  financing,  stop-loss  orders,  guaran- 
tees, fixed  price  repurchase  (or  purchase)  agreenients.  insuranc«».  or  other  similar  arrange- 
ments. A  iierson  with  limited  liability  for  farm  losses  might  include,  in  appropriate  cir 
cumstancGs,  (1)  a  general  partner  who  has  obtained  a  guaranty  or  other  protection  against 
loss  from  another  general  partner  or  an  agent,  and  (2)  a  principal  who  has  given  authority, 
in  fact,  to  another  party  to  conduct  hia  operations  (such  as  an  Investor  who  agrees  to 
allow  a  feedlot  to  manage  feeder  cattle  which  he  has  purchased)  and  who  utilizes  non- 
recourse financing,  stop-loss  orders  insurance,  etc.,  to  limit  his  risk. 

"This  e.xception  (and  the  fifth  exception  to  the  extent  it  applies  this  exception  to 
family  members  of  a  person  qualifying  under  this  exception)  will  continue  to  apply  where 
one  farm  is  substituted  for  or  added  to  another  farm. 


48 

cepted  under  any  of  the  first  four  cases  listed  above  and  liis  inter- 
est is  attributable  to  the  active  participation  of  such  individual. 

The  first  exception  listed  above  (and  its  application  to  family  mem- 
bers by  the  fifth  exception)  is  designed  to  insure  that  the  term  "farm- 
ing sj^ndicate"  does  not  include  an  enterprise  in  which  a  limited  part- 
nership interest  (or  other  passive  interest)  is  held  by  a  person  who 
has  actively  participated  in  the  management  of  the  enterprise  for 
not  less  than  five  years  merely  by  reason  of  his  holding  such  a  limited 
partnership  interest  (or  other  passive  interest).  Also,  a  member  of 
the  family  of  such  a  person,  such  as  one  of  his  heirs,  would  not  be 
treated  as  a  limited  partner  or  limited  entrepreneur  for  purposes  of 
making  the  farming  enterprise  a  farming  syndicate.  Thus,  for  ex- 
ample, if  A,  an  individual  who  has  owned  and  operated  a  farm  for 
more  than  five  years,  wishes  to  retire  and  foiTns  the  AB  limited  part- 
nership with  B,  an  unrelated  individual,  and  more  than  35  percent 
of  the  losses  are  allocated  to  A,  the  limited  partner,  the  AB  partner- 
ship will  not  be  treated  as  a  farming  syndicate  because  A's  interest 
is  not  treated  as  a  limited  partnei-ship  interest  for  purposes  of  de- 
termining whether  losses  are  allocated  to  limited  partners.  Similarly, 
if  A  later  dies  and  the  partnership  is  continued  by  B  and  C,  A's  son, 
the  BC  partnerehip  will  not  be  treated  as  a  farming  syndicate. 

Definition  of  farming. — For  purposes  of  these  farming  syndicate 
rules,  the  term  "farming"  is  defined  to  mean  cultivation  of  land  or  the 
raising  or  harvesting  of  any  agricultural  or  horticultural  commwlity, 
including  the  raising,  shearing,  feeding,  caring  for,  training,  and  man- 
agement of  animals.  Thus,  for  example,  a  syndicate  engaged  in  the 
raising  of  livestock,  fish,  poultry,  bees,  dogs,  flowers,  or  vegetables  is 
engaged  in  farming  and,  thus,  is  a  farming  syndicate. 

For  purposes  of  the  farming  syndicate  rules,  activities  involving 
the  growing  or  raising  of  trees  (other  than  fruit  or  nut  trees)  are  not 
considering  farming.  Thus,  this  provision  does  not  apply  to  forestry  or 
the  growing  of  timber. 

Deduction  of  prepaid  items. — The  Act  adds  a  new  section  (sec. 
464(a) )  to  the  Code  to  provide  in  general,  that,  in  the  case  of  farming 
syndicate^s,  deductions  for  amounts  paid  for  feed,  seed,  fertilizer,  or 
other  similar  farm  supplies  are  allowed  only  in  the  taxable  year  in 
which  the  feed,  seed,  fertilizer  or  other  supplies  are  used  or  consumed. 
This  provision  jjrevents  a  farm  syndicate  from  obtaining  current  de- 
ductions for  prepaid  feed,  seed,  fertilizer,  etc.,  except  in  situations 
where  the  feed,  seed,  fertilizer,  or  other  supplies  are  on  hand  at  the 
close  of  the  taxable  year  solely  tecause  the  consumption  of  such  items 
during  the  taxable  year  was  prevented  on  accoimt  of  fire,  storm,  flood, 
or  other  casualty,  or  on  account  of  disease  or  drought. 

Costs  of  poultry. — Under  prior  law.  taxpayers  engaged  in  farming 
have  not  been  allowed  to  deduct  the  cost  of  purchased  livestock ;  rather, 
they  must  inventory  the  livest(X^k  held  for  sale  and  deduct  the  cost  only 
upon  disposition,  and  they  must  capitalize  the  cost  of  purchased  live- 
stock used  in  the  trade  or  business  (such  as  cattle  held  for  breeding 
purposes)  and  depreciate  them  over  their  useful  lives.  However,  this 
has  not  been  the  case  with  respect  to  poultry.  A  ruling  bv  the  Internal 
Revenue  Service  (Rev.  Rul.  60-101,  1960-1 'C.  B.  78)  has  allowed  cash 
basis  taxpayers  to  deduct  when  paid  the  costs  of  both  poultry  held  for 


49 

sale  and  poultry  used  in  the  trade  or  business.  These  deductions  were 
allowable,  in  general,  because  the  poultry  purchased  for  resale  has  a 
relatively  small  cost,  and  the  poultry  purchased  for  use  in  the  trade  or 
business,  such  a,s  laying  hens,  has  a  useful  life  of  less  than  one  year. 
Some  syndicates,  however,  have  taken  advantage  of  these  rules  and, 
coupled  with  the  prior  rules  relating  to  prepaid  feed,  have  utilized 
the  deductions  for  poultry  to  create  tax  shelters. 

The  Act  adds  a  new  Code  provision  (sec.  464(b))  which  does  not 
allow  a  farming  syndicate  to  deduct  when  paid  costs  of  acquiring 
poultry.  Rather,  it  requires  that  the  cost  of  poultry  acquired  for  resale 
not  be  deducted  until  the  poultry  is  sold  or  otherwise  disposed  of.  Also, 
in  the  case  of  poultry  acquired  for  use  in  the  trade  or  business  (such 
as  laying  hens)  or  acquired  both  for  use  in  trade  or  business  and  for 
later  resale,  the  costs  must  be  capitalized  and  (taking  into  account  sal- 
vage value)  deducted  ratably  on  a  monthly  basis  over  the  lesser  of 
twelve  months  or  their  useful  life  in  the  trade  or  business.^^ 

Capitalization  of  development  costs  of  groves^  orchards^  and  vine- 
yards.— The  Act  amends  section  278  to  provide  that,  in  the  case  of  a 
farming  syndicate,  any  amount  otherwise  allowable  as  a  deduction 
which  is  attributable  to  the  planting,  cultivation,  maintenance,  or 
development  of  a  grove,  orchard,  or  vineyard,  and  which  is  incurred 
prior  to  the  taxable  year  in  whi€h  the  grove,  orchard,  or  vineyard 
begins  to  produce  crops  in  commercial  quantities  is  required  to  be 
capitalized.  Such  expenditures  can  thereafter  be  recovered  by  deprecia- 
tion of  the  grove,  orchard,  or  vineyard.  A  limited  exception  to  this 
capitalization  rule  is  provided  for  amounts  allowable  as  deductions 
(without  regard  to  section  278)  which  are  attiibutable  to  a  grove, 
orchard,  or  vineyard,  which  is  replanted  after  having  been  lost  or 
damaged  while  in  the  iiands  of  the  taxpayer  by  reason  of  freezing 
temperatures,  disease,  drought,  pests,  or  casualty. 

Where  these  new  rules  apply  to  a  situation  in  which  section  278(a) 
(relating  to  capitalization  of  certain  expenses  of  citrus  and  almond 
groves)  requires  capitalization  but  for  a  different  period  (4  years 
instead  of  the  preproductive  period),  the  rules  of  capitalization  of 
section  278(a)  apply  prior  to  the  capalization  rules  with  respect  to 
farming  syndicates.  Also,  if  an  amount  is  incurred  as  a  cost  of  fertil- 
izer, or  other  prepaid  supplies,  which  is  generally  subject  to  the  rules 
of  new  section  464(a),  such  amount  is  nonetheless  subject  to  the 
farming  syndicate  capitalization  rules  of  section  278(b).  Thus,  in 
such  a  case,  no  deduction  would  be  allowed  upon  consumption  of  the 
fertilizer,  but  rather  such  amount  would  have  to  be  charged  to  capital 
account. 

Effective  dates 
The  provisions  of  the  Act  relating  to  prepaid  feed  and  other  farm 
supplies  and  poultry  expenses  apply  generally  to  amoimts  paid  or 
incurred  in  taxable  years  beginning  after  December  .SI,  1975.  In  the 
case  of  farming  syndicates  in  existence  on  December  31,  1975  (but 
only  if  there  is  no  change  in  membership  in  the  farming  syndicate 


-s  since  the  only  basin  for  deducting  the  cost  of  the  laying  hens  currently  was  that  they 
have  an  expected  useful  life  of  less  than  one  year,  the  requirement  that  deductions  be 
taken  over  the  lesser  of  1  year  or  the  useful  life  should  not  result  in  the  acceleration  of  such 
deductions. 


50 

throughout  its  taxable  year  beginning  in  1976) ,  these  provisions  apply 
to  amounts  paid  or  incurred  in  taxable  years  beginning  after  Decem- 
ber 31,  1976.^^  The  provisions  relating  to  orchards,  groves  and  vine- 
yards do  not  apply  where  the  trees  or  vines  were  planted  or  purchased 
for  planting  prior  to  December  31,  1975,  or  where  there  was  a  binding 
contract  to  purchase  the  trees  or  vines  in  effect  on  December  31,  1975. 

Revenue  effect 
This  provision  will  increase  budget  receipts  by  $86  million  in  fiscal 
year  1977,  $32  million  in  fiscal  year  1978,  and  $34  million  in  fiscal 
year  1981. 

h.  Limitation  of  Loss  With  Respect  to  Farms  to  the  Amount  for 
Which  the  Taxpayer  Is  at  Risk  (sec.  204  of  the  Act  and  sec. 
465  of  the  Code) 

Prior  lm.0 

Generally,  the  amount  of  depreciation  or  other  deductions  which  a 
taxpayer  has  been  permitted  to  take  in  connection  with  a  property  has 
been  limited  to  the  amount  of  his  basis  in  the  property.  Likewise,  in 
the  case  of  a  partnership,  the  amount  of  loss  a  partner  may  deduct  is 
limited  to  the  amount  of  his  adjusted  basis  in  his  interest  in  the  part- 
nership. However,  basis  in  a  property  lias  included  nonrecourse  indebt- 
edness (i.e.  a  loan  on  which  there  is  no  personal  liability)  attributable 
to  that  property.  Wliere  a  partnership  incurs  a  debt  obligation,  and 
none  o,f  the  partners  has  personal  liability  on  the  loan,  all  of  the  part- 
ners have  been  treated  for  tax  purposes  as  though  they  shared  the 
liability  in  proportion  to  their  profits  interest  in  the  partnership  (i.e. 
each  partner's  share  in  the  nonrecourse  indebtedness  is  added  to  his 
basis  in  the  partnership) .  (See  regulations  §  1.752-1  (e) ) . 

Also,  there  has  been  generally  no  limitation  on  deductions  which 
take  into  account  a  taxpayer's  protection  agamst  ultimate  loss  by  rea- 
son of  a  stop-loss  order,  guarantee,  guaranteed  repurchase  agreement, 
insurance  or  otherwise. 

Reasons  for  change 
Taxpayers  have  combined  the  special  farm  tax  rules  (discussed 
under  the  farm  syndicate  section  above)  with  nonrecourse  indebted- 
ness, and  stop-loss  orders,  etc.,  to  deduct  losses  in  a  taxable  year  which 
are  substantially  in  excess  of  the  maximum  amounts  they  could  ulti- 
mately lose  with  respect  to  their  investments  in  farming.  Although 
some  of  these  situations  may  be  limited  by  the  restrictions  on  deduc- 
tions imposed  on  syndicates  (as  described  above),  some  farming  shel- 
ters may  not  involve  syndicates.  Also,  the  limitations  on  syndicates 
do  not  affect  all  types  of  farming  operations.  For  instance,  winter 
vegetables,  rose  bushes  and  other  nurserj^  plants  are  not  restricted  by 
the  restrictions  on  farming  syndicates,  except  to  the  extent  that  such 
syndicates  utilize  prepaid  seed,  fertilizer,  and  other  farm  supplies. 
(The  utilization  of  such  prepaid  items  is  not  necessary  for  the  creation 
of  substantial  tax  shelter  in  these  types  of  operations.) 


1*  A  change  in  membership  which  disqualifies  a  farming-  syndicate  from  this  transitional 
rule  does  not  include  substitutions  occurring  by  operation  of  law,  gifts,  or  withdrawals 
by  existing  members. 


51 

Expl-anation  of  provisions 

To  prevent  a  situation  where  a  taxpayer  may  deduct  a  loss  in  ex- 
cess of  his  economic  investment  in  farming  operations,  the  Act  pro- 
vides that  the  amount  of  any  loss  (otherwise  allowable  for  the  year) 
which  may  be  deducted  in  connection  with  a  trade  or  business  of  farm- 
ing, cannot  exceed  the  aggregate  amount  with  respect  to  which  the 
taxpayer  is  at  risk  in  each  such  activity  at  the  close  of  the  taxable  year. 
(For  more  detail  as  to  the  application  and  scope  of  the  at  risk  rule, 
see  section  2,  above.) 

In  applying  the  at  risk  provision  to  farming  operations,^"  Congress 
intends  that  the  existence  of  a  governmental  target  price  program 
(such  as  provided  by  the  Aginculture  and  Consumer  Protection  Act  of 
1973)  or  other  governmental  price  support  program  with  respect  to 
a  product  grown  by  a  taxpayer  does  not,  in  the  absence  of  agreements 
limiting  the  taxpayer's  costs,  reduce  the  amount  which  such  taxpayer 
is  at  risk. 

In  the  case  of  farming  activities  carried  on  by  an  individual,  the 
"at  risk"  provision  applies  separately  to  each  farming  activity. 
Whether  a  taxpayer  is  engaged  in  one  or  more  farming  activities  de- 
pends on  all  the  facts  and  circumstances  of  the  case.  Generally,  some  of 
the  significant  facts  and  circumstances  in  making  a  determination  are 
the  degree  of  organizational  and  economic  interrelationship  of  various 
a/ctivities  in  which  the  taxpayer  is  engaged,  the  business  pui"pose  whicJi 
is  (or  might  be)  served  by  carrying  on  the  various  activities  separately 
or  together,  and  the  similarity  of  the  various  activities.  Thus,  for  in- 
stance, if  a  rancher  engaged  in  cattle  raising  on  his  own  ranch  also 
purchases  cattle  which  he  has  placed  in  a  commercial  feedlot,  he  will 
generally  be  treated  as  being  in  two  separate  fanning  activities.  How- 
ever, if  such  a  rancher  were,  as  a  consistent  business  practice,  to  take 
cattle  raised  on  his  own  ranch  and  place  them  in  a  commercial  feedlot, 
he  might  well  be  treated  as  engaged  in  only  one  farming  activity. 

All  farming  activities  engaged  in  by  a  partnership  or  subchapter  S 
corporation  will  be  treated  as  one  activity  for  purposes  of  applying 
this  provision.^^ 

Effective  date 

In  the  case  of  farm  operations,  the  at  risk  limitation  applies  to  losses 
attributable  to  amounts  paid  or  incurred  in  taxable  years  beginning 
aft^er  December  31, 1975. 

Revenue  estimate 

It  is  estimated  that  this  provision  will  result  in  an  increase  in  budget 
receipts  of  less  than  $5  million  annually. 

c.  Method  of  Accounting  for  Corporations  Engaged  in  Farming 
(sec.  207(c)  of  the  Act  and  new  sec.  447  of  the  Code) 

Prior  lato 

Under  prior  law,  a  taxpayer  engaged  in  farming  activities  was  al- 
lowed to  report  the  results  of  such  activities  for  tax  purposes  on  the 

"  For  purposes  of  the  at  risk  provision,  the  term  "farming"  has  the  same  meaning  as 
it  does  in  the  farming  syndicate  provisions  discussed  above. 

1*  This  ajrgregation  approach  is  adopted  because  of  the  difficulties  of  allocating  a 
partner's  at  rislc  amount  between  different  activities. 


52 

cash  method  of  accounting,  regardless  of  whether  the  taxpayer  was  an 
individual,  a  corporation,  a  trust,  or  an  estate.  As  indicated  in  the 
discussion  of  the  farming  syndicate  rules,  the  availability  of  the  cash 
method  for  farmers  has  contrasted  with  the  tax  rules  which  govern  non- 
farm  taxpayers  engaged  in  the  business  of  selling  products.  Such  non- 
farm  taxpayers  must  report  their  income  using  the  accrual  method  of 
accounting  and  must  accumulate  their  production  costs  in  inventory 
until  the  product  is  sold.^^  TTnder  the  accrual  method  of  accounting  as 
applied  to  farming,  if  crops  are  harvested  and  unsold  at  the  end  of  the 
taxaJble  year,  the  costs  atti-ibutable  to  such  crops  cannot  be  deducted  in 
the  taxable  year  but  must  be  treated  as  inventory.  However,  even  under 
the  accrual  method,  it  has  been  a  longstanding  Treasury  practice  to  per- 
mit a  farmer  to  deduct  expenses  paid  in  the  taxable  year  so  long  as  the 
crops  to  which  these  expenses  relate  are  unharvested  at  the  end  of  the 
taxable  year.  (I.T.  1368, 1-l  C.B.  72(1922).) 

The  Internal  Revenue  Service  has  recently  ruled  that,  for  taxable 
years  beginning  on  or  after  June  28, 1976,  an  accrual  method  taxpayer 
engaged  in  farming  is  required  to  inventory  growing  crops  (unless  the 
taxpayer  uses  the  crop  method  of  accounting).^" 

Furthermore,  except  with  respect  to  citrus  and  almond  groves,  a 
taxpayer  engaged  in  farming  has  generally  been  allowed  to  deduct 
currently  costs  of  developing  certain  assets  used  in  the  trade  or  busi- 
ness of  farming  (such  as  cultivation  expenses  of  orchards  and  groves) 
even  if  an  accrual  method  of  accounting  was  used :  however,  tax- 
payers in  other  businesses  are  generally  required  to  capitalize  the 
costs  of  constructing  or  developing  assets  used  in  the  trade  or 
business.^^ 

Reasons  for  change 
Under  the  cash  method  of  accounting,  all  items  which  constitute 
gross  income  are  reported  in  the  taxable  year  in  which  actually  or  con- 
structively received,  and  expenses  are  deducted  in  the  taxable  years 
in  which  they  are  actually  paid.  The  primary  advantage  of  the  cash 
method  is  that  it  generally  requires  a  minimum  of  recordkeeping; 
however,  it  frequently  does  not  match  income  with  related  expenses. 
Consequently,  the  cash  method  can  be  used  to  create  tax  losses  which 
defer  current  tax  liabilities  on  both  farm  and  nonfarm  income.  Cor- 
porations, as  well  as  individuals,  can  benefit  by  the  time  value  of  such 
deferral  of  taxes. 


19  A  primary  goal  of  the  accrual  method  of  accounting  is  a  matching  of  Income  and  ex- 
penses. Under  this  method,  income  is  included  for  the  taxable  year  when  all  the  events 
have  occurred  which  fix  the  right  to  receive  such  income  and  the  amount  can  be  deter- 
mined with  reasonable  accuracy.  Under  such  a  method,  deductions  are  allowable  for  the 
taxable  year  in  which  all  the  events  have  occurred  which  establish  the  fact  of  the  lia- 
bility giving  rise  to  the  expense  and  the  amount  can  be  determined  with  reasonable  accu- 
racy. Also,  under  the  accrual  method,  where  the  manufacture  or  purchase  of  items  which 
are  to  be  sold  is  an  income-producing  factor,  inventories  must  be  kept  and  the  costs  of 
the  merchandise  must  be  accumulated  in  inventory  (rather  th.'in  deducted  when  incurred). 
These  costs  may  be  deducted  onlv  in  the  year  the  merchandise  is  sold.  Regs.  §  1.446-1 
(a)(4)  and  (c). 

'"'Rev.  Rul.  76-242.  1976-26  I.R.B.  9.  This  ruling  also  specifically  requires  an  accrual 
method  taxpayer  operating  a  nursery  to  inventory  growing  trees  and  an  accrual  method 
florist  to  inventory  growing  plants  (unless  the  taxpayer  uses  the  crop  method  of 
accounting). 

Under  the  crop  method  of  accounting,  where  a  farmer  is  engaged  in  producing  crops 
and  the  process  of  gatherings  and  disposal  of  the  crops  is  not  completed  in  the  taxable 
year  in  which  the  crops  were  planted,  expenses  of  producing,  gathering  and  disposing  of 
the  crop  are  taken  only  in  the  taxable  year  in  which  the  gross  income  from  the  crop  is 
realized.  Regs.  §  1.162-12 (a). 

^  See,  e.g..  Commissioner  v.  Idaho  Power  Co.,  418  U.S.  1   (1974). 


63 

The  opportunity  for  farmers  generally  to  use  the  cash  method  of 
accounting,  without  inventories  and  with  current  deduction  of  certain 
expenses  which  are  properly  capitalizable,  was  granted  over  50  years 
ago  by  administrative  rulings.  These  rulings  were  issued  at  a  time 
when  "most  agricultural  operations  were  small  operations  carried  on 
by  individuals.  The  primary  justification  for  the  cash  method  of  ac- 
counting for  farm  operations  was  its  relative  simplicity  which,  for 
example,  eliminates  the  need  to  identify  specific  costs  incurred  in  rais- 
ing particular  crops  or  animals. 

In  recent  years,  however,  many  corporations  have  entered  farming. 
While  some  of  these  corporations  involve  relatively  small  business 
operations  owned  by  a  family  or  a  few  individuals,  other  corporations 
conduct  large  farm  businesses  which  have  ready  access  to  the  skilled 
accounting  assistance  often  required  to  identify  specific  farm  costs.  In 
addition,  sophisticated  farm  operations  have  often  been  carried  on  by 
fann  syndicates  or  partnerships  consisting  of  high-income  investors 
and  a  corporation  representing  a  promoter  of  a  farm  "tax  shelter." 

In  view  of  this,  Congress  believed  it  was  appropriate  to  require  that 
certain  corporations,  and  certain  partnerships,  engaged  in  farming  to 
this  requirement  small  or  family  corporations  in  order  to  continue  the 
cash  basis  method  of  accounting  essentially  for  all  those  but  the  larger 
corporations  engaged  in  f  arming.^^ 

Explanation  of  provisions 

In  general. — The  Act  adds  a  new  provision  to  the  Code  (sec.  447) 
which  requires  that  corporations  (other  than  nurseries,  certain  "family 
owned"  corporations,  subchapter  S  corporations,  and  certain  corpora- 
tions with  annual  gross  receipts  of  less  than  $1,000,000)  and  certain 
partnerships  to  use  the  accrual  method  of  accounting  for  farm  opera- 
tions and  also  to  capitalize  their  preproductive  period  expenses  of 
growing  or  raising  crops  or  animals. 

For  purposes  of  this  provision,  farming  is  intended  to  be  defined 
in  the  same  manner  as  it  is  defined  in  the  farming  syndicate  rules.^' 
Since  under  this  provision,  a  corporation  engaged  in  forestry  or  the 
growing  of  timber  is  not  thereby  engaged  in  the  business  of  farming,^* 
this  provision  does  not  affect  the  method  of  accounting  (or  treat- 
ment of  preproductive  period  expenses)  of  corporations  engaged  in 
forestry  or  the  growing  of  timber. 

Certain  excepted  corporations. — The  Act  provides  a  series  of  excep- 
tions to  the  rule  that  farming  corporations  must  use  the  accrual  ac- 
counting method.  One  exception  to  the  required  accrual  accounting 
rules  is  provided  for  nurseries.  Thus,  a  corporation  which  is  engaged 

'2  Since  the  new  rules  for  cornorations  enjrased  In  farming  do  not  apply  to  subchaoter  S 
corporations,  anv  corporation  eligible  to  elect  subchaoter  S  status  may  so  elect  and  thus  be 
exemnt'from  being  rennired   to  use  the  accrual  method  of  accounting. 

^^  For  purposes  of  this  provision,  income  derived  from  the  personal  services  of  em- 
plovees  who  are  engaged  in  the  operation  of  machinery  used  in  connection  with  farming 
activities  of  other  taxpayers  is  not  income  from  the  trade  or  business  of  farming.  Conse- 
ouentlv.  unless  otherwise  reouired  by  nrlor  law.  a  corporation  will  not  be  reauired  to 
compute  taxable  income  from  such  activities  on  an  accrual  method  of  accounting.  For 
example,  if  a  corporation  owns  a  combine  and  trucks  which  are  operated  by  its  employees 
in  contract  harvesting  operations,  the  taxable  income  of  such  corporation  need  not  be 
computed  on  an  accrual  method  of  accounting,  unless  otherwise  required. 

"*This  exclusion  of  forestrv  or  the  growing  of  timber  from  "farming"  is  consistent  with 
the  distinction  drawn  in  regulations  relating  to  provisions  of  the  Code  allowing  taxpavers 
engaged  in  the  trade  or  business  of  farming  to  deduct  currently  expenditures  for  soil  or 
water  conservation,  fertilizer  for  land  used  in  farming,  and  land  clearing  (sees.  175,  180, 
182  and  Regs.  §§  1.175-3,  1.180-1  (b),  and  1.182-2). 


234-120  O  -  77 


54 

in  the  business  of  operating;  a  nursery  will  not  be  required  to  utilize 
the  accrual  method  of  accounting  by  reason  of  this  provision  of  the 
Act.  No  inference  is  intended,  however,  with  respect  to  any  business 
operation  which  is  required  to  utilize  the  accrual  method  of  accounting 
under  provisions  of  prior  law. 

Subchapter  S  corporations,  which  by  definition  can  have  no  more 
than  15  shareholders,  and  certain  family  owned  corporations  are  also 
excepted  from  the  requirement  of  accrual  accounting.  A  shareholder 
of  a  subchapter  S  corporation,  however,  is  to  be  subject  to  the  at  risk 
provisions  of  the  Act,  and  the  corporation  itself  may  also  be  farming 
syndicate. 

A  family  corporation  (excerpted  from  the  requirements  of  section 
447)  includes  a  corporation  in  which  at  least  50  percent  of  the  total 
combined  voting  power  of  all  classes  of  stock  entitled  to  vote,  and 
at  least  50  percent  of  the  total  number  of  shares  of  all  other  classes 
of  stock,  are  owned  by  members  of  the  same  family.  For  purposes 
of  this  provision,  the  members  of  a  family  are  an  individual,  his 
brothers  and  sisters,  the  brothers  and  sisters  of  such  individual's 
parents  and  grandparents,  ancestors  and  lineal  descendants  of  any  of 
the  above,  a  spouse  of  any  of  the  above,  and  the  estate  of  any  of  these 
individuals.  Ownership  of  stock  by  a  trust  or  partnership  is  to  be  pro- 
portionately attributed  to  its  beneficiaries  or  partners,  as  the  case  may 
be.  "^^  Also,  stock  ownership  is  to  be  attributed  proportionately  through 
a  corporate  shareholder  (in  a  farm  corporation)  to  the  owne.s  of  the 
corporate  shareholder  if  50  percent  or  more  in  value  of  the  corporate 
shareholder  is  owned  by  members  of  the  same  family.-"  In  applying 
these  rules,  individuals  related  by  the  half-blood  or  by  legal  adoption 
are  treated  as  if  they  were  related  by  the  whole  blood. 

Since  a  principal  justification  for  use  of  the  cash  method  of  ac- 
counting in  agriculture  is  that  small  enterprises  should  not  be  required 
to  keep  books  and  records  on  the  accrual  method  of  accounting, 
a  fourth  exception  to  required  accrual  accounting  covers  small  cor- 
porations. The  provision  exempts  any  corporation  whose  gross  receipts 
(when  combined  with  the  gross  receipts  of  related  corporations)  do 
not  exceed  $1,000,000  per  year.  However,  once  this  level  of  receipts  is 
exceeded  for  a  taxable  year  beginning  after  December  31,  1975,  the 
corporation  must  change  to  the  accrual  method  of  ac<x)unting  for  sub- 
sequent taxable  years  and  may  not  change  back  to  the  cash  method  of 
accounting  for  subsequent  taxable  years  even  if  its  receipts  subse- 
quently fall  below  $1,000,000.^^ 


^  In  determining  family  ownership  under  this  provision,  Congress  beUeves  that,  if  the 
trustee  of  a  trust  has  discretion  to  distribute  income  or  principal  to  family  members  or 
charities  and  if  the  trustee  has  made  no  distributions  lor  taken  deductions  for  set-asides) 
to  charities,  family  beneficiaries  should  be  treated  as  the  sole  beneficiaries  of  the  trust. 
However,  Congress  does  not  intend  that  such  beneficiaries  should  be  treated  as  the  sole 
beneficiaries  of  the  trust  for  other  purposes  by  reason  of  the  preceding  sentence. 

28  Also,  if  a  farming  corporation  is  a  wholly-owned  subsidiary  of  another  corporation 
(the  "parent  corporation"),  stock  of  the  subsidiary  may  be  attributed  from  the  parent 
corporation  to  another  corporation  (the  "grandparent  corporation")  and  through  such 
grandparent  corporation  to  its  shareholders,  if  .50  percent  or  more  in  value  of  the  stock 
of  the  grandparent  corporation  is  owned,  directly  or  through  a  trust  or  partnership,  by 
members  of  the  same  family. 

^  Amounts  received  from  the  sale  of  farmland  and  improvements,  farm  machinery  and 
equipment  would  not  be  included  in  "gross  receipts"  under  this  provision.  With  respect  to 
its  farming  activities,  a  taxpayer  would  include  only  the  receipts  received  from  the  sale 
of  farm  products  including  livestock  held  for  breeding,  draft,  dairy  or  sporting  purposes— 
unless  the  sale  of  livestock  is  not  in  the  ordinary  course  of  business  and  involves  the 
disposition  of  a  substantial  portion  of  the  taxpayer's  livestock.  In  the  case  of  nonfarm 
items,  the  taxpayer  would  include  receipts  from  those  items  which  produce  ordinary 
income  as  contrasted  with  those  which  produce  capital  gains. 


55 

Application  to  partnerships. — Under  this  provision,  a  partnership 
is  also  required  to  use  an  accrual  method  (and  to  capitalize  preproduc- 
tive  period  expenses)  if  a  corporation  is  a  member  of  a  partnership 
and  the  corporation  itself  would  be  required  under  this  provision  to  use 
the  accrual  method  for  its  farm  operations.  (Without  a  rule  of  this 
kind,  a  corporation  directly  engaged  in  farming  could  escape  the  gen- 
eral rule  of  this  provision  by  becoming  a  partner  in  a  partnership 
which  could  still  elect  the  cash  method  of  accounting  for  the  benefit  of 
its  partners.)  Where  the  rules  of  this  provision  apply  to  a  partner- 
ship, noncorporate  partners  will  be  affected  by  the  accounting  method 
required  to  be  used  by  the  partnership.^^ 

Preproductive  penod  expenses. — The  term  "preproductive  period 
expenses"  (required  to  be  capitalized  under  this  section)  means,  in 
general,  any  expenses  which  are  attributable  to  crops,  animals,  trees,  or 
to  other  property  having  a  crop  or  yield,  during  the  preproductive 
period  of  such  property  and  which  are  allowable  as  deductions  for  the 
taxable  year  but  for  the  application  of  this  provision  (and  the  farming 
syndicate  rules,  if  applicable)  .^^ 

In  the  case  of  property  having  a  useful  life  of  more  than  one  year, 
which  will  have  more  than  one  crop — such  as  an  orchard  or  vineyard — 
the  preproductive  period  extends  until  the  disposition  of  the  first 
marketable  crop  or  yield.  Thus,  costs  attributable  to  the  cultivation, 
maintenance  or  development  of  an  orchard  or  vineyard  in  a  taxable 
year  before  the  first  year  in  which  a  marketable  crop  or  yield  is  sold 
(and  which  are  currently  deductible  under  prior  law)  are  preproduc- 
tive period  expenses.^" 

In  the  case  of  other  farm  property,  such  as  annual  crops  (and 
animals  with  useful  lives  of  less  than  one  year),  the  preproductive 
period  includes  the  entire  period  before  the  crop  (or  animal)  is  dis- 
posed of.  For  example,  amounts  paid  for  laying  hens  with  a  useful 
life  of  less  than  one  year  are  "preproductive  period  expenses"  if  the 
hens  are  purchased  in  one  year  and  sold  in  the  following  year. 
Similarly,  in  the  case  of  winter  vegetables  which  are  planted  in 
December  of  one  year  and  harvested  in  January  or  February  of  the 
following  year,  a  calendar  year  taxpayer  would  treat  the  cost  of  seeds, 
planting,  cultivating,  etc.,  of  the  vegetables  in  December  as  preproduc- 
tive period  expenses  which  must  be  capitalized  and  deducted  only 
when  the  crop  is  sold. 

The  term  "preproductive  period  expenses"  does  not  include  taxes 
and  interest,  and  also  does  not  include  any  amount  incurred  on  account 

28  A  partnership  with  a  corporate  general  partner  may  be  required  to  use  the  accrual 
method  of  accounting  and  may  also  be  a  farming  syndicate  subject  to  limitations  on 
deductible  expenses  for  prepaid  feed  and  other  farm  supplies,  expenses  for  poultry,  and 
certain  expenses  of  orchards,  groves  and  vineyards.  However,  feed  and  other  farm  supplies 
are  required  to  be  inventoried  under  the  accrual  method  of  accounting,  and  the  expenses 
(of  poultry,  orchards,  groves  and  vineyards)  that  must  be  capitalized  under  the  farming 
syndicate  rules  are  also  capitalizable  preproductive  period  expenses  under  the  accrual 
method  of  accounting  (as  required  by  this  provision).  Consequently,  the  application  of 
both  provisions  is  not  inconsistent ;  the  farming  syndicate  rules  do  not  appear  to  impose 
any  additional  requirements  for  an  organization  subject  to  this  provision. 

29  Soil  and  water  conservation  expenditures,  as  defined  in  section  175.  and  land-clearing 
expenditures,  as  defined  in  section  182,  are  preproductive  period  expenses  if  they  are  in- 
curred in  a  preproductive  period  of  an  agricultural  or  horticultural  activity  and  if  the 
taxpayer  elects  to  deduct  these  expenditures  rather  than  capitalize  them. 

3"  This  provision  applies  to  preproductive  period  expenses  of  a  citrus  or  almond  grove 
even  though  under  section  278  of  the  Code,  all  preproductive  expenses  of  planting,  cul- 
tivation, maintenance,  or  development  during  the  first  four  taxable  years  beginning  with 
the  taxable  year  in  which  the  tree  is  planted  must  be  capitalized.  The  result  of  this  inter- 
action is  that,  if  the  preproductive  period  is  greater  than  four  years  in  any  of  these  cases, 
the  preproductive  period  expenses  in  later  years  will  have  to  be  <'apitalized. 


56 

of  fire,  storm,  flood,  or  other  casualty,  or  on  account  of  disease  or 
drought. 

AVith  respect  to  preproductive  expenses,  there  is  a  special  dis- 
position nde  for  home-grown  supplies.  This  nile  provides  that,  in 
the  case  of  deductions  whicli  arise  because  feed  is  grown  on  a  farm, 
and  is  fed  to  the  farmer's  chickens,  cattle  or  other  animals,  the 
consumption  of  the  feed  by  the  animals  transforms  the  deductions 
incurred  in  raising  the  feed  into  ordinary  deductions  in  the  year  the 
feed  is  consumed.  Such  deductions  are  thus  not  required  to  be  treated 
as  preproductive  period  expenses,  even  though  the  animals  may  not 
be  disposed  of  during  that  taxable  year. 

Annual  accr-vnl  Tnefhod  of  accounfhig. — The  Act  adds  special  rules 
which  provide,  in  general,  that,  if  a  corporation  (or  its  predecessors) 
has,  for  a  10-year  period  ending  with  its  first  taxable  year  beginning 
after  December  31,  1975,  used  an  "annual  accrual  method  of  account- 
ing" and  if  the  corporation  raises  crops  which  are  harvested  not  less 
than  12  months  after  planting,  the  corporation  may  continue  to  use 
this  method  of  accounting  for  its  farming  operations.  An  "annual 
accrual  method  of  accounting"  means  a  method  of  accounting  under 
which  revenues,  costs,  and  expenses  are  computed  on  an  accrual  method 
of  accounting  and  the  preproductive  period  expenses  incurred  during 
the  taxable  year  are  either  charged  to  crops  harvested  during  that  year 
or  are  currently  deducted.  To  qualify  to  continue  to  use  this  method  of 
accounting,  substantially  all  of  t\\Q  crops  grown  by  the  corporation 
must  be  harvested  not  less  than  12  months  after  planting.  Also,  the 
corporation  (and  its  predecessors)  must  haA'e  used  this  method  of 
accounting  for  at  least  10  years.  In  order  for  a  corporation  to  utilize 
the  period  another  corporation  has  used  the  annual  accrual  method, 
the  first  corporation  must  have  acquired  the  assets  of  a  farming  trade 
or  business  from  the  second  corporation  in  a  transaction  in  which  no 
gain  or  loss  was  recognized  to  the  transferor  or  transferee  corporation. 

In  general,  this  10-year  requirement  is  designed  to  insure  that  the 
method  can  not  be  used  by  new  or  growing  taxpayers  to  achieve  sub- 
stantial future  deferrals,  while  permitting  taxpayers  who  have  had  a 
substantial  history  of  use  of  this  method  to  continue  its  use. 

If  a  corporation  has  used  an  annual  accrual  method  of  accounting 
together  with  a  static  value  method  of  accounting  for  deferred  costs 
of  growing  crops  for  a  10-year  period  prior  to  the  first  year  to  which 
these  new  provisions  apply,  it  may  elect  to  change  to  the  annual 
accrual  method  of  accounting  without  the  static  value  method  of 
accounting  for  deferred  costs. 

Period  for  taking  adjustments  into  account. — A  taxpayer  who  is 
required  to  change  to  the  accrual  method  of  accounting  (or  to  revise 
his  accrual  method  of  accounting  to  capitalize  preproductive  period 
expenses)  pursuant  to  this  provision  will  be  allowed  to  spread  the 
accounting  adjustments  required  by  this  method  over  a  period  of  10 
years  unless  the  Secretary  of  the  Treasury  by  regidations  prescribes 
different  periods  in  certain  types  of  cases.  The  corporation  Avill  also  be 
treated  as  having  made  the  change  with  the  consent  of  the  Secretary 
of  the  Treasury.  Such  a  change  will  be  treated  as  not  having  been 
initiated  by  the  taxpayer  (for  purposes  of  the  rule  which  prohibits 
adjustments  resulting  from  changes  in  a  taxpayer's  method  of  ac- 
counting if  the  taxpayer  initiates  the  change  (sec.  481(a)). 


57 

The  provision  which  states  that  the  Secretary  of  the  Treasury  may 
prescribe  regulations  settinfj  forth  exceptions  to  the  general  rule  that 
a  corporation  (or  partnership)  may  spread  the  adjustments  required 
by  the  change  of  accounting  method  over  a  10-year  period,  is,  in  gen- 
eral, intended  to  give  the  Internal  Revenue  Sei-vice  discretion  to  set 
forth  standards  as  to  when  a  different  period  for  taking  the  adjust- 
ments into  account  would  be  appropriate.^^ 
Effective  Bate 

This  provision  will  apply  to  taxable  years  beginning  after  Decem- 
ber 31, 1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in  budget 
receipts  of  $8  million  in  fiscal  1977  and  $18  million  annually  thereafter. 

d.  Termination  of  Additions  to  Excess  Deductions  Accounts  Un- 
der Sec.  1251  (sec.  206  of  the  Act  and  sec.  1251  of  the  Code) 

Prior  laio 

Under  prior  law  (sec.  1251),  individuals  who  reported  their  farm 
operations  on  the  cash  method  of  accounting,  and  who  have  more  than 
$50,000  of  nonfarm  adjusted  gross  income  during  a  year,  have  been 
required  to  maintain  an  "excess  deductions  account"  (EDA)  for  a  net 
farm  loss  sustained  in  the  same  year  to  the  extent  the  loss  exceeds 
$25,000.  (It  is  immaterial  what  specific  farm  deductions  produced  the 
farm  loss.)  The  EDA  account  is  a  cumulative  account  adjusted  from 
year  to  year  take  into  account  net  farm  income  or  loss.  For  the  most 
part,  when  the  farm  assets  used  in  the  taxpayer's  business  (except  de- 
preciable real  property)  are  sold  or  otherwise  disposed  of,  the  portion 
of  the  gain  on  the  sale  or  other  disposition  equal  to  the  balance  in  the 
excess  deductions  account  must  be  reported  as  ordinary  income,  rather 
than  capital  gain.  Any  gain  recaptured  in  this  manner  is  then,  sub- 
tracted from  the  balance  in  the  EDA  account  as  of  the  end  of  the  same 
taxable  year.^^ 

In  the  case  of  dispositions  of  farm  land,  another  provision  (sec.  1252) 
requires  recapture  of  deductions  allowed  for  soil  and  water  conserva- 
tion expenditures  (sec.  175)  and  for  land  clearing  expenditures  (sec. 
182)  on  a  gradually  reducing  scale  depending  on  how  long  the  land 
is  held.  However,  if  recapture  is  required  as  a  result  of  an  EDA  ac- 
count, this  recapture  is  to  occur  in  the  case  of  a  gain  or  disposition  even 
though  the  property  is  subject  to  a  lesser  recapture  as  a  result  of  prior 
soil  and  water  expenditures  or  prior  land  clearing  expenditures. 

Under  prior  law,  if  a  corporation  had  a  balance  in  an  EDA  account, 
an  otherwise  tax  free  reorganization  in  which  farm  recapture  property 
was  transferred  to  another  corporation  in  exchange  for  its  stock  and 
the  stock  was  then  distributed  would  result  in  EDA  recapture  unless 


^  It  is  contemplatPd  that  the  Internal  Revenne  Service  mijjht,  for  example,  believe  that  a 
shorter  period  would  be  appropriate  where  the  taxpayer  has  been  in  existence  fewer  than 
10  years  prior  to  the  year  of  change  or  where  the  taxpayer  is  a  partnership  with  a  limited 
life  which,  as  of  the  year  of  change,  is  less  than  10  additional  years. 

^^Corporations  (other  than  subchapter  S  corporations)  and  trusts  have  been  required 
to  establish  an  KDA  account  for  the  full  amount  of  their  farm  losses  regardless  of  size 
and  regardless  of  the  amount  of  their  nonfarm  income.  A  subchapter  S  corporation  has 
been  governed  by  the  same  dollar  limitations  that  apply  to  individuals,  except  that  the 
corporation  has  been  required  to  Include  in  its  nonfarm  income  the  largest  amount  of 
nonfarm  income  of  any  of  its  shareholders. 


58 

substantially  all  of  the  assets  of  the  first  corporation  were  transferred 
to  the  second  corporation. 

Reasons  for  change 

Prior  law  allowed  a  farm  investor  who  used  the  cash  method  of 
accounting  to  defei'  current  taxes  on  his  nonfarm  income.  It  merely 
placed  a  potential  limit  on  the  amount  of  ordinary  nonfarm  income 
which  might  be  converted  to  capital  gain  in  a  future  year.  Thus,  even 
where  an  EDA  account  was  required  to  be  maintained,  this  provision 
reduced  the  conversion  of  ordinary  income  into  capital  gain  but  did 
not  affect  the  time  value  of  deferring  taxes  on  nonfarm  income  or  on 
annual  farm  crop  income. 

The  experience  with  this  provision  since  it  was  enacted  in  1969  also 
suggested  that  the  dollar  floors  which  must  be  reached  before  farm 
losses  were  subject  to  recapture  are  quite  high,  and  that  the  applica- 
tion of  the  provision  was  very  limited.  Treasury  statistics  of  income 
since  1969  show  that  the  number  of  tax  returns  which  show  nonfarm 
income  of  $50,000  and  higher  and  a  net  farm  loss  of  $25,000  or  more 
has  generally  been  less  than  one  percent  of  all  returns  which  report 
both  nonfarm  income  and  farm  losses.  Treasury  statistics  also  show 
that  the  provision  affects  no  more  than  8  percent  of  the  dollar  amount 
of  all  farm  losses  reported  on  returns  which  show  both  nonfarm  in- 
come and  farm  losses.  Furthermore,  it  appears  that  the  provision  is 
difficult  to  apply  and  susceptible  of  varying  interpretations. 

Congress  concluded  that  an  approach  which  focused  solely  on  pre- 
venting conversion  of  ordinary  nonfarm  income  to  capital  gain,  with- 
out limiting  the  initial  deferral  of  current  taxes  on  nonfarm  income, 
did  not  deal  effectively  with  the  use  of  farm  tax  rules  by  high  income 
taxpayers  to  "shelter"  nonfarm  income,  particularly  in  some  of  the 
more  flagrant  abuses  of  the  farm  tax  rules  in  publicly  syndicated 
farm  tax  shelters  which  have  been  carefully  structured  to  avoid  or 
minimize  the  effects  of  section  1251. 

Since  the  new  provisions  limiting  the  deductions  in  the  case  of  farm 
syndicates,  providing  an  at  risk  limitation  for  farm  operations,  and 
requiring  certain  corporations  to  use  the  accrual  method  of  account- 
ing, will  prevent  the  deferral  of  taxes  on  nonfarm  income  in  many 
cases.  Congress  did  not  believe  that  it  was  desirable  to  continue  a 
complex  iide  of  limited  applicability  in  the  statute  which  recaptures 
income  previously  offset  by  certain  farm  losses. 

Also,  Congress  believed  that  it  was  inappropriate  for  EDA  recap- 
ture to  be  triggered  by  a  divisive  "D"  reorganization  so  long  as  the 
amounts  in  the  EDA  account  would  remain  subject  to  recapture 
(under  rides  which  are  at  least  as  stringent  as  if  the  reorganization 
had  not  occurred)  when  farm  recapture  property  is  disposed  of  by  a 
corporation  which  survived  the  reorganization. 

Explanation  of  provision 
The  Act  limits  the  future  anplicability  of  the  EDA  provision  (sec. 
1251)  by  providing  that  no  additions  to  an  excess  deductions  account 
need  be  made  for  net  farm  losses  sustained  in  any  taxable  year  begin- 
ning after  December  81,  1975.  Farm  losses  incurred  during  any  such 
taxable  year  or  years  will  instead  be  governed  by  other  limitations 
under  the  Act. 


59 

If  property  which  is  "farm  recapture  property"  (within  the  mean- 
ing of  section  1251(e)(1))  is  disposed  of  during  a  taxable  year  be- 
ginning after  December  31, 1975,  however,  the  recapture  rules  of  pres- 
ent law  will  continue  to  apply,  but  only  with  respect  to  EDA  accounts 
required  to  be  maintained  for  one  or  more  years  beginning  before 
December  31, 1975. 

The  Act  allows  divisive  "D''  reorganizations  without  triggering 
EDA  recapture.  In  these  reorganizations,  the  entire  EDA  account 
is  applied  to  both  the  transferor  corporation  and  the  transferee 
corporation. 

Effective  date 

The  amendments  to  section  1251  will  not  affect  any  recapture  of 
farm  losses  by  reason  of  a  disposition  of  farm  recapture  property 
during  a  taxable  year  beginning  on  or  before  December  31,  1975. 

In  the  case  of  dispositions  of  fann  land,  the  termination  of  the  pro- 
vision described  here  for  farm  losses  incurred  in  taxable  years  be- 
ginning after  December  31,  1975.  will  mean  that  deductions  taken 
under  sections  175  and  182  in  years  beginning  after  December  31, 1975, 
will  continue  to  be  subject  to  recapture,  but  only  to  the  extent  required 
by  section  1252.  In  such  cases,  section  1251  will  cease  to  apply  to  any 
deductions  under  sections  175  and  182. 

The  provisions  relating  to  "D"  reorganizations  apply  to  reorganiza- 
tions occurring  after  December  31, 1975. 

Revenue  estimate 
It  is  estimated  that  these  provisions  will  result  in  a  decrease  in  tax 
liability  of  less  than  $5  million  annually. 

e.  Scope  of  Waiver  of  Statute  of  Limitations  in  Case  of  Activi- 
ties Not  Engaged  in  for  Profit  (sec.  214  of  the  Act  and  sec. 
183(e)  of  the  Code) 

Prior  Jaw 

The  tax  law  distinguishes  between  activities  engaged  in  "for  profit" 
and  activities  which  are  not  engaged  in  for  profit  (sec.  183).  In  the 
case  of  an  activity  engaged  in  for  profit,  a  taxpayer  may  deduct  all 
expenses  attributable  to  the  activity  even  though  they  exceed  the  in- 
come from  the  activity.  In  the  case  of  an  activity  not  engaged  in  for 
profit,  a  taxpayer  can  deduct  the  allowable  expenses  attributable  to 
the  activity  only  to  the  extent  that  income  derived  from  the  activity 
exceeds  amounts  allowable  for  interest,  taxes  and  casualty  losses  attrib- 
utable to  the  activity.  A  taxpayer  thus  cannot  utilize  an  operating 
loss  incurred  in  an  activity  of  this  kind  to  offset  his  other  income. 
Activities  which  raise  issues  of  this  kind  include  horse  breeding,  cattle 
breeding,  the  racing  or  showing  of  horses,  and  vacation  homes. 

In  determining  whether  an  activity  is  engaged  in  for  profit,  the 
facts  and  circumstances  must  be  examined  to  determine  whether  the 
taxpayer  entered  the  activity  and  continued  it  with  the  objective  of 
making  a  profit.  However,  the  tax  law  contains  a  provision  under 
which  an  activity  is  presumed  to  be  engaged  in  for  profit  if  the  activ- 
ity shows  a  profit  in  at  least  2  out  of  5  consecutive  taxable  years  ending 
with  the  taxable  year  in  question.  (In  the  case  of  raising,  breeding, 
training  or  showing  horses,  the  requirement  is  a  profit  in  at  least  2  of  7 
consecutive  years.) 


60 

If,  at  the  end  of  a  given  year,  the  taxpayer  has  not  conducted  the 
activity  for  5  (or  7)  years,  a  special  provision  allows  the  taxpayer  to 
elect  to  postpone  a  determination  as  to  whether  he  can  benefit  by  this 
presumption  until  he  has  conducted  the  activity  for  5  (or  7)  years 
(sec.  183(e) ).  This  election  was  added  to  the  Code  in  1971.  The  com- 
mittee reports  at  that  time  expressed  an  intent  that  a  taxpayer  who 
made  the  election  should  be  required  to  waive  the  statute  of  limita- 
tions for  the  5  (or  7)  year  period  and  for  a  reasonable  time  thereafter. 
The  aim  was  to  prevent  statute  of  limitations  (3  years,  in  the  usual 
case)  from  running  on  any  year  in  the  period.  The  taxpayer,  it  was 
believed,  should  have  time  to  claim  a  refund  of  tax  paid  by  him  during 
the  period,  and  the  Internal  Revenue  Service  should  also  have  time  to 
assess  any  deficiency  owned  by  the  taxpayer  for  any  year  in  the  period. 

In  carrying  out  this  legislative  intent,  the  Service  has  issued  tempo- 
rary regulations  which  require  a  taxpayer  who  makes  an  election 
under  section  183(e)  to  agree  to  extend  the  statute  of  limitations 
for  each  taxable  year  in  the  5  (or  7)  year  period  to  at  least  18  months 
after  the  due  date  of  his  return  for-  the  last  year  in  the  period.  Such 
an  extension  must  apply  to  all  potential  income  tax  liabilities  arising 
during  the  period,  including  issues  unrelated  to  deductions  subject  to 
section  183  issues. 

The  reason  for  requiring  such  a  broad  waiver  stems  from  a  pro- 
vision under  prior  law  which,  in  certain  circumstances,  allows  only 
one  notice  of  deficiency  to  be  sent  to  a  taxpayer  with  respect  to  a  tax- 
able year.  If  a  taxpayer  receives  a  notice  of  deficiency  and  then  files  a 
petition  with  the  Tax  Court  relating  to  that  notice,  the  Service  can- 
not (as  a  general  rule)  determine  an  additional  deficiency  for  the  same 
taxable  year  (sec.  6212(c)).  Therefore,  if,  within  the  present  limita- 
tions period,  the  Sendee  sends  a  deficiency  notice  to  a  taxpayer  relat- 
ing to  an  i^Sue  other  than  section  183  and  the  taxpayer  petitions  the 
Tax  Court  as  to  one  or  more  of  those  issues,  the  Service  cannot  later 
assess  a  separate  deficiency  under  section  183.  In  order  to  prevent  such 
a  result,  the  temporary  regulations  require  the  waiver  to  cover  all  tax 
issues  during  the  presumption  period  and  not  just  the  potential  sec- 
tion 183  issues. 

Reasons  for  change 

Tlie  requirement  that  all  items  on  a  taxpayer's  returns  for  the  early 
years  of  a  5  (or  7)  year  period  be  kept  open  creates  several  problems. 
The  taxpayer  must  retain  all  records  for  those  years  for  a  substan- 
tially longer  period  of  time  than  otherwise  would  be  the  case.  Leaving 
the  statute  of  limitations  open  for  the  entire  return  because  of  an  item 
which  may  well  be  relatively  minor  is  also  contrary  to  the  policy  of 
prompt,  resolution  of  tax  disputes.  A  taxpayer  may  also  want  a  prompt 
resolution  of  other  items  on  his  return  in  order  to  limit  his  potential 
interest  cost  as  to  any  deficiency  arising  from  items  not  related  to  the 
section  183  issues  on  his  return. 

In  order  to  accomplish  the  purposes  which  Congress  sought  when  it 
enacted  the  look- forward  presumption  of  section  183(e),  it  is  not 
necessary  to  keep  the  statute  of  limitations  open  for  all  issues  on  the 
taxpayer's  return  during  the  5  (or  7)  year  period.  Tlie  only  issues 
on  which  the  statute  of  limitations  need's  to  remain  open  concern  the 


61 

deductions  which  will  be  tested  as  to  whether  they  are  mcurred  in  an 
activity  which  the  taxpayer  engaged  in  for  profit.  Congress  believes 
that  a  taxpayer  should  be  able  to  take  full  advantage  of  a  statutory 
presumption  which  was  intended  for  his  benefit,  without  unnecessarily 
extending  the  statute  of  limitations  for  items  on  his  return  which  are 
unrelated  to  deductions  which  might  be  disallowed  imder  section  183. 

Exfla/naUon  of  provision 

The  Act  revises  prior  law  (sec.  183(e))  to  provide  that  if  a  tax- 
payer elects  to  postpone  the  determination  of  his  conduct  of  an  activ- 
ity under  the  presumption  provisions,  the  statutory  period  for  the 
assessment  of  any  deficiency  specifically  attributable  to  that  activity 
during  any  year  in  the  5  (or  7)  year  jx^riod  shall  not  expire  until  at 
least  two  years  after  the  due  date  of  the  taxpayer's  income  tax  return 
for  his  last  taxable  year  in  the  period. 

If  a  taxpayer  makes  an  election  under  section  183(e)  and  postpones 
a  determination  whether  he  engaged  in  a  particular  activity  for  profit, 
the  making  of  this  election  automatically  extends  the  statute  of  limita- 
tions, but  only  with  regard  to  deductions  which  might  be  disallowed 
under  section  183.  The  taxpayer  would  not  have  to  agree  to  extend  the 
statute  of  limitations  for  any  other  item  on  his  return  during  the  5 
(or  7)  year  period.  On  the  other  hand,  even  if  the  taxpayer  has  peti- 
tioned the  Tax  Court  with  regard  to  an  unrelated  issue  on  his  return 
for  any  year  in  the  same  period,  the  Service  will  be  able  to  issue  a  sec- 
ond notice  of  deficiency  relating  to  a  section  183  issue  as  to  any  taxable 
year  in  i\\&  period. 

In  order  to  assure  the  Service  adequate  time  to  reexamine  the  section 
183  issue  after  the  suspension  period  has  ended,  tliis  new  provision  al- 
lows the  Service  two  years  after  the  end  of  the  period  in  which  to  con- 
test the  taxpayer's  deductions.  The  making  of  the  election  extends  the 
statute  of  limitations  on  any  year  in  the  susi^ension  period  to  at  least 
two  years  after  the  due  date  of  his  return  for  the  last  year  in  the  pe- 
riod.^^  (The  due  date  is  to  be  determined  without  regard  to  extensions 
of  time  to  file  his  return  for  the  last  year.) 

The  taxpayer's  limited  waiver  of  the  statute  of  limitations  would 
include  not  only  the  section  183  issue  itself  but  also  dedudtions,  etc., 
which  depend  on  adjusted  gross  income  and  which  might  be  affected 
if  the  deductions  are  disallowed  in  accord  with  section  183. 

The  provision  for  this  limited  waiver  is  not  intended  to  affect  the 
scope  or  duration  of  any  general  waivers  of  the  statute  of  limitations 
which  taxpayers  have  signed  (or  sign)  before  the  date  of  enactment 
of  this  Act  (October  4. 1976)  .^^ 

^^  The  Act  does  not  shorten  the  usual  3-year  statute  of  limitations  as  to  any  taxable  year 
in  the  5  (or  7)  year  period.  Rather,  it  requires  that  the  normal  limitations  period  be  ex- 
tended as  to  any  year  in  the  5  (or  7)  year  period  as  to  which  the  normal  3-year  limitation 
period  would  otherwise  expire  while  the  potential  section  183  issues  are  held  in  suspense. 

■■^  The  provision  is  not  designed  to  affect  existing  general  waivers  of  the  statute  of 
limitations,  because  to  do  so  would  allow  taxpayers  who  have  previously  signed  such 
waivers  to  escape  an  examination  of  issues  not  related  to  section  183  even  though  the 
Internal  Revenue  Service  had  attempted  to  make  a  timely  audit  of  them.  Thus,  for  example 
if,  before  the  date  of  enactment  of  this  bill,  in  examining  a  taxpayer's  income  tax  returns  for 
1970,  a  revenue  agent  had  proposed  adjustments  to  a  taxpayer's  allegedly  unsubstantiated 
charitable  contributions  and  to  his  horse  breeding  activities,  and  if  the  taxpayer  made  an 
election  under  section  183 (e),  and  signed  a  general  waiver  of  the  statute  of  limitations 
until  October  15,  197S  (i.e.,  until  18  months  after  the  due  date  of  his  1976  return),  the 
agent  could  issue  the  taxpayer  a  deficiency  notice  for  both  items  at  any  time  prior  to  that 
date.  After  that  date,  however,  the  statute  of  limitations  would  continue  to  be  open  for 
issues  relating  to  horse  breeding  activities  conducted  in  1970  until  April  15,  1979.  but 
would  be  closed  for  issues  relating  to  the  proper  substantiation  of  charitable  contributions 
after  October  15,  1978. 


62 

Similarly,  the  bill  does  not  affect  general  waivers  of  the  statute  of 
limitations  which  may  be  signed  after  enactment,  since  in  order  to 
avoid  two  controversies  relating  to  overall  income  tax  liability  for  the 
same  year,  a  taxpayer  may  wish  to  postpone  a  resolution  of  non- 
section  183  issues  until  the  information  relating  to  the  section  183 
presumption  is  available. 

Effective  date 
This  provision  generally  applies  to  taxable  years  beginning  after 
December  31, 1969.  However,  it  w^ill  not  permit  a  reopening  of  the  stat- 
ute of  limitations  for  any  taxable  year  ending  before  the  date  of  enact- 
ment of  the  bill  and  as  to  which  the  statute  of  limitations  has  expired 
before  such  date  of  enactment.  Further,  since  this  provision  does  not 
limit  general  waivers  of  the  statute  of  limitations,  a  taxpayer  who  has 
previously  signed  a  general  waiver  will  not  be  able  to  take  advan- 
tage of  this  new  provision  (and  to  argue  that  the  statute  of  limitations 
has  run  on  issues  unrelated  to  section  183)  until  his  general  waiver 
expires. 

Revenue  effect 
This  provision  is  not  expected  to  have  any  revenue  effect. 

4.  Oil  and  Gas 

a.  Limitation  of  Loss  to  Amount  at  Risk  (see  sec.  204  of  the  Act 
and  sec.  465  of  the  Code) 

Prior  laiD 

Under  the  tax  law,  an  owner  of  an  operating  interest  in  an  oil  or  gas 
well  is  allowed  the  option  (under  sec.  263(c))  to  deduct  as  a  current 
expense  the  intangible  drilling  and  development  costs  connected  with 
that  well.  Intangible  drilling  costs  include  amounts  paid  for  labor, 
fuel,  repairs,  hauling  and  supplies  which  are  used  in  drillLig  oil  or 
gas  wells,  the  costs  of  clearing  of  ground  in  preparation  for  drilling, 
and  the  intangible  costs  of  constructing  derricks,  tanks,  pipelines  and 
other  structures  and  equipment  necessary  for  the  drilling  of  the  wells 
and  the  preparation  of  the  wells  for  production.  But  for  the  statutory 
election  to  deduct  these  costs  currently,  they  would,  in  the  case  of  a 
successful  well,  be  added  to  the  taxpayer's  basis  and  recovered  through 
depletion  and  depreciation;  in  the  case  of  a  dry  hole,  the  intangible 
costs  would  be  deducted  at  the  time  the  dry  hole  is  completed. 

In  the  case  of  an  oil  and  gas  drilling  venture,  which  is  most  often  a 
limited  partnership,  the  Service  has  ruled  (in  Rev.  Rul.  68-139, 1968-1 
C.B.  311)  that  a  limited  partnership  may  earmark  a  limited  partner's 
contribution  to  expenditures  for  intangible  drilling  costs,  thereby  al- 
lowing the  allocation  of  the  entire  deduction  to  the  limited  partnei*s 
(if  the  principal  purpose  of  such  allocation  is  not  the  avoidance  of 
Federal  taxes). 

The  Service  has  also  ruled  (Rev.  Rul.  71-252,  1971-1  C.B.  146) 
that  a  deduction  may  be  claimed  for  intangible  drilling  costs  in  the 
year  paid,  even  though  the  drilling  is  performed  during  the  following 
year,  so  long  as  such  payments  are  required  to  be  made  in  the  first  year 
under  the  drilling  contract  in  (..uestion. 


63 

Generally,  the  amount  of  losses  which  a  taxpayer  is  permitted  to 
take  in  connection  with  a  business  or  investment  in  an  oil  or  gas  prop- 
erty is  limited  to  the  amount  of  his  basis  in  the  property.  In  the  case 
of  a  partnership  investing  in  oil  and  gas  properties,  the  amount  of 
losses  a  partner  may  deduct  is  limited  to  the  amount  of  his  adjusted 
basis  in  his  interest  in  the  partnership.  However,  under  prior  law, 
basis  in  a  property  could  include  nonrecourse  indebtedness  (i.e.,  a  loan 
on  which  there  is  no  personal  liability)  attributable  to  that  property. 
Where  a  partnership  incurred  a  debt  and  none  of  the  partners  had 
personal  liability  on  the  loan,  then  all  of  the  partners  were  treated  for 
tax  purposes  as  though  they  shared  the  liability  in  proportion  to  their 
profits  interest  in  the  partnership  (i.e.,  each  partner's  share  in  the 
nonrecourse  indebtedness  was  added  to  his  basis  in  the  partnei-ship). 

Reasmhs  for  change 

The  use  of  leverage  through  nonrecourse  loans  in  an  oil  or  gas  drill- 
ing fund  expanded  the  tax  shelter  potential  of  these  investments  to 
the  extent  that  the  leveraged  amounts  are  used  for  intangible  drilling 
and  development  costs.  In  these  cases  investors  could  deduct  amounts  to 
produce  losses  sufficiently  in  excess  of  their  cash  investment  so  that 
the  tax  savings  in  the  year  of  investment  coidd  exceed  the  amount  in- 
vested. For  example,  an  investor  contributing  $100,000  to  a  partner- 
ship for  a  10  percent  profits  interest  could  have  added  to  his  basis 
another  $100,000  if  the  partnership  obtained  a  nonrecourse  loan  for 
$1,000,000.  If  all  of  the  partnership's  capital  ($2,000,000)  were  spent 
on  drilling  costs  and  the  partnership  had  no  income,  the  investor  could 
deduct  all  of  his  share  of  those  costs,  or  $200,000.  If  the  investor  were  in 
the  70  percent  tax  bracket,  that  deduction  would  reduce  his  taxes  in 
that  year  by  $140,000,  or  $40,000  more  than  his  investment. 

This  leveraging  of  investments  to  produce  tax  savings  in  excess  of 
amounts  invested  has  substantially  altered  the  economic  substance  of 
the  investments  and  distorted  the  working  of  the  investment  markets. 
Taxpayers  could  be  led  into  investments  which  were  otherwise  eco- 
nomically unsound  and  which  constituted  an  unproductive  use  of  the 
taxpayer's  investment  funds. 

Explanation  of  provisions 
To  prevent  a  taxpayer  from  deducting  a  loss  in  excess  of  his  economic 
investment  in  an  oil  or  gas  property,  the  Act  provides  that  the  amount 
of  any  loss  incurred  in  connection  with  an  oil  or  gas  property  may  not 
exceed  the  aggregate  amount  with  respect  to  which  the  taxpayer  is  at 
risk  at  the  close  of  the  taxable  year.  (The  detailed  provisions  of  the 
at  risk  rule  have  been  discussed  in  section  2  above.)  The  limitation 
applies  to  all  taxpayers  (other  than  corporations  which  are  not  sub- 
chapter S  corporations  or  personal  holding  companies)  including  in- 
dividuals and  sole  proprietorships,  estates,  trusts,  shareholders  in 
subchapter  S  corporations,  and  partners  in  a  partnership  which  con- 
dividuals  and  sole  proprietorships,  estates,  trusts,  shareholders  in 

1  Since,  except  for  subchapter  S  corporations  and  personal  holding  companies,  this  pro- 
vision does  not  limit  the  deductibility  of  amounts  paid  or  incurred  by  corporation,  the 
provision  would  not  apply  to  partners  in  a  partnership  which  are  corporations  (other 
than  subchapter  S  corporations  and  personal  holding  companies). 


64 

In  general,  in  the  case  of  an  activity  engaged  in  by  an  individual 
other  than  through  a  partnership,  each  oil  and  gas  property  (deter- 
mined on  a  property-by-property  basis,  as  defined  for  purposes  of 
computing  depletion  under  section  614)  is  treated  as  a  separate  ac- 
tivity. However,  in  the  case  of  a  partnersliip  or  subchapter  S  corpora- 
tion, all  oil  and  gas  properties  are  to  be  treated  as  one  activity. 

For  purposes  of  the  65  percent  of  net  income  limitation  (under  sec- 
tion 613A(d) ),  and  the  50  percent  of  income  from  the  property  limi- 
tation (under  section  613(a)),  the  deduction  for  intangible  drilling 
and  development  costs  is  to  be  taken  into  account  without  regard  to  the 
at  risk  provision  (i.e.,  on  the  assumption  that  the  intangible  drilling 
and  development  costs  are  fully  deductible) . 

As  discussed  above,  where  the  taxpayer  has  no  personal  liability 
with  respect  to  a  loan,  he  is  to  be  considered  at  risk  with  respect  to  any 
indebtedness  where  the  loan  is  secured  by  the  taxpayer's  personal  or 
partnership  assets  (oth»r  than  assets  which  are  used  in  the  same  ac- 
tivity) which  have  an  established  value,  to  the  extent  of  the  value  of 
the  assets  (net  of  any  other  nonrecourse  indebtedness  secured  by  these 
same  assets) .  In  the  case  of  oil  and  gas  wells,  a  property  is  not  con- 
sidered to  have  an  established  value  unless  sufficient  drilling  has  taken 
place  to  establish  proven  reserves  on  the  property. 

Effective  date 
This  provision  is  to  apply  to  losses  attributable  to  amounts  paid 
or  incurred  with  respect  to  oil  and  gas  properties  after  December  31, 
1975,  in  taxable  years  beginning  after  that  date. 

Revenue  effect 
This  provision  will  increase  budget  receipts  by  $50  million  in  fiscal 
year  1977,  $18  million  in  fiscal  year  1978,  and  $6  million  in  fiscal  year 
1981. 

b.  Gain  From  Disposition  of  an  Interest  in  Oil  and  Gas  Property 
(sec.  205  of  the  Act  and  sec.  1254  of  the  Code) 

Prior  law 

Under  the  tax  law,  the  operating  interest  in  an  oil  or  gas  property 
is  considered  to  be  either  a  capital  asset  or  real  property  used  in  a  trade 
or  business.  As  a  result,  where  the  operating  interest  is  sold  after  being 
held  for  more  than  six  months,^  the  income  from  the  sale  will  qualify 
for  treatment  as  long-term  capital  gain.  Similarly,  an  interest  in  a 
partnership  is  generally  treated  as  a  capital  asset  the  sale  of  which 
will  qualify  for  long-term  capital  gain  treatment. 

Prior  law  provided  for  the  recapture  of  any  deductions  upon  the  sale 
of  oil  or  gas  property  only  to  the  extent  that  any  deductions  taken 
(under  sec.  167)  for  the  depreciation  of  tangible  personal  property 
(sec.  1245).  Amounts  deducted  currently  for  intangible  drilling  and 
development  costs  (under  sec.  263  (c) )  were  not  subject  to  recapture. 

General  reasons  for  change 
The  provision  allowing  gain  from  the  sale  of  oil  or  gas  property  to 
be  treated  as  capital  gain  without  any  significant  recapture  of  deduc- 

2  Thp  required  holding  period  is  Increased  to  nine  months  for  taxable  years  beginning 
in  1977  and  to  one-year  for  years  beginning  after  1977  under  section  1402  of  the  Act. 


65 

tions  taken  against  ordinary  income  increases  the  value  of  an  oil  and 
gas  tax  shelter  investment  because  it  permits  an  investor,  who  has 
(Obtained  a  deferral  of  tax  through  the  deduction  of  intangible  drilling 
and  development  costs,  to  convert  amounts  which  would  in  later  years 
be  taken  into  account  as  ordinary  income  into  capital  gains  subject  to 
the  lower  capital  gains  tax  rates.  The  opportunity  to  convert  these 
amounts  into  capital  gains  by  selling  the  property  occurs  in  all  cases 
of  producing  wells  where  the  option  to  deduct  intangible  drilling  costs 
has  been  made.  Even  apart  from  tax  shelter  considerations,  the  Con- 
gress sees  no  7'eason  why  the  principle  which  applies  to  other  areas  of 
the  tax  law  (i.e.,  that  deductions  attributable  to  property  should  be 
subject  to  recapture  if  that  property  is  sold  or  disposed  of)  should  not 
also  apply  here. 

Exjdanation  of  pravisions 

The  Act  provides  for  the  recapture  of  certain  intangible  drilling 
and  development  costs  upon  the  disposition  of  oil  and  gas  properties 
if  the  disposition  takes  place  after  December  31, 1975.  The  amount  sub- 
ject to  recapture  is  the  amount  deducted  for  intangible  drilling  and 
development  costs  (paid  or  incurred  after  December  81,  1975),  re- 
duced by  the  amounts  which  would  have  been  deductible  had  those 
intangible  costs  been  capitalized  and  deducted  through  cost  depletion. 
However,  the  amount  recaptured  cannot  exceed  the  amount  of  gain 
realized  from  the  dispositioji.  The  amount  recaptured  is  to  be  treated 
as  gain  which  is  ordinary  income  and  is  to  be  recognized  upon  the 
disiiosition  of  the  property,  regardless  of  anj^  other  provision  of  the 
Code  which  would  otherwise  provide  for  nonrecognition. 

The  recapture  provision  applies  to  all  intangible  drilling  and  devel- 
opment costs  which,  but  for  the  option  to  deduct  these  costs  under 
section  263(c) ,  would  be  reflected  in  the  adjusted  basis  of  the  property 
at  the  time  the  costs  are  paid  or  incurred.  Amounts  subject  to  recap- 
ture are  to  be  reduced  by  the  amount  of  cost  depletion  attributable  to 
those  intangible  drilling  and  development  costs  actually  deducted  or 
permitted  to  be  deducted  under  cost  depletion  (under  sec.  611) . 

Costs  which,  but  for  the  election  to  deduct  intangibles,  would  be 
added  to  basis  and  recovered  through  depreciation  (rather  than  to 
cost,  depletion)  are  to  be  recaptured  under  this  provision.^ 

This  net  amount  of  intangible  drilling  and  development  costs  over 
the  amount  allowable  under  cost  depletion  is  to  be  treated  as  ordinary 
income  only  to  the  extent  of  any  gain  realized  (or  to  the  extent  of  the 
excess  of  the  fair  market  value  of  the  property  transferred  over  the 
basis  in  the  property).  This  limitation  on  the  amount  recaptured  to 
the  amount  of  gain  (or  the  excess  of  fair  market  value  over  basis)  is 
the  same  limitation  applied  (under  sec.  1245)  for  the  recapture  of 
certain  depreciation  or  amortization  expenses  relating  to  personal 
property.  The  computation  of  the  amount  realized,  the  fair  market 
value  of  any  intercvst,  and  the  adjusted  basis  of  the  property  are  to  be 
made  under  substantially  the  same  rules  which  apply  to  that  provision. 

The  rules  of  this  provision  are  to  be  applied  separately  to  the  in- 
tangible costs  attributable  to  each  oil  and  gas  property.  A  property  is 

'These  amounts  were  not,  of  course,  previously  subject  to  recapture  under  sec.  1245. 
since  they  are  deducted  under  sec.  26.3(c)  and  not  under  sees.  168,  169,  184,  185.  187,  or 
188,  as  is  required  under  sec.  1245(a)  (2). 


66 

defined  for  purposes  of  these  rules  in  the  same  way  as  under  the  exist- 
ing rules  (under  sec.  614)  for  purposes  of  computing  the  amount  of 
depletion  allowable.  Thus,  each  different  taxpayer's  interest  in  a  tract 
or  parcel  of  land  is  generally  to  constitute  a  separate  property,  but  all 
of  a  single  taxpayer's  operating  interests  in  one  tract  or  parce^l  of 
land  are  generally  to  be  combined.  However,  if  one  or  more  taxpayers 
combine  their  interests  for  depletion  purposes  under  a  pooling  or 
unitization  agreement  (as  described  in  sec.  614(b)  (3)),  the  property 
is  to  include  all  of  the  interests  as  so  combined. 

A  property  is  to  be  considered  an  oil  or  gas  property  only  if  intan- 
gible drilling  and  development  costs  are  properly  chargeable  to  that 
property  (either  in  the  hands  of  the  taxpayer  or  his  predecessor  in 
interest).  Thus,  an  interest  in  a  tract  or  parcel  of  land  which  is  not 
an  operating  interest  does  not  constitute  an  oil  or  gas  property. 

The  recapture  rule  is  to  apply  to  all  taxpayers  who  own  oil  or  gas 
properties,  including  citizens  and  residents, "trusts  and  estates,  and 
corporations. 

The  recapture  rule  applies  to  the  disposition  of  all  or  any  portion 
of  an  oil  or  gas  property.  In  the  case  of  a  disposition  of  a  portion  of 
an  oil  or  gas  property  other  than  an  undivided  interest,  the  entire 
amount  of  intangible  costs  attributable  to  that  property  are  to  be 
allocated  to  the  portion  of  the  property  which  is  first  disposed  of.  Any 
excess  of  intangible  costs  not  recaptured  in  the  first  disposition  of  a 
portion  of  an  interest  other  than  an  undivided  interest  (because,  for 
example,  the  gain  realized  from  the  disposition  was  less  than  the 
amount  of  costs  subject  to  recapture)  is  to  be  subsequently  allocated 
to  the  remaining  portions  of  the  oil  or  gas  property.  However,  in  cases 
of  dispositions  of  a  portion  of  an  oil  or  gas  propertv  which  are  not 
subject  to  recapture  under  this  provision  (such  as  gifts),  a  propor- 
tionate part  of  the  intangible  costs  subject  to  recapture  is  to  be  treated 
as  allocable  to  the  portion  of  the  property  transferred  and  is  to  be 
treated  in  the  hands  of  the  transferee  as  a  transfer  of  a  separate  oil 
or  gas  property. 

In  the  case  of  a  disposition  of  an  undivided  interest  in  an  oil  or  gas 
property  or  in  a  portion  of  an  oil  or  gas  property,  a  proportionate  part 
of  the  intangible  costs  attributable  to  that  property  are  to  be  allocated 
to  the  undivided  interest  and  recaptured  to  the  extent  of  the  gain  from 
the  disposition  of  the  undivided  interest.  For  purposes  of  this  rule 
(as  well  as  for  purposes  of  the  rule  relating  to  gifts  and  other  non- 
recapture  dispositions  as  discussed  in  the  next  paragraph),  it  is  in- 
tended that  the  expenditures  are  to  be  allocated  in  proportion  to  the 
rights  to  income  from  the  property. 

The  recapture  rule  is  to  apply  to  all  dispositions  ffenerally  except 
those  which  are  not  treated  as  dispositions  under  tl^e  existin<r  recapture 
provisions  relating  generally  to  gains  from  the  disposition  of  depre- 
ciable personal  property  (sec.  1245).  This  provision  excepts  from 
recapture  dispositions  by  gift,  transfers  at  death,  transfers  in  certain 
tax-free  reorganizations,  like-kind  exchanges  and  involuntary  conver- 
sions in  certain  circumstances,  and  certain  sales  or  exchauires  required 
by  order  of  Federal  agencies.  These  same  exceptions  are  to  be  applied 


67 

under  regulations  in  the  appropriate  manner  to  the  recapture  of  intan- 
gible drilling  and  development  costs  from  oil  or  gas  properties. 
Also,  for  purposes  of  this  provision  a  unitization  or  pooling  arrange- 
ment (within  the  meaning  of  section  614(b)  (3) )  is  not  to  be  treated  as 
a  disposition.* 

In  addition,  the  rules  relating  to  the  distribution  of  property  by  a 
partnership  to  a  partner  which  are  applied  (under  sec.  617(g) )  to  dis- 
tributions of  any  property  or  mine  with  respect  to  which  mining  ex- 
ploration expenditures  have  been  deducted  are  to  be  applied  in  a 
similar  manner  to  the  distribution  of  oil  or  gas  property  to  a  partner 
and  to  the  distribution  of  other  property  to  a  partner  by  a  partner- 
ship which,  after  the  distribution,  continues  to  hold  oil  or  gas  property. 

For  purposes  of  these  rules,  where  a  partner  sells  or  exchanges  his 
interest  in  a  partnership  holding  an  interest  in  oil  or  gas  property, 
intangible  drilling  costs  which  would  be  subject  to  recapture  under 
these  provisions  (should  the  partnersliip  dispose  of  its  interest  in  the 
property)  are  to  be  treated  as  an  unrealized  receivables  (within  the 
meaning  of  section  751).  Thus,  any  gain  realized  by  the  partner  upon 
the  sale  or  exchange  of  his  interest  would  be  subject  to  ordinary  income 
treatment  to  the  extent  of  his  share  of  these  costs.  Similar  rules  are 
to  apply  upon  the  sale  or  exchange  of  stock  in  a  subchapter  S  corpo- 
ration (in  accordance  with  regulations  to  be  prescribed  by  the  Secre- 
tary or  his  delegate). 

Effective  date 
The  rules  providing  for  the  recapture  of  deductions  for  intangible 
drilling  and  development  costs  are  to  apply  to  dispositions  of  oil  and 
gas  properties  in  taxable  years  ending  after  December  31,  1975,  with 
respect  to  intangible  drilling  and  development  costs  paid  or  incurred 
after  December  31,  1975. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in  budget 
receipts  of  $7  million  for  fiscal  year  1977,  $14  million  for  1978,  and 
$65  million  for  1981. 

5.  Motion  Picture  Films 

a.  At  Risk  Rule  and  Capitalization  of  Production  Costs  (sees.  204 
and  210  of  the  Act  and  sees,  280  and  465  of  the  Code) 

Prior  law 
Under  prior  law,  motion  picture  shelters  generally  had  two  basic 
forms.  In  one  format,  a  limited  partnership  was  formed  to  purchase 
the  rights  to  an  already  completed  film.  The  purchase  price  was  heavily 
leveraged  (and  often  unrealistically  inflated)  and  the  partners  claimed 
substantial  depreciation  deductions.  The  principal  features  of  the 
shelter  was  deferral  and  leverage.  This  format  was  sometimes  referred 
to  as  a  "negative  pick-up"  or  "amortization  purchase"  transaction. 


*  Also,  arrangements  under  which  the  interests  of  two  or  more  parties  in  a  drilling 
venture  (such  as  a  leaseholder  and  a  driller)  shift  after  a  certain  amount  of  production 
is  obtained  are  not  generally  to  be  considered  a  disposition  where  the  shift  in  interests 
occurs  under  an  agreement  "made  prior  to  the  time  that  the  intangible  drilling  expenses 
were  paid  or  incurred. 


68 

In  the  second  type  of  format,  the  limited  partnership  was  formed 
to  produce  a  film  (rather  than  to  buy  a  completed  film).  The  partner- 
ship entered  into  an  agreement  with  a  studio,  with  a  distributor  or 
with  an  independent  producer  to  produce  a  particular  film.  The  part- 
nership used  the  cash  method  of  accounting  and  wrote  off  the  costs  of 
production  as  they  were  paid.  Typically  the  partnership  was  heavily 
leveraged  and  significant  costs  were  paid  with  borrowed  funds.  The 
principal  elements  of  this  form  of  motion  picture  shelter  were  also 
deferral  and  leverage.  The  partnership  in  this  type  of  shelter  was 
sometimes  referred  to  as  a  "service  company"  or  "production 
company." 

Another  variation  of  this  shelter  was  the  film  distribution  partner- 
ship. In  this  shelter,  the  partnership  also  did  not  own  an  interest  in 
the  film.,  but  obligated  itself  to  distribute  the  film.  By  writing  off  the 
costs  of  distribution,  the  deferral  occurred  for  the  partners  because 
the  partnership's  income  from  its  distribution  services  was  not  realized 
until  later  years. 

The  basic  principles  of  partnership  tax  law  which  benefited  the 
motion  picture  tax  shelter  (and  other  shelters  as  well)  included  the 
use  of  the  partnership  form  to  allow  limited  partners  to  take  into  in- 
come their  distributive  share  of  the  partnership's  income  or  losses 
(which  are  generally  determined  under  the  partnership  agreement). 
Also,  the  amount  of  partnership  loss  which  the  partner  may  deduct 
included  not  only  his  own  equity  contributions  to  the  partnership,  but 
also  his  share  of  any  nonrecourse  debt  which  the  partnership  has 
incurred  (see  regulations  §  1.752-1  (e) ) .  There  were  also  several  aspects 
of  prior  law,  however,  which  relate  particularly  to  motion  picture 
shelters. 

(/)  Film  purchase  shelter 

The  income  forecast  method. — Motion  pictures  were  usually  (and 
may  continue  to  be  under  the  Act)  depreciated  on  the  "income  forecast" 
method.  (Rev.  Rul.  60-358,  1960-2  C.B.  68:  Rev.  Rul.  64-273,  1964-2 
r.B.  62.)  This  method  is  used  because,  unlike  most  other  depreciable 
assets,  the  useful  life  of  a  motion  picture  is  difficult  to  ascertain.  Under 
the  income  forecast  method,  the  taxpayer  computes  depreciation  by 
using  a  fraction,  the  numerator  of  which  is  the  income  received  from 
the  film  during  the  year  and  the  denominator  of  which  is  the  total  esti- 
mated income  which  the  film  is  expected  to  n-enerate  over  its  remain- 
ing lifetime.  This  fraction  is  then  multiplied  bv  tlie  cost  of  the  film. 
For  example,  if  the  taxpayer  has  a  basis  of  5f;500,000  in  liis  interest  in 
the  film,  the  income  from  the  film  throuo-h  the  end  of  tlie  first  vear  is 
^750,000,  and  the  total  estimated  income  from  the  film  over  its  lifetime 
is  $1,000,000,  the  taxpaver  would  be  allowed  to  depreciate  75  percent  of 
his  basis,  or  $375,000.  (If  the  income  forecast  increases  or  decreases  as  a 
result  of  changed  circumstances,  this  change  is  tnken  into  account  for 
later  periods.  Thus,  in  the  second  year,  depreciation  under  the  income 
forecast  method  might  be  ba^^-ed  on  an  income  forecast  denominator 
which  was  more  or  less  than  the  amount  used  for  the  fii-st  year.) 

The  film  purchase  transaction  worked  as  a  tax  shelter  onlv  where 


69 

the  purchase  price  of  the  film  (inchiding  nonrecourse  indebtedness) 
exceeded  its  economic  value.  ^ 

However,  there  was  a  substantial  question  even  under  prior  law 
whether  taxpayers  in  a  film-purchase  shelter  were  legally  entitled  to 
claim  depreciation  based  on  nonrecourse  indebtedness  where  the  "pur- 
chase price'"  of  the  film  was  in  excess  of  the  income  forecast  on  the  film. 

While  the  authorities  in  this  area  have  not  been  uniform,  there  are 
several  cases  which  have  disallowed  the  depreciation  deduction  based 
on  nonrecourse  liability  where  there  was  no  substantial  prospect  that 
this  liability  would  be  discharged.  In  Leonard  Marcus,  30  T.C.M.  1263 
(1971) ,  the  court  held  that  where  the  taxpayer  purchased  two  bowling 
alleys  for  a  5  percent  down  payment,  with  a  20-year  nonrecourse  note 
for  the  balance,  the  taxpayer  could  depreciate  only  the  basis  repre- 
sented by  his  down  payment,  and  that  the  note  could  be  taken  into 
account  for  purposes  of  increasing  the  taxpayer's  basis  only  to  the 
extent  that  payments  were  actually  made.  The  court  held  that  the 
liability  represented  by  the  note  was  too  contingent  to  be  included 
in  basis  until  payments  were  made.^ 

In  Marvin  M.  May.  31  T.C.M.  279  (1972),  the  Tax  Court  held  that 
a  transaction  in  which  the  taxpayer  purchased  13  television  episodes 
for  $35,000,  and  obligated  himself  to  pay  an  additional  $330,000  on  a 
nonresource  basis  was  a  sham,  because  this  amount  was  far  in  excess 
of  the  fair  market  value  of  the  films  and  there  was  no  realistic  prospect 
(or  intention)  that  the  debt  would  ever  be  paid.  Therefore  the  court 
disallowed  the  depreciation  deduction  claimed  with  respect  to  the  film. 
See  also  Rev.  Rul.  69-77, 1969-1  C.B.  59.^ 

It  would  seem  that  some  of  these  same  principles  could  often  be 
applied  in  the  case  of  a  film  purchase  shelter,  where  the  purchase 
price  of  the  film  consists  largely  of  nonrecourse  indebtedness  and  sub- 
stantially exceeds  the  film's  income  forecast. 

Depreciation  recapture. — There  is  some  question  as  to  whether  a 
movie  film  in  the  hands  of  a  limited  partnership,  such  as  those  de- 
scribed here,  constitutes  a  capital  asset  (within  the  meaning  of  sec. 
1221),  or  "property  used  in  the  trade  or  business"  of  the  taxpayer 

1  Assume,  for  example,  that  a  limited  partnership  pays  $1,000,000  for  a  film  (consisting 
of  $200,000  in  cash  and  a  10-year  nonrecourse  note  for  $800,000).  After  the  film  is 
released,  it  becomes  apparent  that  the  film  mav  not  be  successful  and  an  income  forecast  of 
$200,000  is  made  for  the  film.  Assuming  $160,000  of  this  revenue  (or  80  percent  of  the 
predicted  total)  were  realized  in  the  first  year,  the  partners  would  depreciate  80  percent 
of  their  basis  in  the  film,  or  $800,000  for  a  net  tax  loss  (after  taking  account  of  the 
$160,000  of  income  from  the  film)  of  $640,000. 

On  the  other  hand,  where  the  income  stream  is  equal  to  or  greater  than  the  purchase 
price  there  was  no  shelter.  For  example,  if  the  film  is  purchased  for  $2  million  (and  has 
this  as  its  basis),  but  has  an  estimated  income  stream  of  $4  million,  $3  million  of  which  is 
earned  during  the  first  year,  the  result  would  be  as  follows.  The  partners  would  be  allowed 
to  take  75  percent  of  their  $2  million  basis  as  depreciation  in  the  first  year  under  the 
income  forecast  method  (or  a  $1,500,000  deduction).  However,  the  film  would  be  also 
generating  $.3  million  of  income  which  the  partners  would  have  to  recognize.  Thus,  the  net 
tax  effect  would  be  positive  taxable  income  to  the  partners  of  $1,500,000.  Where  the  pur- 
chase price  of  the  film  and  its  estimated  income  stream  are  exactly  equal,  the  depreciation 
deduction  and  the  amount  of  income  from  the  film  should  exactly  offset  each  other. 

=2  In  Marcus,  the  20-year  term  of  the  note  was  substantially  in  excess  of  the  useful  life 
of  the  bowling  alleys. 

3  As  indicated  above,  under  the  partnership  provisions,  the  partner  could  add  to  his  basis 
in  the  partnership  his  share  of  the  nonrecourse  liabilities.  However,  section  752(c)  pro- 
vides that  "a  liability  to  which  property  Is  subiect"  shall  be  considered  as  a  liability  of  the 
owner  of  the  property  "to  the  extent  of  the  fair  market  value  of  such  property  .  .  ."  Since 
the  "fair  market  value"  of  a  movie  film  ordinarily  will  not  exceed  its  total  projected 
lifetime  earnings,  this  suggests  that  a  partner's  basis  could  not,  even  under  prior  law. 
Include  his  share  of  nonrecourse  indebtedness  to  the  extent  that  this  indebtedness  (plus 
the  partner's  down  payment)  exceeded  the  income  forecast  for  the  film. 


234-120   O  -  77 


70 

which  is  neither  "inventory,"  nor  "propert}'  held  by  the  taxpaper 
primarily  for  sale  to  customers  in  the  ordinary  course  of  his  trade  or 
business"  (within  the  meaning  of  sec.  1231) . 

If  the  film  is  not  a  capital  asset  (or  section  1231  property),  any 
income  received  with  respect  to  the  film  would  be  ordinary  income. 
Assuming  that  the  film  is  found  to  be  a  capital  asset,  income  realized 
on  the  sale  or  exchange  of  the  film  would  be  subject  to  the  depreciation 
recapture  rules  of  section  1245.  Thus,  the  proceeds  of  the  sale  in  excess 
of  the  taxpayer's  adjusted  basis  would  constitute  ordinary  income  to 
the  extent  of  any  depreciation  previously  allowable  with  respect  to  the 
film.* 

Even  if  the  film  is  not  sold,  there  should  eventually  be  recapture  of 
the  depreciation  attributable  to  the  unpaid  balance  of  a  nonrecourse 
note  which  entered  into  the  depreciable  basis  of  the  film.  If  the  film  is 
successful  and  the  loan  is  repaid  out  of  the  partnership  income,  each 
partner  must  take  into  income  his  distributive  share  of  the  amounts 
used  for  repayment;  the  partner's  basis  would  not  be  affected.  (The 
partner's  basis  would  increase  to  the  extent  that  his  distributive  share 
of  the  partnership  income  was  used  for  partnership  purposes,  such 
as  repayment  of  the  loan,  but  his  basis  would  decrease  in  an  equal 
amount  because  his  share  of  the  nonrecourse  partnership  liability  was 
being  reduced  by  the  repayment, )  If  the  film  is  not  successful  and  the 
nonrecourse  debt  becomes  worthless,  a  default,  foreclosure  or  abandon- 
ment of  the  debt  generally  constitutes  income  to  the  partnership  be- 
cause such  events  are  treated  as  a  "sale"  of  the  movie  film,  which  is 
subject  to  the  recapture  rules  of  section  1245.^ 

The  rules  on  depreciation  recapture  are  essentially  the  same  under 
prior  law  and  under  the  Act. 

(2)  Production  company  shelter 

OasJi  method  of  accounting. — Under  prior  law,  obtaining  tax  de- 
ferral through  a  production  company  transaction  depended  on  whether 
the  partnership  could  properly  deduct  its  costs  of  producing  the  film 
as  it  paid  them.  This  in  turn  depended  on  whether  proper  tax  ac- 
counting practices  permitted  the  partnership  to  treat  these  costs  as 
an  item  of  expense  or  required  the  partnership  to  capitalize  these  ex- 
penditures and  amortize  them  over  the  life  of  the  asset.  (In  this  case, 
the  asset  was  the  partnership's  rights  under  the  contract  with  the 
distributor-owner  of  the  film.) 

Under  prior  law  (and  present  law),  a  taxpayer  is  generally  per- 
mitted to  select  his  own  method  of  accounting  (sec.  446(a))  imless 
the  method  selected  "does  not  clearlv  reflect  income"  (sec.  446(b)). 
If  it  does  not,  the  law  permits  the  IRS  to  compute  the  taxpayer's  in- 
come in  a  way  that  will  clearly  reflect  his  income. 

One  problem  with  the  motion  picture  service  partnership's  use  of 
the  cash  method  under  prior  law  was  the  possibility  that  a  particular 
partnership  is  really  engaged  in  a  joint  venture  with  the  distributor  or 
with  an  independent  producer,  i.e.,  the  investors  provided  financing 

*  If  the  partner  sold  hif?  interest  in  tlie  partnership,  the  depreciation  would  be  recap- 
turerl  as  an  "unrealized  receivable"  under  section  751. 

^  Likewise,  if  the  partnership  discontinues  its  operations,  this  should  constitute  a  con- 
structive distribution  of  the  partnership  assets  (includinjr.  for  this  purpose,  the  unpaid 
portion  of  the  nonrecourse  note)  to  the  partners,  whicli  in  turn  triggers  the  recapture  rules 
of  section  1245. 


71 

and  the  studio/distributor  or  producer  supplied  personnel,  production 
skills  and  also  loan  guarantees.  As  part  owners  of  the  film,  the  partner- 
ship would  then  have  to  capitalize  its  production  costs.^ 

In  such  circumstances  the  question  is  whether  failure  to  capitalize 
the  expenses  of  producing  the  film  (and  thus,  of  the  partnership's 
rights  under  the  contract)  results  in  a  material  distortion  of  income. 
There  is  a  strong  argument,  even  under  prior  law,  that  a  material  dis- 
tortion of  income  does  occur  under  these  circumstances.  See  Commis- 
sioner V.  Idaho  Power  Co.,  418  U.S.  1  (1974),  holding  that  "accepted 
accounting  practice"  and  "established  tax  principles"  require  the 
capitalization  of  the  cost  of  acquiring  a  capital  asset,  including  costs, 
such  as  depreciation  on  equipment,  which  would  generally  be  deducti- 
ble if  they  were  not  allocable  to  the  construction  of  the  asset.  (The 
production  company's  contract  rights  are  not  a  capital  asset,  but  these 
rights  are  an  asset  with  a  long  useful  life,  so  there  is  a  strong  argu- 
ment that  the  capitalization  principle  should  apply.) 

On  the  other  hand,  there  is  one  case  relied  on  heavily  in  the  past 
by  the  investors  in  movie  production  partnerships  which  held  that  a 
building  contractor's  income  was  not  distorted  where  the  company 
constructed  apartments  and  shopping  centers  under  long-term  con- 
struction contracts  and  deducted  its  costs  on  the  cash  method,  while 
receiving  payments  over  a  five-year  period  after  each  project  was  com- 
pleted. C.  A.  Hunt  Engineering  Co.,  15  T.C.M.  1269  (1956).  Produc- 
tion company  investors  have  argued  that  the  same  result  should  be 
allowed  in  their  situation. 

A  related  question  under  prior  law  is  whether  a  limited  partner- 
ship producing  a  motion  picture  is  engaged  in  selling  or  delivering  a 
product  (the  film)  and  is  therefore  required  to  maintain  an  inventory. 
If  this  were  the  case,  the  labor  costs  paid  in  producing  the  inventory 
could  not  be  deducted  until  the  inventory  item  was  sold.  The  argu- 
ment against  that  view  is  that  the  production  company  was  selling 
services  (i.e.  production  services)  rather  than  a  product. 

Another  question  under  prior  law  is  whether  the  funds  supplied 
by  the  limited  partners  were  merely  part  of  a  financing  transaction  in 
which  the  investors  were  basically  only  loaning  money  to  the  distrib- 
utor or  other  party  who  would  own  the  completed  film.  As  creditors, 
the  financing  parties  would  not  be  entitled  to  tax  deductions  for  the 
amounts  which  they  are  lending. 

(S)  IRjS  rulings  position 

The  Service  has  issued  several  revenue  rulings  with  respect  to  the 
use  of  limited  partnerships  and  nonrecourse  loans.'^  Although  these 
rulings  have  applicability  outside  the  area  of  movie  shelters,  they 
also  impose  some  limitations,  at  least  insofar  as  the  position  of  the 
Service  is  concerned,  which  apply  both  to  the  film  purchase  type  trans- 
action, and  the  production  company  arrangement. 


*  In  some  cases,  the  personnel  hired  by  the  partnership  to  make  the  film  were  not  in 
reality  the  investors'  own  employees  but  were  supplied  by  the  studio/distributor.  In  other 
cases,  the  investors'  partnership  subcontracted  actual  production  work  to  the  studio/ 
distributor  (or  to  its  agents).  Factors  such  as  these,  along:  with  the  sharing  of  profits 
and  risks  of  loss,  the  distributor's  day-to-day  involvement  in  production  and  budget  changes, 
etc..  would  tend  to  supnort  treatment  of  the  partnership  as  a  participant  in  a  ioint  venture. 

Still  another  difficult  question  under  prior  law  for  the  motion  picture  "service  com- 
l>any"  was  whether  the  partnership  was  conducting  a  trade  or  business  if  it  made  only  one 
picture  or  did  not  operate  with  regularity. 

'Rev.  Proc.  74-17,  1974-1  C.B.  438;  Rev.  Rul.  72-135,  1972-1  C.B.  200;  Rev.  Rul. 
72-350,  1972-2  C.B.  394. 


72 

These  rulings  suggest  that  many  forms  of  nonrecourse  loans  may,  in 
substance,  be  equity  investments  by  the  lender,  which  cannot  be  used  by 
the  limited  partners  to  increase  their  bases  in  the  film  or  in  a  produc- 
tion partnership.  Purchase  money  loans  by  the  seller  of  a  film  (in 
a  negative  pickup  transaction)  might  be  included  in  this  categoiy. 
The  logic  of  these  rulings  might  well  apply  also  to  the  case  where  a 
loan  is  made  to  the  investors'  partnership  by  a  bank,  but  is  guaran- 
teed by  the  studio  which  is  selling  the  film  (or  for  whom  the  film  is 
being  made,  in  the  case  of  the  production  company  shelter) . 

Reasons  for  change 

The  two  formats  commonly  employed  in  connection  witli  movie 
films,  the  film  purchase  shelter  and  the  production  company  shelter, 
had  the  same  basic  elements,  i.e.,  tax  deferral  and  the  use  of  leverage. 
In  the  case  of  the  film  purchase  shelter,  deferral  occurred  because  of 
the  rapid  depreciation  which  is  allowed  in  connection  with  movie  films, 
and  which  is  passed  through  to  the  limited  partners,  particularly  in 
cases  where  the  film  is  not  economically  successful.  In  the  case  of  the 
production  company,  the  mismatching  of  expenses  and  income  occurred 
because  the  partnership  deducts  the  full  cost  of  producing  the  film  be- 
fore the  film  is  released  and  because  the  contract  which  the  limited 
partnership  enters  with  the  "owner"  of  the  film  (usually  a  studio- 
distributor)  often  provided  that  payments  to  the  production  company 
for  its  "services-'  will  be  spread  over  a  relatively  long  time  period. 

Both  types  of  investments  involved  the  use  of  leverage  (i.e.,  non- 
recourse loans)  which  allow  the  limited  partners  to  receive  tax  de- 
ductions for  amounts  in  excess  of  their  economic  investment.  This 
result  distorted  the  economic  substance  of  the  transaction  b}^  permit- 
ting the  taxpayer  to  deduct  money  which  he  has  neither  lost  nor  placed 
at  risk.  In  the  case  of  movie  shelters,  the  use  of  very  heavy  leverage 
factors  was  not  uncommon. 

As  indicated  above,  questions  existed  under  prior  law  as  to  whether 
investors  in  certain  cases  were  entitled  to  the  deductions  they  are  claim- 
ing in  connection  with  movie  shelters.  Thus,  many  participants  in 
these  shelters  may  have  claimed  deductions  which  will  later  be  dis- 
allowed by  the  Service.^ 

In  addition,  the  Congress  was  informed  that  the  production  com- 
pany shelter  may  be  expanding  into  other  areas,  such  as  the  publishing 
field. 

For  these  reasons,  under  the  Act,  the  film  purchase  shelter  is  to  be 
subject  to  an  at  risk  rule,  to  prevent  taxpayers  from  writing  off  more 
than  their  economic  investment  in  this  type  of  transaction.  In  the  case 
of  the  production  company  shelter  (including  the  use  of  a  service 
company  to  produce  books,  recordings  and  similar  property  as  well 
as  films) ,  the  Act  requires  capitalization  of  the  expenses  of  production, 
not  only  for  movies,  but  also  for  similar  types  of  service  company 
shelters.  In  addition,  the  production  company  movie  shelter  is  also  to 
be  subject  to  the  at  risk  rule. 


'  In  the  case  of  the  film  purchase  shelter,  the  principal  issue  in  potential  abuse  situa- 
tions is  whether  the  taxpayers  have  used  an  inflated  basis  for  purposes  of  depreciation.  In 
the  case  of  the  production  company,  the  issue  is  whether  the  partnership  has  failed  to 
reflect  income  properly  by  not  capit.i'lizing  the  production  costs  of  the  film.  In  both  shelters, 
the  use  of  leverage  to  increase  the  partners'  bases  might  be  subject  to  question,  at  least 
under  certain  facts  and  circumstances. 


73 

Explanation  of  provisions 

The  '■''at  risk''''  rule 

Under  the  xlct,  as  indicated  above,  both  the  fihn  purchase  shelter 
and  the  production  company  shelter  are  to  be  subject  to  the  at  risk 
limitation.  (The  provisions  of  the  at  risk  rule  have  already  been 
explained  in  detail  in  section  2  above.) 

In  the  case  of  movie  films  activities  engaged  in  by  an  individual 
(other  than  through  a  partnership)  each  film  in  which  the  taxpayer 
has  an  ownership  interest,  and  each  film  which  the  taxpayer  pro- 
duces or  distributes,  is  to  be  considered  a  separate  activity  for  pur- 
poses of  the  at  risk  rule.  However,  in  the  case  of  a  partnership  (or 
subchapter  S  corporation),  all  films  in  which  the  partnership  (or 
subchapter  S  corporation)  has  an  ownership  interest,  and  all  films 
which  the  partnership  (or  subchapter  S  corporation)  produces  or 
distributes,  are  to  be  treated  as  part  of  one  activity. 

Amortization  of  production  costs  of  motion  pictures,  hooks,  records, 
and,  other  similar  property 

To  prevent  a  situation  where  a  taxpayer  may  attempt  to  accelerate 
his  deductions  in  connection  with  the  production  costs  of  a  motion 
picture  film  (or  other  property),  thus  producing  a  mismatching  of  in- 
come and  expenses  attributabie  to  the  income,  the  Act  provides  that  a 
taxpayer  is  to  be  required  to  capitalize  his  share  of  the  production  costs 
and  deduct  them  over  the  life  of  the  income  stream  generated  from  the 
production  activity.  This  rule  is  to  apply  to  persons  (other  than  cor- 
porations which  are  neither  subchapter  S  corporations  nor  personal 
holding  companies)  engaged  in  the  service  of  producing  a  film  (in- 
cluding the  costs  of  making  prints  of  the  film  for  distribution),  sound 
recording  (including  discs,  records,  tapes,  etc.)  book,  or  similar  prop- 
erty ( such  as  a  play,  etc. ) . 

Generally,  it  is  anticipated  that  taxpayers  who  are  subject  to  this 
capitalization  requirement  will  (in  effect)  depreciate  their  capitalized 
expenses  (in  accordance  with  regulations  to  be  prescribed  by  the  Sec- 
retary) under  a  method  analogous  to  the  income  forecast  method.  Thus, 
the  production  costs  will  be  written  off  by  the  taxpayer  over  the  useful 
life  of  the  asset  which  he  has  acquired  as  a  result  of  his  investment. 
In  the  case  of  a  service  company  shelter,  the  asset  will  be  the  taxpayer's 
contract  rights  under  his  contract  with  the  motion  picture  distributor, 
publisher,  etc. 

For  purposes  of  these  rules,  the  numerator  of  the  income  forecast 
fraction  will  be  the  income  which  the  taxpayer  has  received  under  the 
contract.  The  denominator  of  the  fraction  is  to  be  the  total  income 
which  the  taxpayer  may  reasonably  expect  to  receive  under  the  con- 
tract. Thus,  in  the  case  of  a  film  service  partnership,  for  example,  the 
denominator  of  the  fraction  is  to  include  the  partnership's  share  of 
any  anticipated  income  from  the  film  (where  the  partnership  is  com- 
pensated by  a  percentage  of  income  from  the  film),  as  well  as  any 
guaranteed  payments  which  the  partnership  is  to  receive  under  the 
contract,  and  any  income  from  the  discharge  of  indebtedness.  Of  course 
each  item  of  anticipated  income  is  to  be  taken  into  account  only  once ; 
thus,  where  a  partnership  is  entitled  to  10  percent  of  gross  income  from 
the  film,  with  a  guaranteed  payment  of  $1  million,  the  denominator  of 


74 

the  income  forecast  fraction  would  be  the  greater  of  ( 1 )  10  percent  of 
the  anticipated  gross  revenues  from  the  fihn,  or  (2)  $1  million  (so  as 
to  avoid  double  counting) . 

Effective  dates 

Under  the  Act,  the  at  risk  rule  is  to  apply  to  losses  attributable  to 
amounts  paid  or  incurred  (or  amounts  allowable  as  depreciation  or 
amortization)  in  taxable  years  beginning  after  December  31,  1975. 
The  at  risk  provision  does  not  apply  to  a  film  purchase  shelter  if 
the  principal  photography  began  before  September  11,  1975,  there 
was  a  binding  written  contract  for  the  purchase  of  the  film  on  that 
date,  and  the  taxpayer  held  his  interest  in  the  film  on  that  date.  The 
at  risk  rule  also  does  not  apply  to  production  costs,  etc.,  if  the  principal 
photography  began  before  September  11,  1975,  and  the  investor  had 
acquired  his  interest  in  the  film  before  that  date. 

Under  a  second  transition  rule  in  the  Act,  this  provision  will  not 
apply  to  costs  of  producing,  displaying  or  distributing  a  film,  in 
the  case  of  a  film  production  partnership,  if  (1)  the  principal  photog- 
raphy begins  before  January  1,  1976,  (2)  the  picture  is  to  be  pro- 
duced within  the  United  States,^  and  (3)  there  was  binding  written 
agreement  in  effect  on  Sei:)tember  10,  1975  (and  at  all  times  there- 
after) between  a  director  (or  a  principal  star)  for  the  picture  and  the 
partnership  which  w^ill  produce  the  film.  An  alternative  to  the  third 
of  these  requirements  may  also  be  satisfied :  under  this  alternative,  on 
September  10,  1975,  there  must  have  been  expended,  or  irrevocably 
committed,  to  the  film  the  lower  of  (1)  $100,000  or  (2)  10  percent  of 
the  reasonably  estimated  total  production  costs  of  the  film.  This 
second  transititon  rule  applies,  however,  only  to  taxpayers  who  held 
their  interests  in  the  film  (or  in  a  partnership  which  will  produce  the 
film)  on  or  before  December  31,  1975. 

In  applying  the  at  risk  provisions  to  activities  which  were  begun  in 
taxable  years  l)eginning  before  January  1,  1976  (and  not  exempted 
from  this  provision  by  the  above  transition  rules) ,  amoimts  paid  or 
incurred  in  taxable  years  beginning  prior  to  that  date  and  deducted  in 
such  taxable  yeai-s  will  be  generally  be  treated  as  reducing  first  that 
portion  of  the  taxpayer's  basis  which  is  attnbutable  to  amounts  not  at 
risk.  (On  the  other  hand,  withdrawals  made  in  taxable  years  begin- 
ning before  January  1,  1976,  will  be  treated  as  reducing  the  amount 
which  the  taxpayer  is  at  risk.) 

The  capitalization  requirement  applies  to  costs  of  producing  a  film 
(i.e.  a  production  partnership)  or  other  similar  property,  if  such  costs 
are  paid  or  incurred  after  December  31,  1975,  and  the  principal  pi'o- 
duction  of  the  property  began  after  that  date.  In  the  case  of  a  film, 
principal  production  means  principal  photography;  in  the  case  of  a 
sound  recording,  principal  production  is  the  date  of  the  recording ;  in 
the  case  of  a  book,  principal  production  begins  with  the  preparation  of 
the  material  for  publication ;  in  the  case  of  other  similar  property,  the 
commencement  of  principal  production  is  to  be  determined  in  ac- 
cordance with  regulations. 

9  For  purposes  of  this  rule,  a  film  is  to  be  treated  as  bein^  produced  in  the  United 
States  if  at  least  80  percent  of  the  "direct  production  costs"  of  the  film  are  paid  or 
incurred  for  U.S.  production  (see  discussion  of  this  issue  in  connection  with  the  "Invest- 
ment Credit  in  the  Case  of  Movies  and  Television  Films,"  infra). 


75 

As  indicated  above,  in  the  case  of  both  the  film  purchase  shelter  and 
the  "production  company"  shelter  there  are  some  substantial  ques- 
tions under  prior  law  as  to  whether  the  deductions  which  are  claimed 
in  connection  with  some  of  these  shelters  are  allowable.  ( Such  questions 
include  the  amount  of  depreciation  which  may  be  claimed,  whether 
the  deduction  or  capitalization  is  the  appropriate  treatment  with 
respect  to  costs  o.f  production,  and  whether  nonrecourse  loans  should 
be  treated  as  debt  or  equity,  etc.)  In  establishing  transition  rules  with 
respect  to  the  new  restrictions  on  the  deductibility  of  these  items  as 
added  by  the  Act,  the  Congress  intends  to  make  clear  that  these  transi- 
tion rules  are  not  to  be  read  as  implying  that  deductions  not  otherwise 
allowable  under  prior  law  are  to  be  allowable  until  the  capitalization 
requirement  and  at  the  risk  rule  take  effect.  No  inference  is  intended 
that  such  deductions  were  allowable  under  prior  law  and,  quite  to 
the  contrary,  it  appears  that,  at  least  under  certain  facts  and  circum- 
stances, the  questions  as  to  the  nonallowability  of  certain  of  these 
deductions  under  prior  law  are  very  substantial. 

Revenue  ejfect 
It  is  estimated  that  the  provisions  with  respect  to  the  at  risk  re- 
quirement will  result  in  an  increase  in  budget  receipts  of  $3  million 
for  fiscal  year  1977,  $10  million  for  1978,  and  $18  niillion  for  1981.  It  is 
estimated  that  the  capitalization  requirement  will  result  in  an  in- 
crease in  budget  receipts  of  $29  million  for  fiscal  year  1977,  $19  million 
for  1978,  and  $4  million  for  1981. 

h.  Clarification  of  Definition  of  Produced  Film  Rents  (sec.  211 
of  the  Act  and  sec.  543  of  the  Code) 

Prior  law 

Under  prior  law  (and  under  the  Act) ,  a  corporation  which  is  a  per- 
sonal holding  company  is  taxed  on  its  undistributed  personal  holding 
company  income  at  a  rate  of  70  percent  (sec.  541).  A  corporation  is  a 
personal  holding  company  w^here  five  or  fewer  individuals  own  more 
than  50  percent  in  value  of  its  outstanding  stock  and  where  a/t  least  60 
percent  of  the  corporation's  adjusted  ordinary  gross  income  comes 
from  specified  types  of  income. 

One  income  category  treated  as  personal  holding  company  income  is 
"produced  film  rents."  Generally,  this  category  covere  payments  re- 
ceived by  the  corporation  from  the  distribution  and  exhibition  of 
motion  picture  films  if  these  rents  arise  from  an  "interest"  in  the  film 
acquired  before  its  production  was  substantially  completed  (sec.  543 
(a)  (5)  (B) ).  Produced  film  rents  are  not  treated  as  personal  holding 
company  income,  however,  if  such  rents  constitute  50  percent  or  more 
of  the  corporation's  ordinary  gross  income.  The  qualifying  rental  in- 
terest under  this  category  is  one  which  arises  from  participation  in  the 
production  of  the  film.  In  such  cases  Congress  has  regarded  production 
activities  as  an  active  business  enterprise. 

Amounts  received  pursuant  to  a  contract  under  which  the  corpora- 
tion is  to  fuiTiish  pei^onal  services  ma.y  be  classified,  under  certain 
conditions  as  personal  holding  company  income  (sec.  543(a)  (7)). 

These  statutory  rules  affect,  among  others,  independent  motion  pic- 
ture and  television  producers,  actors,  directors,  writers,  etc.  (or  persons 
possessing  more  than  one  of  these  skills),  who  form  corporations 


76 

through  which  they  participate  in  making  motion  picture  or  television 
fihns. 

Reasons  for  change 

A  question  concerning  the  proper  definition  of  produced  film  rents, 
for  purposes  of  the  personal  holding  company  rules,  has  resulted  from 
a  recent  decision  by  the  Tax  Court  ^°  which  denied  depreciation  deduc- 
tions to  an  independent  production  company  which  produced  an 
original  motion  picture  with  nonrecourse  financing  supplied  by  a 
major  studio-distributor  under  an  agreement  that,  on  completion,  all 
rights  to  the  picture  except  a  share  in  distribution  profits  vested  in  the 
distributor.  The  court  held  that,  in  these  circumstances,  the  produc- 
tion company  had  no  ownerehip  interest  in  the  film  after  it  was  com- 
pleted and  therefore  could  not  depreciate  the  costs  of  producing  film. 

Although  this  case  involved  depreciation  rather  than  personal  hold- 
ing company  issues,  it  appears  that  the  Internal  Revenue  Service  has 
interpreted  the  decision  to  require  that  an  "interest"  in  a  film,  for 
purposes  of  the  definition  of  produced  film  rents  in  sec.  543(a)(5), 
must  be  a  depreciable  interest.  If  a  production  company  has  only  a 
profit  participation  after  the  picture  is  completed  and  released,  but 
legally  does  not  have  an  ownership  interest  sufficient  to  claim  deprecia- 
tion, some  revenue  agents  have  treated  all  of  the  company's  income  as 
personal  service  contract  income  (under  sec.  543(a)  (7)  of  the  Code). 

Congress  decided  that  a  production  company  does  not  have  to  have 
a  depreciable  interest  in  a  picture  it  makes  in  order  for  its  profits  inter- 
est to  qualify  as  produced  film  rents.  The  test  under  section  543  (a)  (5) 
should  be  whether  i\\e,  company  in  fact  produced  the  film. 

Explcmation  of  provision 

In  order  to  avoid  ambiguities,  the  Act  (sec.  543(a)(5)(B))  sets 
forth  more  clearly  the  nature  of  the  qualifying  "interest"  in  a  film.  In 
the  case  of  a  producer  who  actively  participates  in  producing  a  film, 
the  term  "produced  films  rents"  will  include  an  interest  in  the  proceeds 
or  profits  from  the  film,  but  only  to  the  extent  that  this  interest  is 
attributable  to  active  participation  in  production  activities.^^ 

Under  this  provision,  a  production  company  will  be  considered  a 
"producer"  if  it  engages  in  production  activities  and  is  involved  in 
principal  photography  or  taping  of  the  production.  The  term  "pro- 
ducer" also  includes  participation  in  qualifying  production  activities 
as  a  co-producer. 

Qualifying  production  activities  cover  preproduction  activities, 
principal  photograph}^  or  taping,  and  postproduction  functions  neces- 
sary to  produce  a  film  or  television  tape.  Preproduction  activities  in- 
clude acquiring  literary  rights  on  which  the  film  is  to  be  based; 
developing  a  shooting  script,  supervising  writers,  preparing  budgets, 
scouting  locations  and  employing  crews  to  be  involved  in  the  produc- 
tion. Activities  during  principal  photography  (or  taping)  include 
administration  of  budgeted  items,  contracting  for  production  facil- 
ities, actual  filming  or  taping  and  reviewing  rough  cuts.  Postproduc- 

10  Carnegie  Productions,  Inc..  50  T.C.  642  (1973). 

"  Other  requirements  in  the  existing:  definition  of  produced  film  rents  must  also  be  sat- 
isfied, namely,  that  the  payments  received  by  the  producer  are  for  the  use  of,  or  right  to 
use,  the  film  and  that  the  interest  must  be  acquired  before  substantial  completion  of  pro- 
duction of  the  film. 


77 

tion  activities  include  film  editing,  dubbing,  musical  scoring,  synchro- 
nizing, showings  to  exhibitors  or  other  previewers,  re-editing  and 
delivering  the  completed  film  (or  tape)  for  showing  to  the  public. 

If  the  income  of  a  corporation  qualifies  as  produced  film  rents  under 
this  provision,  as  amended,  the  Congress  believes  that  such  income 
should  not  be  subject  to  being  treated  as  income  from  personal  service 
contracts  (for  purposes  of  section  543(a)  (7) ). 

On  the  other  hand,  if  all  or  part  of  the  conduct  of  production  activi- 
ties lacks  substance  or  is  otherwise  not  bona  fide  (such  as  a  corporation 
which  primarily  provides  the  services  of  an  actor  or  actress  who  is 
nominally  named  "producer"),  the  Service  is  not  to  be  precluded 
from  attributing  part  of  the  company's  income  to  personal  service  con- 
tracts (if  the  requirements  of  sec.  543(a)  (7)  are  otherwise  present). ^^ 

Congress  does  not  intend  the  amendment  made  by  this  provision  to 
affect  depreciation  questions,  e.g.^  whether  a  production  company 
owns  a  depreciable  interest  in  a  film  financed  by  nonrecourse  loans. 

Effective  date 
This  amendment  applies  to  taxable  years  ending  on  or  after  Decem- 
ber 31,  1975.  The  Congress  intends  that  no  inference  should  be  drawn 
from  this  change  as  to  whether,  before  the  effective  date  of  this  amend- 
ment, the  definition  of  produced  film  rents  required  the  corporation 
to  have  a  depreciable  interest  in  the  film  under  production. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  reduction  in 
budget  receipts  of  less  than  $5  million  annually. 

6.  Equipment  Leasing — ^Limitation  on  Loss  to  Amount  At  Risk 
(sec.  204  of  the  Act  and  sec.  465  of  the  Code) 

Prior  law 

Accelerated  depreciation. — The  owner  of  personal  property  used  for 
the  production  of  income  may  generally  claim  annual  deductions  for 
depreciation  to  reflect  the  approximate  decline  in  the  value  of  the  prop- 
erty over  the  period  of  the  owner's  use  of  the  property.  These  deprecia- 
tion deductions  are  also  available  where  the  owner  is  not  the  actual  user 
of  the  property,  such  as  in  a  leasing  transaction  where  the  owner  leases 
the  depreciable  property  to  another  party  who  has  possession  and  use 
of  the  property.  In  certain  cases  where  title  to  the  depreciable  property 
is  held  for  the  benefit  of  individual  investors  by  a  legal  entity,  such  as 
a  partnership  or  grantor  trust,  the  depreciation  deductions  are  passed 
through  them  to  the  individual  taxpayers  who  own  the  actual  beneficial 
interests  in  the  property  and  are  deducted  on  these  taxpayer's  income 
tax  returns. 

There  are  a  number  of  depreciation  methods.  One  depreciation 
method  for  tangible  personal  property  is  the  straiglit-line  method, 
under  which  an  exjual  portion  of  the  property's  depreciable  basis  is 
deducted  each  year  of  the  property's  useful  life. 

'^^  A  corporation  which  "loans  out"  the  services  of  an  actor,  writer,  director,  or  Individual 
producer  employed  by  It  to  another  company  which  produces  the  picture  should  also 
not  be  considered  to  receive  produced  film  rents.  In  that  type  of  case,  the  loaned-out  em- 
ployee does  not  assume  the  business  risks  involved  in  producing  the  picture. 


78 

Equipment  leasing  transactions  have  often  characterized,  however, 
by  use  of  one  of  the  accelerated  methods  of  tax  depreciation  which 
allow  large  deductions  initially,  with  gradually  reduced  deductions  for 
each  successive  year  of  the  asset's  useful  life.  The  accelerated  deprecia- 
tion methods  allowed  for  productive  equipment  include  the  double- 
declining  balance  method  and  the  sum-of-the-years-digits  method. 

Additional  -first-year  depreciation. — An  owner  of  equipment  may 
also  elect,  for  the  first  year  the  property  is  depreciated,  a  deduc- 
tion for  additional  first-year  depreciation  of  20  i)ercent  of  the  cost  of 
property  which  has  a  useful  life  of  six  years  or  more  (sec.  179).  The 
amount  of  cost  on  which  this  "bonus"  depreciation  is  calculated  is 
limited  to  $10,000  per  taxable  year  ($20,000  for  an  individual  who 
files  a  joint  return).  The  maximum  bonus  depreciation  in  any  taxable 
year  is  as  a  result  limited  to  $2,000  ($4,000  for  an  individual  filing  a 
joint  return). 

Where  the  lessor  is  a  partnership,  the  election  for  bonus  deprecia- 
tion is  made  by  the  partnership.  However,  the  dollar  limitation  de- 
scribed above  was,  under  prior  law,  applied  to  the  individual  partners 
rather  than  the  partnership  entity.  For  example,  each  one  of  40  indi- 
vidual investors  who  contribtued  $5,000  to  an  equipment  leasing  limited 
partnership,  which  purchased  a  $1  million  executive  aircraft  on  a 
leveraged  basis,  would  be  entitled  to  $4,000  of  bonus  depreciation  if  he 
filed  a  joint  return.  In  this  case,  additional  first-year  depreciation 
would  have  provided  a  total  deduction  to  the  partners  of  $160,000. 
(This  provision  in  prior  law  has  been  changed  by  sec.  213(a)  of  the 
Act.) 

The  additional  first-year  depreciation  reduces  the  depreciable  basis 
of  the  equipment.  However,  the  partnership  is  still  entitled  to  claim, 
and  the  partners  to  deduct,  accelerated  depreciation  on  the  reduced 
basis  in  the  property  both  for  the  first  year  and  for  the  later  years  of 
the  property's  useful  life. 

Asset  depreciation  range  {ADR). — The  ADR  system  for  deprecia- 
tion was  authorized  by  the  Congress  in  the  Revenue  Act  of  1971  in 
order  to  bolster  a  lagging  economy  and  to  eliminate  a  number  of  diffi- 
cult interpretative  problems  pertaining  to  depreciation  which  had 
arisen  under  prior  law.  The  ADR  system  operates  under  regulations 
issued  by  the  Treasury  Department,  and  became  effective  in  1971. 
(Reg.  §  1.167(a)-ll.) 

One  of  the  important  features  o.f  ADR  is  that  taxpayers  are  allowed 
to  depreciate  tangible  personal  property,  including  leased  property, 
over  useful  lives  which  may  vary  up  to  20  percent  from  the  guide- 
line lives  which  are  otherwise  authorized  for  use  under  the  ADR 
system. 

This  means,  for  example,  that  an  asset  with  a  depreciable  useful  life 
of  10  years  under  the  ADR  guidelines  may  instead  be  depreciated 
over  a  period  of  8  years,  giving  the  taxpayer  a  type  of  "accelerated" 
depreciation  deduction  even  with  straight-line  depreciation.^ 

1  In  computing  depreciation  under  the  ADR  system,  a  taxpayer  also  is  entitled  to  use 
one  of  two  first-year  "conventions,"  or  methods,  on  all  assets  first  placed  in  service  during 
any  one  tax  year  or  period.  Under  the  first  of  these  conventions,  the  taxpayer  may  elect  to 
claim  a  half-year's  depreciation  on  all  assets  put  into  service  at  any  time  during  the  year. 
The  other  convention  allows  a  full  year's  depreciation  for  all  assets  placed  in  service  during 
the  first  half  of  the  tax  year  and  no  depreciation  (for  the  first  year)  on  assets  placed  in 
service  during  the  last  half  of  the  tax  year. 


79 

Rapid  amortization. — Certain  categories  of  assets  which  are  subject 
to  equipment  leasing  transactions  have  been  eligible  for  rapid  amorti- 
zation. Under  the  rapid  amortization  provisions,  the  costs  for  qualify- 
ing categories  of  property  may  be  amortized  over  a  period  of  60  months 
in  lieu  of  depreciation  deductions  otherwise  allowable  for  these  assets. 
Rapid  amortization  has  been  allowed  for  pollution  control  facilities 
(sec.  169),  railroad  rolling  stock  (sec.  184),  and  coal  mine  safety 
equipment  (sec.  187).  These  provisions  expired  at  the  end  of  1975.^ 

Depreciation  recapture. — The  equipment  leasing  venture  does  not 
give  rise  to  the  "conversion"  characteristic  common  in  many  other 
types  of  tax  shelters  because  of  the  full  recapture  rules  that  apply  to 
dispositions  of  depreciated  personal  property.  When  personal  prop- 
erty is  disposed  of  at  a  gain,  the  gain  is  "recaptured"  as  ordinary  in- 
come to  the  extent  of  all  previous  depreciation  or  amortization  deduc- 
tions claimed  on  the  property  (not  just  accelerated  deductions).  The 
recapture  treatment  for  depreciable  personal  property  thus  differs 
from  that  accorded  depreciable  nonresidential  real  property,  which 
is  limited  to  a  recapture  of  the  amount  by  which  accelerated  depreci- 
ation deductions  claimed  exceed  those  allowable  on  a  straight-liup 
basis. 

In  the  case  of  a  partnership,  the  individual  partners  are  generally 
allocated  a  share  of  the  partnership's  depreciation  recapture  in  accord- 
ance with  the  provisions  of  the  partnership  agreement  concerning  the 
allocation  of  partnership  gains.  The  recognition  of  depreciation  re- 
capture by  a  partner  may  be  triggered  directly  by  a  sale  of  the  de- 
preciated partnership  property  or  indirectly  by  a  disposition  of  the 
partner's  interest  in  the  partnership  itself.  Also,  if  a  lender  forecloses 
on  the  debt  used  to  finance  the  partnership's  purchase  of  the  equip- 
ment, this  is  treated  as  a  disposition  which  will  trigger  recapture. 
The  amount  "received"  in  a  foreclosure  will  include  the  unpaid  non- 
recourse debt.  If  this  amount  exceeds  the  undepreciated  basis  in  the 
equipment,  there  will  be  so-called  "phantom  gain"  which  is  taxed  as 
ordinary  income  to  the  partners. 

Limfiitation  on  deduction  of  losses. — Generally,  the  amount  of  deduc- 
tions or  of  losses  which  a  taxpayer  was  permitted  to  claim  in  connec- 
tion with  a  business  or  investment  property  was  limited  to  the  amount 
of  his  basis  in  the  property.  Likewise,  in  the  case  of  a  partnership,  the 
amount  of  losses  a  partner  may  deduct  was  limited  to  the  amount  o.f 
his  adjusted  basis  in  his  interest  in  the  partnership.  However,  basis  in 
a  property  may  include  nonrecourse  indebtedness  (i.e.,  a  loan  on  which 
there  is  no  personal  liability)  attributable  to  that  property,  and  where 
a  partnership  incurs  a  debt  and  none  of  the  partners  have  personal 
liability  on  the  loan,  then  all  of  the  partnere  are  treated  for  tax  pur- 
poses as  though  they  shared  the  liability  in  proportion  to  their  profits 
interest  in  the  partnership  (i.e.,  each  partner's  share  in  the  nonrecourse 
indebtedness  is  added  to  this  basis  in  the  partnership).  As  a  result, 
prior  law  enabled  investors  in  an  equipment  leasing  activity  to  deduct 
losses  from  the  activity  in  excess  the  total  amount  of  economic  risk  the 
investor  had  from  the  activity. 

3  However,  amortization  for  pollution  control  facilities  was  extended  under  Sec.  2112  of 
the  Act. 


80 

Also,  there  was  generally  no  limitation  on  the  amount  of  deductions 
that  can  be  taken  in  situations  where  the  taxpayer  is  protected  against 
ultimate  loss  by  reason  of  a  stop-loss  order,  guarantee,  guaranteed  re- 
purchase agreement,  insurance  or  otherwise. 

Reasons  for  change 

A  business  may  acquire  productive  equipment  in  a  variety  of  ways, 
including  an  outright  purchase  or  a  lease  of  the  equipment.  Although 
an  outright  purchase  remains  the  most  common  form  of  acquiring  the 
use  of  equipment,  recent  years  have  shown  a  substantial  growth  in 
the  leasing  alternative.  Some  of  the  more  common  types  of  property 
and  equipment  which  have  been  leased  include  computers,  aircraft, 
railroad  rolling  stock,  ships  and  vessels,  and  oil  drilling  rigs.  Also, 
utility  companies  have  begim  to  lease  the  nuclear  fuel  assemblies  used 
in  their  generating  plants. 

There  are  several  reasons  for  the  growth  in  equipment  leasing. 
From  the  standpoint  of  the  business  lessee  who  uses  the  equipment, 
one  factor,  for  example,  is  the  opportunity  to  acquire  use  of  the  equip- 
ment in  a  manner  which,  in  comparison  with  the  purchase  alternative, 
places  less  strain  upon  the  available  cash  of  the  business.  Another 
important  advantage  for  the  lessee  is  that  leasing  provides  greater  tax 
benefits  through  the  ability  to  deduct  its  rental  costs.  There  are  also 
significant  tax  benefits  to  the  lessor  in  an  equipment  leasing  trans- 
action (such  as  accelerated  depreciation  deductions,  as  discussed 
above)  which  attract  the  participation  of  individual  investors. 

The  equipment  leasing  tax  shelter  generally  operates  through  the 
limited  partnership  f omi  of  business  organization,  with  the  individual 
investors  participating  as  limited  partners.  All,  or  virtually  all,  of 
the  equity  capital  of  the  venture  is  contributed  by  the  limited  partners 
and  non-recouse  financing  is  obtained  for  75-80  percent  of  the  cost  of 
the  equipment  w^hich  is  purchased  by  the  partnei-ship  and  leased  to  a 
business  user.  The  partnership  generally  leases  the  equipment  to  the 
lessee  at  a  rental  rate  which,  over  the  initial  term  of  the  lease,  will 
enable  the  partnership  to  repay  the  loan,  plus  interest,  fees  and  other 
expenses,  and  generate  a  modest  positive  cash  flow. 

In  most  leasing  shelters,  the  limited  partnership  elects  the  method 
of  depreciation  or  amortization  which  will  generate  the  largest  capital 
recovery  deductions  allowable  in  the  early  years  of  the  lease.  The 
partnership  may,  in  addition,  prepay  some  of  its  interest  charges,  and 
often,  during  the  first  year  of  operation,  pays  the  promoter  for  man- 
agement and  syndication  fees.  The  large  depreciation,  fees,  interest, 
and  other  expenses  generally  exceed  the  partnership's  receipts  from 
rental  of  the  equipment  during  the  first  8-7  years  of  the  lease  (depend- 
ing upon  i\\e  estimated  useful  life  of  the  leased  equipment),  and  this 
generates  sizable  losses  for  the  partnership. 

Partnership  losses  are  allocated  to  the  investor-limited  partners 
under  the  partnership  agreement  and  are  used  by  the  individual  in- 
vestors to  offset  income  from  other  sources  (and  thus  defer  taxes  on 
this  income  for  a  number  of  years) .  The  individual  investor  may  also 
obtain  an  apportioned  share  of  the  investment  credit  if  the  equipment 
is  eligible  for  the  credit  and  the  lease  is  of  a  type  which  enables  an 
individual  investor  to  claim  the  credit. 


81 

Because  of  these  tax  advantages  under  prior  law,  when  an  invest- 
ment was  solicited  in  an  equipment  leasing  venture,  it  was  common 
practice  to  promise  a  prospective  investor  substantial  tax  losses  which 
could  be  used  to  decrease  the  tax  on  his  incx)me  from  other  sources. 
The  Congress  believed  that  is  was  not  equitable  to  allow  these  individ- 
ual investors  to  defer  tax  on  income  from  other  sources  through  the 
losses  generated  by  equipment  leasing  transactions,  to  the  extent  the 
losses  exceed  the  amount  of  his  resources  the  investor  has  actually 
placed  at  risk  in  the  transaction. 

This  leveraging  of  investments  to  produce  tax  savings  in  excess  of 
amounts  invCvSted  substantially  alters  the  economic  substance  of  the 
investment  and  distorts  the  workings  of  the  investment  markets.  Tax- 
payers, ignoring  the  possible  tax  consequences  in  later  years,  can  be 
led  into  investments  which  are  otherwise  economically  unsound  and 
which  constitute  an  unproductive  use  of  the  taxpayer's  (and  the  fed- 
eral government's)  investment  funds.  Because  of  these  considerations, 
the  Act  applies  the  "at  risk"  rules  to  equipment  leasing  activities. 

Explanatimi  of  provision 

The  Act  provides  that  where  an  individual  taxpayer  may  otherwise 
be  entitled  to  deduct  a  loss  in  excess  of  his  economic  investment  in  an 
equipment  leasing  activity,  the  amount  of  the  loss  deduction  is  limited 
to  the  aggregate  amoimt  with  respect  to  which  the  taxpayer  is  at  risk 
in  this  trade  or  business  at  the  close  of  the  taxable  year.  This  "at  risk" 
limitation  applies  to  all  individual  taxpayers  who  invest  in  an  equip- 
ment leasing  activity,  including  individuals  who  invest  for  their 
own  account  and  those  who  do  so  through  another  entity  such  as  a 
partnership,  personal  holding  company,  or  subchapter  S  corporation. 
In  addition,  the  limitation  extends  to  trusts  and  estates,  which  are 
taxed  like  individuals.  ( For  more  detail  as  to  the  application  and  scope 
of  the  risk  rule,  see  section  2,  above.) 

Under  the  at  risk  rule  as  it  applies  to  equipment  leasing,  the  tax- 
payer is  considered  to  be  in  a  leasing  activity  if  he  has  an  ownership 
interest,  either  direct  or  indirect,  in  section  1245  property  (as  defined 
in  sec.  1245(a)  (3))  which  is  leased  or  held  for  leasing.^  In  the  case 
Avhere  equipment  leasing  activity  is  conducted  by  an  individual,  the 
at  risk  limitation  applies  separately  to  each  property  leased  or  held 
for  leasing.  (However,  where  several  properties,  such  as  parts  of  a 
computer,  comprise  one  unit  under  the  same  lease  agreement  and  are 
neither  separately  financed  nor  are  subject  to  different  lease  terms, 
the  properties  are  to  be  considered  one  property  for  purposes  of  the 
at  risk  rule.) 

All  equipment  leasing  activities  engaged  in  through  a  partnership 
or  subchapter  S  corporation  will  be  treated  as  one  activity  under  this 
provision.  However,  if  the  partnership  or  corporation  engages  in  more 
than  one  type  of  activity  covered  by  the  at  risk  rule,  then  each  type  of 
activity  is  treated  as  a  separate  activity.  For  example,  if  a  partnership 
has  one  farm  and  a  number  of  equipment  leasing  transactions,  it  will 
be  considered  to  have  two  activities,  farming  and  equipment  leasing, 

» Since  the  at  risk  rule  does  not  apply  to  real  estate  activities,  in  a  situation  where 
section  1245  property  is  leased  as  a  minor  incident  of  a  lease  of  real  property  (such  as 
where  an  unfurnished  rental  apartment  is  equipped  with  a  stove  or  refrigerator),  the 
at  risk  rules  for  equipment  leasing  will  not  be  considered  to  apply. 


82 

and  a  separate  application  of  the  at  risk  limitation  must  be  made  for 
each  of  the  two  activities. 

Effective  date 

The  at  risk  rule  for  equipment  leasing  will  apply  generally  to  losses 
attributable  to  amounts  paid  or  incurred  (including  depreciation  or 
amortization  allowed  or  allowable)  after  December  31,  1975.  Special 
transitional  rules  are  provided  however  for  pre-existing  leasing  trans- 
actions.* In  the  case  of  leasing  transactions  where  the  property  is  leased 
under  an  operating  lease,  the  at  risk  rule  will  not  apply  if  the  property 
was  either  subject  to  a  binding  lease  before  May  1, 1976  or  subject  to  a 
binding  purchase  order  by  the  lessor  or  lessee  before  this  date.  How- 
ever, this  grandfather  rule  will  apply  only  to  those  taxpayers  who 
owned  their  interests  in  the  leased  property  on  April  30,  1976.^  The 
at  risk  rule  will  not  apply  to  any  type  of  leasing  transaction  where 
the  property  was  either  leased  or  ordered  (by  the  lessor  or  lessee)  be- 
fore January  1,  1976,  but  only  for  those  taxpayers  who  owned  their 
interests  in  the  property  on  JDecember  31,  1975.  In  those  situations 
where  the  eventual  lessee  has  executed  a  binding  purchase  order  for 
property  by  the  relevant  effective  date  and  an  investor  has  similarly 
Acquired  (or  has  irrevocably  committed  himself  to  acquire)  an  interest 
in  the  partnership  or  other  entity  which  becomes  the  eventual  lessor  of 
the  property  by  that  date,  the  investor  will  be  considered  to  have 
acquired  an  interest  in  the  property  for  purposes  of  these  transitional 
rules  even  though  the  assumption  of  the  lessee's  purchase  order  by  the 
lessor  entity  actually  occurs  after  the  relevant  date  under  these  rules. 

For  purposes  of  these  transitional  rules,  an  order,  a  lease,  and  the 
acquisition  of  an  interest  in  the  property  will  not  be  considered  to  have 
occurred  luitil  they  are  evidenced  by  binding  and  legally  enforceable 
agreements  which  are  complete  as  to  all  relevant  terms.  However,  a 
lease  agreement  will  be  considered  binding  on  the  relevant  dates  under 
the  above  provisions  even  though  it  is  later  modified  to  increase  (but 
not  decrease)  the  lease  term. 

Revenue  effect 
This  provision  will  increase  budget  receipts  by  $4  million  in  fiscal 
year  1977,  $14  million  in  fiscal  year  1978,  and  $14  million  in  fiscal  year 
1981. 

7.  Sports  Franchises  and  Player  Contracts  (sec.  212  of  the  Act  and 
sec.  1245  and  new  sec.  1056  of  the  Code) 

Prior  law 

Generally,  the  cost  of  tangible  property  used  in  a  taxpayer's  trade 

or  business  may  be  depreciated  and  deducted  over  the  useful  life  of 

the  property.  In  the  case  of  a  sports  franchise,  players'  contracts 

(contracts  for  the  services  of  athletes)  are  intangible  assets  and  usually 

*  These  transitional  rules  In  the  Act  erroneously  refer  to  actiivtles  "described  in  [Code] 
section  465(c)(1)(B)",  that  is,  farming  activities.  Congress  intends,  however,  that  these 
transitional  rules  apply  to  equipment  leasing  activities  described  in  section  46.t(c)  (1)  (C). 

°  An  operating  lease  for  purposes  of  this  transitional  rule  is  defined  in  Code  section 
46(e)(3)(B)  as  generally  one  where  the  lease  term  is  less  than  50  percent  of  the 
property's  useful  life  and  the  lessor's  unreimbursed  ordinary  and  necessary  business 
deductions^  (under  section  162)  from  the  property  are  greater  than  15  percent  of  Its 
rental  income  during  the  first  12  months  the  property  Is  held  by  the  lessee. 


83 

represent  one  of  the  important  costs  incurred  in  connection  with  the 
acquisition  of  the  franchise.  It  is  the  position  of  the  IRS  (as  described 
below)  that  player  contracts  have  a  useful  life  of  more  than  one 
year  and  therefore  the  cost  of  acquiring  a  player's  contract  is  to  be 
capitalized  and  depreciated  over  the  life  of  the  contract.  While  the 
terms  of  players'  contracts  vary  with  the  type  of  sport  involved,  the 
typical  contract  will  provide  employment  for  one  year  and  give  the 
employer  (the  team)  a  unilateral  option  to  renew  the  contract  for  an 
additional  year  at  a  specified  percentage  of  the  player's  previous 
salary.^ 

In  1967,  the  Commissioner  of  Internal  Revenue  ruled  that  the  cost 
of  a  player's  contract  must  be  capitalized  and  depreciated  over  the  use- 
ful life  of  the  contract.  (Rev.  Rul.  67-379, 1967-2  C.B.  127.)  In  adopt- 
ing this  position,  the  IRS  noted  that  by  reason  of  the  reserve  clause, 
a  player  contract  has  a  useful  life  extending  beyond  the  taxable  year 
in  which  the  contract  was  acquired.  In  Rev.  Rul.  71-137,  1971-1  C.B. 
104,  the  same  result  was  reached  with  respect  to  football  contracts  by 
virtue  of  the  option  clause  under  the  contract.  Although  the  useful  life 
varies  from  sport  to  sport,  sports  teams  typically  adopt  a  maximum 
life  ranging  between  three  and  six  years.  The  cost  to  be  capitalized  in- 
cludes amounts  paid  or  incurred  upon  purchase  of  a  player  contract 
and  bonuses  paid  to  players  for  signing  contracts. 

The  depreciable  basis  of  player  contracts  also  affects  the  current 
capitalization  and  depreciation  of  bonus  payments  to  be  made  in  the 
future  under  the  terms  of  the  contract.  Generally,  an  accrual  basis 
taxpayer  is  entitled  to  deduct  an  unpaid  expense  for  the  taxable  year 
in  which  all  the  events  have  occurred  which  determine  the  fact  of 
liability  and  the  amount  can  be  determined  with  reasonable  accuracy 
(Treas.  Reg.  §  1.461-1  (a)  (2)).  Under  this  general  rule,  accrued  sal- 
aries would  ordinarily  be  deductible  expenses  for  the  taxable  year  in 
which  earned  by  the  employees  even  if  paid  in  the  following  taxable 
year.  However,  any  expenditure  which  results  in  the  acquisition  of  an 
asset  having  a  useful  life  which  extends  substantially  beyond  the  close 
of  the  taxable  year  may  not  be  deductible  for  the  taxable  year  in  which 
the  liability  for  the  expenditure  was  incurred.  This  limitation  would 
generally  apply  to  amounts  required  to  be  capitalized  with  respect  to 
a  liability  for  future  payments  u^.der  a  player  contract. 

In  addition,  another  specific  limitation  would  also  apply  in  the  case 
of  such  a  contract  if  it  is  treated  as  a  nonqualified  deferred  compensa- 
tion plan.  An  employer  is  not  entitled  to  deduct  contributions  made  to 
or  under  a  nonqualified  deferred  compensation  plan,  usually  a  trust, 
until  the  taxable  year  in  which  an  amount  attributable  to  the  con- 

1  Baseball  and  hockey  contracts  contain  a  specific  "reserve  clause"  in  whicli  the  right 
to  renew  the  contract  Is  Itself  renewed.  Although  the  team  obligates  Itself  for  only  one 
year,  the  effect  of  this  reserve  clause  in  the  contract,  and  certain  league  rules,  is  to 
f-lnd  the  player  to  play  only  for  the  team  which  owns  the  contract.  Under  league  rules,  if 
the  player  refuses  to  sign  a  new  contract  or  play  for  an  additional  year  under  the  terms 
contained  In  the  original  contract,  the  team  can  prevent  the  player  from  playing  for 
another  team.  Basketball  and  football  player  contracts  purport  to  be  less  restrictive  in  that 
although  they  provide  an  option  for  an  additional  year's  contract,  they  do  not  contain  a 
reserve  clause  per  «e.  Neither  the  contract  nor  the  league  rules  prevent  the  player  from 
"playing  out  his  option"  and  becoming  a  "free  agent."  However,  in  the  case  of  football,  if  a 
player  becoming  a  free  agent  signs  a  contract  with  a  different  team  in  the  NPL,  then  unless 
mutually  satisfactory  arrangements  have  been  reached  between  the  two  league  teams,  the 
Commissioner  of  the  NFL  can  assert  the  right  to  award  to  the  former  team  one  or  more 
players  (including  future  draft  choices)  of  the  acquiring  team.  This  right  is  currently  being 
litigated. 


84 

tribution  is  includible  in  the  gross  income  of  the  employee,  (sec.  404 
(a)(5)).  The  employee-beneficiary  must  generally  include  amounts 
paid  on  his  behalf  in  his  taxable  year  in  which  there  is  no  substantial 
risk  of  forfeiture  (sees.  83,  402(b),  and  403(c)).  In  addition,  the 
Internal  Eevenue  Service  has  ruled  that  if  compensation  is  paid  by 
an  employer  directly  to  a  former  employee,  under  an  unfunded  plan, 
such  amounts  are  deductible  when  actually  paid  in  cash  or  other 
property  (Rev.  Rul.  60-31,  1960-1  C.B.  174).  Thus,  the  deferred 
compensation  rules  would  preclude  the  allowance  of  a  deduction  under 
an  unfunded  plan  before  the  team  makes  the  payment  where  the  useful 
life  of  the  player  contract  is  shorter  than  the  actual  payout  period. 

When  there  is  a  sale  or  exchange  of  a  sports  franchise,  both  the 
buyer  and  the  seller  must  generally  make  an  allocation  of  the  consid- 
eration for  the  sale  or  exchange  between  the  various  assets  acquired  or 
sold.  Franchise  rights  are  not  usually  depreciable  because  these  rights 
exist  for  an  unlimited  period  of  time.  Therefore,  a  purchaser  of  a 
sports  team  will  benefit  from  larger  depreciation  deductions  if  he  is 
able  to  allocate  more  of  the  aggregate  purchase  price  to  player  con- 
tracts and  less  to  franchise  rights.  Under  prior  law,  there  was  no  spe- 
cific rule  relating  to  the  allocation  of  a  portion  of  the  total  considera- 
tion paid  to  acquire  a  franchise,  players'  contracts  and  other  assets 
which  might  be  acquired  at  the  time  of  acquisition  of  a  franchise. 
Generally,  this  allocation  was  made  on  the  basis  of  the  fair  market 
values  (or  relative  fair  market  values)  of  the  various  assets.  The 
allocation  to  players'  contracts  was  also  necessary  when  a  new  franchise 
is  acquired  through  the  expansion  of  an  existing  league  or  the  forma- 
tion of  a  new  league. 

Generally,  depreciable  property  that  is  used  in  a  trade  or  business 
is  not  treated  as  a  capital  asset.  However  (under  section  1231),  a  tax- 
payer who  sells  property  used  in  his  trade  or  business  benefits  from 
special  tax  treatment.  All  gains  and  losses  from  section  1231  property 
are  aggregated  for  the  taxable  year  and  any  gain  is  treated  as  capital 
gain.  If  the  losses  exceed  the  gains,  the  loss  is  treated  as  an  ordinary 
loss.  Thus,  gains  from  the  sale  of  player  contracts  will  be  treated  as 
capital  gain  and  taxed  at  the  more  favorable  long-term  capital  gain 
rates  if  the  contracts  were  held  for  the  requisite  holding  period,  to 
the  extent  such  gains  are  not  "recaptured"  as  ordinary  income  under 
section  1245.^ 

Reasons  for  change 

In  many  cases,  the  tax  benefits  which  can  be  derived  from  mvesting 
in  a  sports  franchise  combine  to  transform  an  otherwise  unprofitable 
investment  into  a  very  profitable  one.  In  addition,  the  tax  benefits  to 
some  extent  may  have  increased  the  price  of  sports  franchises. 

One  practice  that  increased  the  tax  benefits  resulting  from  the  opera- 
tion of  a  sports  franchise  was  the  allocation  of  a  large  part  of  the 
amount  paid  for  the  acquisition  of  a  sports  team  to  player  contracts. 
Typically,  a  purchaser  of  a  sports  franchise  attempted  to  allocate 
most  of  the  aggregate  purchase  price  of  the  franchise  to  player  con- 

2  The  Internal  Revenue  Service  has  ruled  that  gains  from  the  disposition  of  depreciable 
professional  baseball  and  football  player  contracts  which  are  owned  by  teams  for  more 
than  6  months  are  subject  to  recapture  as  ordinary  income.  [Rev.  Rul.  67-380,  1967-2  C.B. 
291  :  Rev.  Rul.  71-137,  1971-1  C.B.  104.] 


85 

tracts  because  the  cost  of  a  player  contract  could  be  deprecia.ted  over 
the  life  of  the  contract.^  Amounts  that  were  allocated  to  other  assets 
such  as  the  franchise  rights  or  to  good  Avill  could  not  be  depreciated 
because  these  assets  have  an  indeterminate  useful  life. 

On  the  othei-  hand,  the  seller  attempted  to  allocate  most  of  the  aggre- 
gate sales  price  to  franchise  rights.  In  this  way,  a  greater  amount  of 
any  gain  was  tiTiated  as  capital  gain  and  a  lesser  amount  was  treated 
as  gain  attributable  to  depreciable  assets  (e.g.,  players'  contracts)  sub- 
ject to  recapture  as  ordinary  income. 

Since  under  prior  law,  depreciation  with  respect  to  player  contracts 
was  recaptured  on  a  contract  by  contract  basis,  a  substantial  amount 
of  lepreciation  allowed  was  not  recaptured  since  Uiany  of  the  original 
players  had  retired  or  had  been  "cut"  and  replaced  by  new  players.  In 
addition,  an  abandonment  loss  is  allowed  for  the  adjusted  basis  of  the 
player  contract  in  the  year  a  player  retired  or  was  cut.  To  the  extent 
that  gain  attributable  to  player  contracts  was  not  recaptured,  it  can  be 
argued  that  the  taxpayer  has  converted  an  ordinary  deduction  into 
capital  gain.  Since  the  amount  allocated  to  player  contracts  was  usual- 
ly a  large  portion  of  the  acquisition  cost  of  a  sports  franchise  and  may 
be  depreciated  ov^er  a  short  life,  the  amount  allowed  as  a  deduction  in 
the  early  years  in  most  cases  was  in  excess  of  the  income  generated  by 
the  sports  franchise  for  that  year  and  produced  a  tax  loss  to  shelter 
other  income. 

The  Congress  believed  it  was  appropriate  to  deal  directly  with  the 
tax  treatment  of  player  contracts  in  these  cases  since  the  concern  has 
been  with  the  allocation  of  basis  to  player  contracts  in  the  case  of  a 
sale  or  exchange  of  a  sports  franchise  and  the  conversion  of  ordinary 
income  into  capital  gain  upon  a  subsequent  sale.  As  a  result,  the  Act 
in  general  provides  that  the  purchase  price  allocated  to  player  con- 
tracts by  the  purchaser  cannot  exceed  the  amount  of  the  sales  price  allo- 
cated to  those  contracts  by  the  seller.  Also  upon  the  subsequent  sale 
of  the  franchise  by  the  })urchaser,  the  Act  generally  provides  for  the  re- 
capture of  the  depreciation  taken  (or  any  abandonment  of  losses)  on 
the  player  contracts  which  were  initially  acquired  with  the  original 
acquisition  of  the  franchise  by  the  seller. 


3  Of  the  total  cash  consideration  paid  for  an  expansion  major  league  football  team,  the 
Atlanta  Falcons,  the  purchaser  (a  subchapter  S  corporation)  treated  $7,722,914  as  the 
cost  of  player  contracts  and  options,  $727,08t5  as  deferred  interest  and  the  remaining 
$50,000  as  the  cost  of  the  franchise.  This  resulted  in  tax  losses  to  the  corporation  of 
$506,.329  in  1967  and  $581,047  in  1968  which  was  passed  through  to  the  shareholders  on 
a  proportionate  basi.s.  TTpon  audit,  the  IRS  determined  that  onl.v  .fl, 050,000  should  be 
allocated  to  the  player  contracts  and  options,  and  $6.72'.i,914  should  be  allocated  to  the 
nondepreciable  cost  of  the  National  Football  League  franchise.  The  taxpayer  paid  the 
additional  assessment,  submitted  a  claim  for  refund,  and  after  its  disallowance,  filed  a 
suit  for  refund.  The  court  rejected  both  the  taxpayer's  initial  allocation  of  $7,722,914  and 
the  Commissioner's  allocation  of  $1,050,000  and  "concluded  that  the  amount  that  should 
have  been  allocated  to  the  players'  contracts  and  options  was  $3.0.'^5,0O0.  (Laird  v.  U.S., 
391  F.  Supp.  656,  75-1  U.S.T.C.  Par.  9274  (N.D.  Ga.  1975)),  The  court  further  concluded 
that  $4,277,04.3  represented  the  value  of  the  television  rights  granted  to  the  Atlanta 
Falcons  under  a  4-year  contract  between  the  NFL  and  the  CBS  television  network  and  that 
this  amount  was  not  amortizable  because  the  useful  life  of  the  television  rights  was  for  an 
Indefinite  period.  The  case  is  presently  on  appeal  in  the  Fifth  Circuit. 

Questions  have  been  raised  as  to  the  method  used  by  the  District  Court  in  allocating 
the  purchase  price  to  the  various  assets  acquired  in  the  Laird  case.  Although  the  court  held 
rhat  the  right  to  participate  in  receipts  from  television  contracts  could  not  be  depreciated 
since  it  "had  no  defiinite  limited  useful  life  the  duration  of  which  could  be  ascertained  with 
reasonable  accuracy,"  the  court  relied  upon  the  existing  4-year  contract  in  valuing  this 
risrht  for  purposes  of  allocating  the  purchase  price.  Concern  has  been  expressed  as  to 
whether,  it  the  television  contract  had  only  1  year  left  at  the  time  of  acquisition,  the  court 
would  have  deterniiued  the  contract's  value  to  be  the  present  value  of  the  right  to  receive 
television  receipts  for  only  1  year. 


234-120  O  -  77  -  7 


86 

Explanation  of  provision 

The  Act  provides  that  in  the  case  of  the  sale,  exchange,  or  other 
disposition  of  a  sports  franchise  (or  the  creation  of  a  new  franchise), 
the  amount  of  consideration  allocated  to  a  player  contract  by  the  trans- 
feree shall  not  exceed  the  sum  of  the  adjusted  basis  of  the  contract  in 
the  hands  of  the  transferor  immediately  before  the  transfer  and  the 
gain  (if  any)  recognized  by  the  transferor  on  the  transfer  of  the 
player  contract.  In  this  way,  a  more  appropriate  allocation  will  be 
achieved  since,  to  a  substantial  extent  the  buyer  and  seller  will  be 
adverse  parties  with  respect  to  the  allocation  (i.e.,  to  the  extent  that 
the  amount  of  gain  attributable  to  player  contracts  will  be  fully  re- 
captured as  ordinary  income,  the  buyer  and  seller  will  be  operating 
at  arms-length  with  respect  to  the  allocation).  This  limitation  is  not  to 
apply  to  a  like-kind  exchange  under  section  1031  of  the  code.  In  addi- 
tion, the  provision  is  not  to  apply  with  respect  to  the  determination  of 
basis  of  the  player  contract  in  the  hands  of  a  person  acquiring  the  con- 
tract from  a  decedent. 

Under  this  provision,  th^  transferor  must  provide  both  the  Secre- 
tary and  transferee  with  information  stating  the  amount  which  the 
transferor  believes  to  be  the  adjusted  basis  in  the  player  contract,  the 
amount  which  the  transferor  believes  to  be  the  gain  (if  any)  recog- 
nized on  the  transfer  of  the  player  contract  and  any  subsequent  modi- 
fication to  either  amount.  The  time  and  manner  for  furnishing  this 
information  is  to  be  provided  by  regulations  prescribed  by  the  Secre- 
tary. Further,  these  amounts  are  to  be  binding  on  both  the  transferor 
and  the  transferee  to  the  extent  provided  in  such  regulations. 

The  Act  also  provides  that  in  the  case  of  the  sale  or  exchange  of 
a  sj>orts  franchise,  it  is  presumed  that  not  more  than  50  percent  of 
the  consideration  is  allocable  to  player  contracts  unless  the  taxpayer 
can  satisfy  the  Secretary  of  the  Treasury  that  under  the  facts  and  cir- 
cumstances of  the  particular  case,  it  is  proper  to  allocate  an  amourt  in 
excess  of  50  percent.  However,  the  Act  provides  that  the  presumption 
does  not  mean  that  an  allocation  of  less  than  50  percent  of  the  consid- 
eration to  player  contracts  is  proper.  The  proper  allocation  is  to  de^yend 
upon  the  facts  and  circumstances  of  each  particular  case.  Facl:>rs  to 
be  taken  into  account  by  the  Secretary  are  to  include  the  amount  of 
gate  receipts  received  by  the  past  owner  of  the  franchise  (as  well  as 
the  amount  expected  to  be  received  in  the  future) ,  the  amount  of  radio 
and  television  receipts  that  were  received  by  the  past  owner  of  the 
franchise  (as  well  as  the  amount  expected  to  be  received  in  the  future) , 
etc.  It  is  recognized  that  there  are  differences  among  the  various  sports 
which  ai-e  relevant  to  the  proper  allocation  and,  therefore  it  is  intended 
that  factors  peculiar  to  each  sport  (and  to  each  team)  be  taken  into 
account.  For  example,  in  the  case  of  baseball,  revenues  from  television 
and  radio  contracts  are  to  a  substantial  degree  derived  from  individual 
team  contracts  rather  than,  as  in  the  case  of  football,  from  leaarue 
contracts. 

The  Act  provides  special  rules  for  the  recapture  of  depreciation 
and  deductions  for  losses  taken  with  respect  to  player  contracts.  The 
special  recapture  rules  apply  only  in  the  case  of  the  sale,  exchange,  or 
other  disposition   (other  than  a  disposition  under  vihich  the  trans- 


87 

feree  has  a  carry-over  basis)  of  the  entire  sports  franchise.  In  the  case 
of  the  sale  or  exchange  of  individual  player  contracts  recapture  will 
continue  to  be  determined  on  a  contract-by-contract  basis.  Under  these 
special  rules,  to  the  extent  of  any  gain  attributable  to  plaj^er  contracts, 
the  amount  recaptured  as  ordinary  income  will  be  the  greater  of  (1) 
the  sun\  of  the  depreciation  taken  plus  any  deductions  taken  for  losses 
(i.e.,  abandonment  losses)  with  respect  to  those  player  contracts  which 
are  initially  acquired  as  a  part  of  the  original  acquisition  of  the  fran- 
chise or  (2)  the  amount  of  depreciation  taken  with  respect  to  those 
player  contracts  which  are  owned  by  the  seller  at  the  time  of  the  sale  of 
the  sports  franchise.  To  the  extent  that  depreciation  taken  on  player 
contracts  which  were  acquired  as  part  of  the  original  acquisition  of  the 
franchise  has  previously  been  recaptured,  the  amount  so  recaptured 
will  reduce  the  aggregate  amount  of  depreciation  and  losses  attributa- 
ble to  player  contracts  initially  acquired  for  purposes  of  determining 
the  recapture  amount  under  (1)  above.  The  amount  determined  under 
(2)  above  with  respect  to  player  contracts  held  at  the  time  the  fran- 
chise is  sold  will  be  equal  to  the  aggregate  depreciation  allowed  or 
allowable  for  all  such  contracts.  Thus,  the  amount  subject  to  recapture 
will  be  determined  for  player  contracts  on  a  consolidated  basis  and 
may  exceed  the  sum  of  the  amounts  which  would  otherwise  be  sub- 
ject to  recapture  if  determined  on  a  contract-by-contract  basis,  e.g., 
the  aggregate  gain  is  ecpial  to  or  greater  than  the  aggregate  depre- 
ciation deductions,  but  the  gain  attributable  to  one  or  more  of  the  con- 
tracts is  less  than  the  applicable  depreciation. 

Effectme  dates 
The  provision  relating  to  the  allocation  of  basis  to  player  contracts 
applies  to  sales  or  exchanges  of  franchises  after  December  31,  1975,  in 
taxable  years  ending  after  that  date.  The  provision  relating  to  the 
recapture  of  depreciation  applies  to  transfers  of  player  contracts  in 
connection  with  any  sale  or  exchange  of  a  franchise  after  December  31, 
1975. 

Revenue  efect 
It  is  estimated  that  the  provision  relating  to  allocation  of  basis  to 
player  contracts  will  result  in  a  revenue  gain  of  $1  million  for  fiscal 
year  1977,  and  $8  million  for  fiscal  year  1981.  In  addition,  it  is  esti- 
mated that  the  provision  relating  to  depreciation  recapture  will  result 
in  a  revenue  gain  of  $7  million  for  fiscal  year  1977  and  1981. 

8.  Partnership  Provisions 

o.  Partnership  Additional  First-Year  Depreciation  (sec.  213(a)  of 
the  Act  and  sec.  179(d)  of  the  Code) 

Prior  Imii 
An  owner  of  tangible  personal  property  is  eligible  to  elect,  for  the 
first  year  the  property  is  depreciated,  a  deduction  for  additional  first- 
year  depreciation  of  20  percent  of  the  cost  of  the  property  (sec.  179). 
The  cost  of  the  property  on  which  this  "bonus"  depreciation  is  calcu- 
lated is  not  to  exceed  $10,000  ($20,000  for  an  individual  who  files  a 


88 

joint  return).  The  maximum  bonus  depreciation  deduction  is  thus 
Rmited  to  $2,000  ($4,000  for  an  individual  filing  a  joint  return).  Bonus 
depreciation  is  available  only  for  property  that  has  a  useful  life  of  six 
years  or  more. 

Wliere  the  owner  is  a  partnership,  the  election  for  bonus  deprecia- 
tion is  made  by  partnership.  However,  under  prior  law,  the  dollar 
limitation  described  above  was  applied  to  the  individual  partners 
rather  than  to  the  partnership  entity.  For  example,  each  one  of  40 
individual  investors  who  contributed  $5,000  to  an  equipment  leasing 
limited  partnership,  which  purchased  a  $1  million  executive  aircraft, 
would  have  been  entitled  to  $4,000  of  bonus  depreciation  if  he  filed  a 
joint  return.  In  this  case,  additional  first-year  depreciation  would  have 
provided  total  deductions  to  the  partners  of  up  to  $160,000. 

A  corporation,  however,  under  present  law,  is  allowed  to  deduct  only 
$2,000  of  additional  first-year  depreciation.  Thus,  in  the  case  of  the 
purchase  of  an  aircraft,  as  described  above,  a  corporation  would  be 
limited  to  $2,000  of  additional  first-year  depreciation,  whereas  the 
partnership,  under  prior  law,  could  have  passed  through  to  the  part- 
ners total  first-year  additional  depreciation  of  up  to  $160,000. 

RemoTis  for  change 

Allowing  each  individual  partner  in  a  partnership  to  have  the  full 
$2,000  first-year  depreciation  deduction  (or  $4,000,  in  the  case  of  a 
married  partner  filing  a  joint  return)  inflates  the  amount  of  "bonus 
depreciation"  which  should  be  allowable  in  the  year  the  property  is 
placed  in  service. 

The  provision  for  bonus  depreciation  (sec.  179)  was  enacted  to 
provide  a  special  incentive  for  small  businesses  to  make  investments  in 
depreciable  property.  The  limitations  on  the  dollar  amount  of  property 
with  respect  to  which  a  taxpayer  can  take  additional  first-year  de- 
preciation were  intended  to  insure  that  this  provision  allow  only  a 
very  limited  dollar  benefit  to  any  enterprise,  regardless  of  size.  The 
dollar  limitation  was  thus  intended  to  insure  that  the  allowance  for 
additional  first-year  depreciation  would  be  of  significance  primarily 
for  small  businesses.  In  practice,  however,  the  lack  of  a  dollar  limita- 
tion on  the  amount  of  depreciable  basis  with  respect  to  which  a  part- 
nership could  calculate  the  bonus  depreciation — even  though  there 
is  a  dollar  limitation  which  applies  to  each  partner — had  enabled 
partnerships  with  many  partners,  especially  tax-shelter  partnerships, 
to  pass  through  amounts  of  bonus  depreciation  very  substantially  in 
excess  of  what  was  intended  to  be  allowed. 

Explanation  of  provision 

The  Act  provides  that,  with  respect  to  a  partnership,  the  dollar 
limitation  is  first  applied  at  the  partnership  level.  Thus,  the  cost  of  the 
property  on  which  additional  first-year  depreciation  is  calculated  for 
the  partnership  as  a  whole  is  not  to  exceed  $10,000,  However,  this  pro- 
vision does  not  affect  the  dollar  limitation  which  is  applicable  to  the 
individual  partners.  Thus,  for  example,  if  a  single  individual  is  a 
member  of  a  partnership  and  also  owns  a  sole  proprietorship,  the  total 
amount  of  the  cost  basis  of  property  on  which  he  can  calculate  addi- 
tional first-year  depreciation  is  $10,000. 


Ejfecti/ve  date 
This  provision  is  effective  for  partnership  taxable  years  beginning 
after  December  31, 1975. 
Revenue  effect 
It  is  estimated  that  this  provision  and  the  three  following  partner- 
ship provisions  will  result  in  an  increase  in  budget  receipts  of  $12  mil- 
lion in  fiscal  year  1977  and  $10  million  annually  thereafter. 

6.  Partnership  Syndication  and  Organization  Fees  (sec.  213(b) 
of  the  Act  and  sees.  707(c)  and  709  of  the  Code) 

Prior  law 

Prior  law  (sec.  707(c))  provided  for  the  deduction  by  a  part- 
nership of  so-called  "guaranteed  payments"  made  to  a  partner  for 
services  or  for  the  use  of  capital  to  the  extent  the  payments  were  deter- 
mined without  regard  to  the  income  of  a  partnership,  "but  only  for  the 
purposes  of  section  61(a)  (relating  to  gross  income)  and  section  162 
(a)  (relating  to  trade  or  business  expenses)."  However,  present  law 
(sec.  263)  generally  provides  that  no  current  deduction  shall  be 
allowed  for  capital  expenditures.  Nonetheless,  it  has  been  contended 
that  these  payments  under  section  707(c)  were  automatically  deducti- 
ble by  the  partnership  without  regard  to  the  "ordinary  and  necessary" 
requirements  of  section  162  (a)  or  section  263. 

Thus,  until  recently,  it  has  been  the  common  practice  for  limited 
partnerships  to  deduct  the  payments  made  to  the  general  partner  for 
the  services  he  rendered  in  connection  with  the  syndication  and  orga- 
nization of  the  limited  partnership.  However,  in  recently  issued  Rev. 
Rul.  75-214  (1975-1  C.B.  185),  the  Internal  Revenue  Service  ruled 
that  payments  made  by  a  partnership  to  a  general  partner  to  reim- 
burse^ him  for  costs  of  "organizing  the  partnership  and  for  selling  the 
limited  partnership  interests  were  not  automatically  deductible  by 
virtue  of  section  707(c),  but  rather  were  capital  expenditures  under 
section  263.  The  ruling  stated  that:  "For  purposes  of  either  section 
707(a)  or  section  707(c)  of  the  Code,  payments  to  partners  for  serv- 
ices on  behalf  of  the  partnership  may  be  deducted  by  the  partnership 
only  if  such  payments  would  otherwise  be  deductible  (under  section 
162)  if  they  had  been  made  to  persons  who  are  not  members  of  the 
partnership." 

Similarly,  the  Tax  Court,  in  Jaclcson  E.  Cagle.  Jr.,  63  T.C.  86  ( 1974) 
a.fd,  539  F.  2d  409  (5th  Cir.  1976),  disallowed  deductions  for  part- 
ners' shares  of  payments  made  by  a  partnership  to  another  partner  for 
services  rendered  in  conducting  a  feasibility  study  of  a  proposed  oifice- 
showroom  facility,  obtaining  financing:,  and  developing  a  building  for 
the  partnership.  In  this  decision,  the  Tax  Court  expressly  rejected  the 
contention  that  Congress,  in  enacting  section  707(c),  had  intended 
to  make  guaranteed  payments  to  partners  automatically  deductible  to 
the  partnership  without  regard  to  sections  162(a)  and  263. 

Reasons  for  change 
The  correct  interpretation  of  section  707(c)  is  the  interpretation 
given  that  subsection  by  the  Internal  Revenue  Service  and  the  Tax 


90 

Court,  as  discussed  above.  However,  despite  this  court  decision 
and  Revenue  Ruling,  prior  law  was  not  entirely  clear  that,  to  be  de- 
ductible, guaranteed  payments  must  meet  the  same  tests  under  section 
162(a)  as  if  the  payments  had  been  made  to  a  person  who  is  not  a 
member  of  the  partnership.  A  contrary  conclusion  would  allow  part- 
nerships to  treat  capital  expenditures  as  current  deductions,  while  a 
corporation  incurring  these  expenditures  would  not  be  entitled  to  simi- 
lar treatment. 

While  section  263  requires  these  expenditures  of  a  corporation  to 
be  capitalized,  section  248  allows  the  corporation  to  elect  to  amortize 
the  organizational  expenditures  (as  opposed  to  syndication-type  ex- 
penditures) over  a  period  of  not  less  than  60  months.  Under  the  regula- 
tions, the  costs  incurred  by  a  corporation  in  marketing  and  issuing  its 
stock  are  capital  expenditures  under  section  263,  but  are  not  subject 
to  the  60-month  amortization  provisions  of  section  248.  (Regs. 
§  1.248-1  (b)  (3)  (i)i 

Explanation  of  provisions 

The  Act  adds  a  new  provision  (sec.  709)  which  provides  that,  sub- 
ject to  the  special  amortization  provision  described  below,  no  deduc- 
tion shall  be  allowed  to  a  partnership  or  to  any  partner  for  any 
amounts  paid  or  incurred  to  organize  a  partnership  or  to  promote  the 
sale  (or  to  sell)  an  interest  in  the  partnership.  The  Act  also  amends 
section  707(c)  to  make  it  clear  that,  in  determining  whether  a  guar- 
anteed payment  is  deductible  by  the  partnership,  it  must  meet  the  same 
tests  under  section  162  (a) ,  as  if  the  payment  had  been  made  to  a  person 
who  is  not  a  member  of  the  partnership,  and  the  normal  rules  of  sec- 
tion 263  (relating  to  capital  expenditures)  must  betaken  into  account.^ 

The  Act  provides  that  a  partnership  may  elect  to  deduct  ratably, 
over  a  period  of  not  less  than  60  months,  amounts  paid  or  incurred 
in  organizing  the  partnership.^  The  organizational  expenses  subject 
to  the  60-month  amortization  provision  are  defined  as  those  expendi- 
tures which  are  incident  to  the  creation  of  the  partnership,  chargeable 
to  the  capital  account,  and  of  a  character  which,  if  expended  in  con- 
nection with  the  creation  of  a  partnership  having  an  ascertainable  life, 
would  be  amortized  over  that  period  of  time. 

The  capitalized  syndication  fees,  i.e.,  the  expenditures  connected 
with  the  issuing  and  marketing  of  interests  in  the  partnership,  such  as 
commissions,  professional  fees,  and  printing  costs,  are  not  to  be  sub- 
ject to  the  special  60-month  amortization  provision. 

E-ffective  date 
The  provisions  relating  to  guaranteed  payments  and  the  capitaliza- 
tion of  partnership  syndication  and  organization  fees  apply  to  taxable 
years  beginning  after  December  31,  1975.  The  provision  pertaining  to 
the  amortization  of  organization  fees  applies  to  amounts  paid  or  in- 

'  For  cases  supportlne:  this  position,  see  Davis  v.  Cotnmiaaioner,  151  F.  2d  441  (8th  Clr. 
1945),  cert,  den.,  327  U.S.  783;  United  Carlton  Company.  ^'1  B.T.A.  1000   (1935). 

"The  Act  is  not  Intended  to  adversely  affect  the  deductibility  to  the  partnership  of  a 
payment  described  in  section  736(a)(2)  to  a  retiring  partner  or  to  a  deceased  partner's 
successor  in  Interest. 

'  If  the  partnership  were  liquidated  before  the  end  of  the  60-month  period,  the  remaining 
organizational  expenses  would  be  deductible  to  the  extent  provided  under  the  provision 
relating  to  lo.sses  (sec.  165). 


91 

curred  in  partnership  taxable  years  beginning  after  December  31, 
1976. 

Revenue  effect 
The  revenue  impact  of  these  provisions  is  included  in  the  estimate 
under  a  above. 

c.  Retroactive  Allocations  of  Partnership  Income  or  Loss  (sec. 
213(c)  of  the  bill  and  sees.  704(a)  and  706(c)  of  the  Code) 

Prior  I'T'n 
Investments  in  tax  shelter  limited  partnerships  have  commonh^  been 
made  toward  the  end  of  the  taxable  year.  It  has  also  been  common  for 
the  limited  partnership  to  have  been  formed  earlier  in  the  year  on  a 
skeletal  basis  with  one  general  partner  and  a  so-called  "dummy" 
limited  partner.  In  many  cases,  the  limited  partnerships  incurs  sub- 
stantial deductible  expenses  prior  to  the  year-end  entiy  of  the  limited 
partner-investoi-s. 

In  these  cases,  a  full  share  of  the  partnership  losses  for  the  entire 
year  had  usually  been  allocated  to  those  limited  partners  joining  at  the 
close  of  the  year.  These  are  referred  to  as  "retroactive  allocations." 
For  example,  in  the  case  of  a  limited  partnership  owning  an  apart- 
ment house  which  had  been  under  construction  for  a  substantial  part 
of  the  year,  where  construction  interest  and  certain  deductible  taxes 
had  been  paid  during  that  time,  such  deductions  might  have  been  retro- 
actively allocated  to  investors  entering  the  partnership  on,  say,  Decem- 
ber 28th  of  that  year. 

Prior  law  was  not  clear  whether  retroactive  allocations  were  per- 
missible under  the  Code.*  Essentially,  there  are  four  partnership  Code 
provisions  which  had  a  direct  or  indirect  bearing  on  this  issue — sections 
704(a),  761  (c),  704(b)  (2)  and  706(c)  (2)  (B). 

Section  704(a)  of  prior  law  provided,  in  effect,  that  except  as  other- 
wise provided  in  section  704,  the  partnership  agreement  would  govern 
the  manner  of  allocation  of  "income,  gain,  loss,  deduction,  or  credit." 
With  respect  to  a  particular  taxable  year,  section  761(c)  of  present 
law  treats  a  partnership  agreement  as  consisting  of  any  amendment 
made  up  to  and  including  the  time  for  which  the  partnership's  tax 
return  must  be  filed  for  such  year.  It  was  argued  that  sections  704(a) 
and  761(c),  particularly  when  read  together,  allowed  retroactive  al- 
locations. On  the  other" hand,  it  was  argued  that  sections  704(b)  (2) 
and/or  706(c)  (2)  (B)  of  prior  law,  discussed  below,  prohibited  some 
or  all  retroactive  allocations. 

Section  704(b)  (2)  prohibited  the  allocation  of  items  of  income,  de- 
duction, loss  or  credit  (such  as  capital  gains  and  depreciation)  where 
the  principal  purpose  of  the  allocation  was  the  avoidance  or  evasion  of 
tax.  This  pi'ovision,  it  was  argued,  prohibited  any  retroactive  alloca- 
tion having  tax  avoidance  as  its  principal  purpose.  The  counter-argu- 
ment to  this  claim  was  that  section  704(b)  (2)  was  inapplicable  to  re- 
troactive allocations  of  taxable  income  and  loss,  since,  by  its  own  terms, 


*Two  primary  cases  dealing  with  thp  issue  of  retroactive  allocations  are  Smiih  v.  Com- 
mif,f<ioner.  331  F.  2d  29,S  {7th  Clr.  1964).  and  Rodman  v.  Commissioner,  --F^  2d  —  (2d 
rir.  1076)  [CPH  U.S.  Tax  Cases.  H  No.  9710],  reversing  and  remanding  32  T.C.M.  JiOl 
(1973). 


92 

it  only  pertained  to  allocations  of  particular  iteTns  of  income,  deduc- 
tion, loss,  or  credit.^ 

Section  706(c)  (2)  (B)  provides  that  where  a  partner  disposes  of  less 
than  his  entire  interest  in  a  partnership,  Or  his  interest  is  reduced,  the 
partnership  taxable  year  does  not  close  as  to  such  partner,  but  that  his 
distributive  share  of  partnership  income  and  loss  is  determined  '^by 
taking  into  account  his  varying  interests  in  the  partnership  during  the 
taxable  year."  Wliile  not  specifically  stated  in  this  provision  or  the 
relevant  regulations  (Regs.  §  1.706-1  (c)  (4)),  it  is  implicit  that  the 
transferee  of  less  than  the  entire  interest  of  a  transferor-partner  would 
necessarily  be  subject  to  the  same  rule,  i.e.,  his  distributive  share  of 
partnership  income  and  loss  would  be  determined  by  taking  into  ac- 
count his  varying  interests  in  the  partnership  during  the  taxable  year. 
For  example,  if,  on  July  1,  a  person,  who  was  not  previously  a  partner, 
were  to  acquire  from  an  existing  partner  a  25  percent  interest  in  a  cal- 
endar year  reporting  partnership,  which  had  a  loss  for  the  year  of 
$1,000,  then,  by  taking  into  account  his  varying  interests  of  zero  during 
the  first  half  of  the  year  and  25  percent  during  the  second  half,  $125 
of  the  loss  would  be  allocable  to  the  transferee-partner  under  section 
706(c)(2)(B). 

As  previously  stated,  section  706(c)  (2)  (B)  also  applies  where  the 
interest  of  a  partner  is  reduced.  Under  prior  law,  it  was  unclear 
whether  this  provision  pertained  to  the  situation  where  a  partner's 
proportionate  interest  in  the  partnership  was  reduced  as  the  result  of 
the  purchase  of  an  interest  directly  from  the  partnership.  Conse- 
quently, it  was  unclear  whether  an  incoming  partner,  who  purchased 
his  interest  directly  from  the  partnership,  would  be  subject  to  the  rule 
of  including  partnership  income  and  loss  according  to  his  varying 
interests  during  the  year.  Some  argued  that  the  varying  interests  rule 
of  section  706(c)  (2)  (B)  was  inapplicable  to  this  situation. 

It  was  further  argued  that,  even  if  section  706(c)  (2)  (B)  imposed 
the  varying  interests  rule  in  the  above  situation,  a  timely  amendment 
to  the  partnership  agreement  providing  for  a  retroactive  allocation  of 
the  entire  year's  losses  would,  pursuant  to  sections  704(a)  and  761(c), 
override  this  provision. 

Section  706(c)  (2(A)  of  present  law  provides  that  where  a  partner 
retires  or  sells  his  entire  interest  in  a  partnership,  the  taxable  year  of 
the  partnership  will  close  and  the  partner's  distributive  share  of  vari- 
ous income  and  deduction  items  will  be  determined  under  the  income 
tax  regulations.  Essentially,  the  regulations  (Regs.  §  1.706-1  (c)  (2) 
(ii) )  provide  the  alternatives  of  either  an  interim  closing  of  the  part- 
nership books  or  the  determination  of  a  partner's  distributive  share 
of  income  and  deductions  by  a  proration  of  such  items  for  the  taxable 
year,  the  proration  being  based  either  upon  the  portion  of  the  taxable 

5  The  main  case  dealing;  with  the  Interpretation  of  section  704(b)(2)  with  respect  to 
this  Issue  Is  Jean  V.  Kresser,  54  T.C.  Ifi21  (1970).  In  Kresser,  the  retroactive  allocation 
involved  was  disallowed  upon  the  court's  flndinjjs  that  the  partnership  agreement  was 
not  amended  to  provide  for  the  allocation  and  the  allocation  of  Income  was,  in  fact, 
nothing  more  than  a  paper  transaction  lacking  in  economic  substance.  One  of  the  argu- 
ments of  the  Government  was  that  section  704(b)  (2)  precluded  the  retroactive  allocation. 
The  court  dealt  with  this  contention  in  a  footnote  (supra,  at  p.  1631).  which  indicated 
support  for  the  interpretation  of  section  704(b)  (2)  as  applying  only  to  allocations  of  par- 
ticular items  of  income,  deductions,  or  credit,  and  not  to  allocations  of  the  composite  of  the 
partnership's  income  or  loss.  However,  because  of  the  court's  initial  findings  (i.e.,  the 
absence  of  both  an  amendment  to  the  partnership  agreement  and  a  bona  fide  reallocation 
of  Income),  it  did  not  resolve  this  Issue. 


93 

year  that  had  elapsed  prior  to  the  sale  or  retirement  or  under  any 
other  method  that  is  reasonable.  These  alternative  methods  of  com- 
putation were  not  specifically  provided,  however,  with  respect  to  the 
sale  or  exchange  of,  or  a  reduction  in,  a  partnership  interest  under  sec- 
tion 706(c)  (2)  (B).  As  previously  mentioned,  in  cases  to  which  sec- 
tion 706 (c)  (2)  (B)  applied,  the  only  guidance  provided  was  that  in- 
come and  loss  allocations  should  take  into  account  a  partner's  "vary- 
ing: interests  in  tlie  partnership  during  the  taxable  year." 

Reasons  for  change 

Under  prior  law,  it  was  unclear  whether  section  706(c)  (2)  (B)  re- 
quired the  inclusion  of  income  and  loss  according  to  a  partners  varying 
interests  during  the  year  where  the  partner's  interest  was  acquired  di- 
rectly from  the  partnershi]).  Even  if  section  706(c)(2)(B)  imposed 
the  varying  interests  rule  in  this  situation,  there  was  the  further  am- 
biguity whether  a  retroactive  allocation  provided  in  a  partnership 
agreement  would,  under  the  authority  of  sections  704(a)  and  761(c), 
override  any  allocation  provided  under  section  706(c)  (2)  (B).  More- 
over, even  if  it  were  established  that  section  706(c)  (2)  (B)  was  not 
overridden  by  a  retroactive  allocation  pursuant  to  sections  704(a)  and 
761(c),  no  clear  method  was  provided  in  the  Code  or  regulations  for 
taking  into  account  the  varying  intei-ests  of  the  partners  during  the 
partnership  year. 

In  essence,  the  consequence  of  allowing  retroactive  allocations  was 
that  new  partners  investing  in  the  partnership  toward  the  close  of 
the  taxable  year  were  allowed  to  deduct  expenses  which  were  incurred 
prior  to  their  entry  into  the  paitnership.  Some  argued  that  these  retro- 
active allocations  were  proper  because  the  funds  invested  by  the  new 
partners  served  to  reimburse  the  origiiuil  partners  for  their  expendi- 
tures and  that,  as  an  economic  matter,  the  new  partners  had  incurred 
the  costs  for  which  they  were  claiming  deductions.  However,  this  argu- 
ment loses  its  persuasiveness  when  the  new  partner  in  a  partner- 
ship situation  is  compared  to  that  of  an  investor  who  directly  pur- 
chases property  which  had  previously  generated  tax  losses  during  the 
taxable  year.  It  is  clear  that  in  the  latter  case  the  investor  would  not 
be  entitled  to  deduct  the  losses  incurred  prior  to  his  ownership  of  the 
property,  notwithstanding  the  fact  that  he,  in  effect,  may  be  reim- 
bursing the  seller  of  the  property  for  losses  already  incurred. 

In  order  to  deal  with  the  problem  of  retroactive  allocations  and 
clarify  the  treatment  of  a  partner's  interest  where  the  partner  ac- 
quired the  interest  directly  from  the  partnership,  the  Act  specifically 
provides  that  the  present  varying  interests  rule  is  to  apply  to  a  part- 
ner's interest  acquired  directly  from  the  partnership. 

Explanation  of  provision 
The  Act  amends  section  706(c)(2)(B)  to  make  it  clear  that  the 
varying  interests  rule  of  this  provision  is  to  apply  to  any  partner 
whose  interest  in  a  partnership  is  reduced,  whether  by  entry  of  a  new 
partner  who  purchased  his  interest  directly  from  the  partnership,  par- 
tial liquidation  of  a  partner's  interest,  gift,  or  otherwise.  Correspond- 
ingly, the  provision  is  to  apply  to  the  incoming  partner  so  as  to  take 
into  accoimt  his  varj'ing  interests  during  the  year.  In  addition,  regu- 
lations are  to  apply  the  same  alternative  methods  of  computing  al- 


d4 

locations  of  income  and  loss  to  situations  falling  under  section  706(c) 
(2)(B)  as  those  now  applicable  to  section  706(c)(2)(A)  situations 
(sale  or  liquidation  of  an  entire  interest).  As  under  section  706(c) 
(2)  (A),  these  rules  will  permit  a  partnership  to  choose  (1)  the  easier 
method  of  prorating  items  either  according  to  the  portion  of  the 
year  for  which  a  partner  was  a  partner  or  under  any  other  method 
that  is  reasonable  or  (2)  an  interim  closing  of  books  (as  if  the  year 
had  closed).  However,  any  proration  or  interim  closing  of  the  books 
under  section  706(c)  (2)  (B),  unlike  that  under  section  706(c)  (2)  (A), 
would  not  result  in  the  actual  closing  of  the  partnership  taxable  year. 

The  interim  closing  of  the  books  or  proration  is  to  relate  to  the  time 
of  the  reduction  (and  corresponding  increase)  in  partnership  interest. 
To  alleviate  the  undue  accounting  complexity  that  may  result  with 
respect  to  reductions  in  interest  occurring  over  several  days  in  the 
same  month,  the  regulations  may  provide,  for  example,  that  the  in- 
terim closing  of  the  books  could  relate  to  the  fifteenth  and  last  day 
of  each  month.  Thus,  an  interim  closing  of  the  books  as  of  the  close 
of  December  15th  would  be  suflficient,  for  example,  with  respect  to 
new  partners  entering  on  the  16th,  19th,  20th,  and  21st  of  December. 

In  addition,  section  704(a)  (relating  to  the  effect  of  a  partnei*ship 
agreement)  is  amended  to  provide  that  it  is  overridden  by  any  con- 
trary income  tax  provisions  of  the  Code.  Thus,  a  partnership  agree- 
ment, amended  (pursuant  to  section  761(c) )  to  provide  for  a  retroac- 
tive allocation,  will  not  override  an  allocation  required  under  section 
706(c)(2)(B). 

Ejfective  date 
These  provisions  are  effective  for  partnership  taxable  yeai-s  that 
begin  after  December  31,  1975.  The  Congress  does  not  intend  that 
any  inference  be  drawn  as  to  the  propriety  or  impropriety  of  a  retro- 
active allocation  under  prior  law. 

Revenue  effect 

The  revenue  impact  of  this  provision  is  included  in  the  revenue 
estimate  under  a  above. 

d.  Partnership  Special  Allocations  (sec.  213(d)  of  the  Act  and 
sec.  704(b)  of  the  Code) 

PHor  law 

A  limited  (or  a  general)  partnership  agreement  mav  allocate  in- 
come, gain,  loss,  deduction,  or  credit  (or  items  thereof)  among  the 
partners  in  a  manner  that  is  disproportionate  to  the  capital  contribu- 
tions of  the  partners.  These  are  sometimes  referred  to  as  "special 
allocations"  and,  with  respect  to  any  taxable  year,  may  be  made  by 
amendment  to  the  partnership  agreement  at  any  time  up  to  the  initial 
due  date  of  the  partnership  tax  return  for  that  vear  (sec.  761  (c) ) . 

A  special  allocation  was  not  recognized  under  prior  law  (sec.  704 
(b)  (2) )  if  its  principal  purpose  was  to  avoid  or  evade  a  Federal  tax. 
In  determining  whether  a  special  allocation  had  been  made  princi- 
pally for  the  avoidance  of  tax,  the  regulations  focused  upon  whether 
the  special  allocation  had  "substantial  economic  effect,"  that  is, 
whether  the  allocation  may  actually  affect  the  dollar  amount  of  the 


95 

partner's  share  of  the  total  partnership  income  or  loss  independently 
of  tax  consequences  (Regs.  §  1.704-1  (b)  (2)).  The  reflations  also 
inquired  as  to  whether  there  was  a  business  purpose  for  this  special 
allocation,  whether  related  items  from  the  same  source  were  subject  to 
the  same  alloccition,  whether  the  allocation  ignored  normal  business 
factors  and  was  made  after  the  amount  of  the  specially  allocated  item 
could  reasonably  be  estimated,  the  duration  of  the  allocation,  and  the 
overall  tax  consequences  of  the  allocation. 

By  its  terms,  the  tax  avoidance  provisions  of  prior  law  section  704 
(b)  (2)  applied  to  allocations  of  ite7-m  of  income,  gain,  loss,  deduction, 
or  credit.  It  was  thus  argued  that  these  provisions  did  not  apply  to  and 
would  not  preclude  allwations  of  taxable  income  or  loss,  as  opposed  to 
specific  items  of  income,  gain,  deduction,  loss,  or  credit. 

The  main  case  dealing  with  the  interpretation  of  section  704(b)  (2) 
with  respect  to  this  issue  is  Jean  V.  Kressei\  54  T.C.  1621  (1970).  In 
Kresser,  a  purported  allocation  of  all  a  partnership's  taxable  income 
for  one  taxable  year  to  one  partner  who  had  a  net  operating  loss  cari-y- 
forward  expiring  in  that  year  was  disallowed  upon  the  court's  findings 
that  the  partnei-ship  agreement  was  not  amended  to  provide  for  the 
allocation  and  the  allocation  of  income  was,  in  fact,  nothing  more  than 
a  paper  transaction  lacking  in  economic  substance.  One  of  the  argu- 
ments of  the  Government  was  that  section  704(b)  (2)  precluded  the 
allocation.  The  court  dealt  with  this  contention  in  a  footnote  {supra,  at 
p.  1631),  which  indicated  support  for  the  interpretation  of  section  704 
(b)  (2)  as  applying  only  to  allocations  of  particular  items  of  income, 
deduction,  or  credit,  and  not  to  allocations  of  the  composite  of  the  part- 
nership's income  or  loss.  However,  because  of  the  court's  initial  find- 
ings (i.e.,  the  absence  of  both  an  amendment  to  the  partnership  agree- 
ment and  a  bona  fide  reallocation  of  income),  it  did  not  resolve  this 
issue. 

Reasons  for  change 

Congress  believed  that  an  overall  allocation  of  the  taxable  income 
or  loss  for  a  taxable  year  (described  under  section  702(a)  (9) )  should 
be  subject  to  disallowance  in  the  same  manner  as  allocations  of  items 
of  income  or  loss. 

Also,  allocations  of  special  items  and  overall  allocations  should  be 
restricted  to  those  situations  where  the  allocations  have  substantial  eco- 
nomic effect. 

ExplaThation  of  provisions 
The  Act  provides  that  an  allocation  of  overall  income  or  loss  (de- 
scribed under  section  702 (a)  (9) ) ,  or  of  any  item  of  income,  gain,  loss, 
deduction,  or  credit  (described  under  section  702(a)  (l)-(8)),  shall 
be  controlled  by  the  partnership  agreement  if  the  partner  receiving  the 
allocation  can  demonstrate  that  it  has  "substantial  economic  effect", 
i.e.,  whether  the  allocation  may  actually  affect  the  dollar  amount  of 
the  partners'  share  of  the  total  partnership  income  or  loss,  independ- 
ent of  tax  consequences."  Other  factors  that  could  possibly  relate  to 


*  The  determination  of  whether  an  allocation  may  actually  aflfect  the  dollar  amount  of 
the  partners'  shares  of  total  partnership  Income  or  loss,  independent  of  tax  consequences, 
will  to  a  substantial  extent  involve  an  examination  of  how  these  allocations  are  treated 
in  the  partners'  capital  accounts  for  financial  (as  opposed  to  tax)  accounting  purposes  ; 
this  assumes  that  these  accounts  actually  reflect  the  dollar  amounts  that  the  partners 
would  have  the  rights  to  receive  upon  the  liquidation  of  the  partnership. 


96 

the  determination  of  the  validity  of  an  allocation  are  set  forth  under 
the  present  regulations  (Regs.  §  1.704r-l(b)  (2) ). 

If  an  allocation  made  by  the  partnership  is  set  aside,  a  partner's 
share  of  the  income,  gain,  loss,  deduction  or  credit  (or  item  thereof) 
will  be  determined  in  accordance  with  his  interevSt  in  the  partnership. 

In  determining  a  "partner's  interest  in  the  partnership",  all  the 
relevant  facts  and  circumstances  are  to  be  taken  into  account.  Among 
the  relevant  factors  to  be  taken  into  account  are  the  interest  of  the 
respective  partners  in  profits  and  losses  (if  different  from  that  in 
taxable  income  or  loss),  cash  flow,  and  their  rights  to  distributions  of 
capital  upon  liquidation. 

Effective  date 
The  provision  applies  to  partnership  taxable  years  beginning  after 
December  31,  1975.  No  inference  is  to  be  drawn  as  to  the  propriety  or 
impropriety  of  a  special  allocation  under  prior  law. 

Revenue  e-ffect 

The  revenue  impact  of  this  provision  is  included  in  the  revenue 
estimate  under  a  above. 

e.  Treatment  of  Partnership  Liabilities  Where  a  Partner  Is  Not 
Personally  Liable  (sec.  213(e)  of  the  Act  and  sec.  704(d)  of 
the  Code) 

Prior  law 
Under  both  prior  and  present  law,  a  partner  may  deduct  his  distribu- 
tive share  of  all  the  deductible  items  of  the  partnership,  but  not  more 
than  the  amount  of  the  adjusted  basis  of  his  interest  in  the  partner- 
ship (sec.  704(d)).  Under  the  income  tax  regulations,  a  partner's 
adjusted  basis  in  his  partnership  interest  is  increased  by  a  portion 
of  any  partnership  liability  with  respect  to  which  there  is  no  per- 
sonal liability  on  the  part  of  any  of  the  partners  (Treas.  Reg.  §  1.752- 
1(e)). 

Reasons  for  change 
Under  prior  law,  a  partner  was  allowed  to  substantially  increase 
the  adjusted  basis  in  his  partnership  interest,  and  thus  the  amount  of 
partnership  losses  he  could  deduct,  by  a  portion  of  the  partnership 
liabilities  with  respect  to  which  he  had  no  personal  liability.  This  rule 
enabled  partners  to  deduct  amounts  for  tax  purposes  exceeding  the 
amount  of  investment  that  they  had  economically  at  risk  in  the 
partnership. 

Explarvation  of  provision 

The  Act  amends  section  704(d)  by  providing  that,  for  purposes  of 
fhe  limitation  on  allowance  of  partnership  losses,  the  adjusted  basis  of 
a  partner's  interest  will  not  include  any  portion  of  any  partnership 
liability  with  respect  to  which  the  partner  has  no  personal  liability. 

It  is  intended  that  in  determining  whether  a  partner  has  personal 
liability  with  respect  to  any  partnership  liability,  rules  similar  to  the 
rules  of  section  465  (relating  to  the  limitation  on  deductions  to 
amounts  at  risk  in  case  of  certain  activities)  will  apply.  Thus,  for 
example,  guarantees  and  similar  arrangements  may  be  taken  into 
account  in  determining  whether  there  is  personal  liability. 


97 

This  provision  will  not  apply  to  the  extent  that  a  partnership 
activity  is  subject  to  the  provisions  of  section  465  (relating  to  the 
limitation  on  deductions  to  amounts  at  risk  in  case  of  certain  activ- 
ities) nor  will  it  apply  to  any  partnership  the  principal  activities  of 
which  involve  real  property  (other  than  mineral  property).^ 

This  provision  will  not  apply  to  a  corporate  partner  (other  than  a 
subchapter  S  corporation  or  a  personal  holding  company)  with  respect 
to  liabilities  incurred  in  an  activity  to  the  extent  that  the  activity  is 
subject  to  the  provisions  of  section  465.  Thus,  if  two  corporations  form 
a  partnership  for  an  equipment  leasing  activity,  this  provision  will 
not  apply;  but,  if  in  addition  to  equipment  leasing,  the  partnership 
invents  in  an  activity  not  specified  under  section  465  and  which  does 
not  involve  real  property  (other  than  mineral  property),  then  this 
provision  will  apply  to  the  extent  of  liabilities  incurred  wtih  respect 
to  that  other  activity. 

It  is  contemplated  that  this  provision  and  the  specific  at-risk  rules 
of  section  465  could  apply  to  a  partnership  carrying  on  more  tJhan  one 
activity.  For  example,  a  partnership  involved  in  equipment  leasdng 
to  which  the  'at-risk  provisions  of  section  465  would  apply,  may  also 
be  indebted  on  a  nonrecourse  basis  with  respect  to  activities  which 
are  mirelated  to  the  equipment  leasing  ac'ti\^ty  of  the  partnership. 
In  this  instance,  separate  computations  for  purposes  of  allowance 
of  losses  would  have  to  be  made  under  both  sections  465  and  704(d). 

Also,  for  example,  if  a  partnership  engages  in  the  raising  of  trees, 
some  of  which  bear  fruit  and  nuts,  this  provision  will  not  apply  to 
the  extent  that  the  tree-raising  activity  is  subject  to  the  provisions  of 
section  465. 

Effect'we  date 
This  provision  applies  to  liabilities  incurred  after  December  31, 
1976. 

Revenue  ejfect 

The  revenue  impact  of  this  provision  is  included  in  the  revenue 
estimate  under  a.  above. 

9.  Interest 

a.  Treatment  of  Prepaid  Interest  (sec.  208  of  the  act  and  sec.  461(g) 
of  the  Code) ) 

Prior  l^aw 
A  taxpayer  may  generally  claim  deductions  in  the  year  which  is 
proper  under  the  method  of  accounting  which  he  uses  in  computing 
his  taxable  income  (sec.  461).  Under  prior  law,  a  taxpayer  using 
the  cash  receipts  and  disbursements  method  of  accounting  has  gen- 
erally been  able  to  claim  a  deduction  for  interest  paid  within  his 
taxable  year  (sec.  163(a)).  However,  if  the  taxpayer's  method  of 
accounting  does  not  clearly   reflect  income,  the   Internal   Revenue 

■^  Generally,  the  principal  activities  of  a  partnership  would  Involve  real  property  if 
substantially  all  of  its  activities  involve  the  holding  of  real  property  for  sale,  for  invest- 
ment, or  for  deriving  rental-type  Income.  The  holding  of  real  property  for  sale,  for  Invest- 
ment, or  for  deriving  rental-type  income  would  include  the  investment  in  a  partnership  or 
joint  venture  where  substantially  all  of  the  activities  of  the  partnership  or  joint  venture 
involve  the  holding  of  real  property  for  sale,  for  investment,  or  for  deriving  rental-type 
Income. 


98 

Service  may  recompute  the  income  using  the  method  which  the 
Service  believes  clearly  reflects  income  (sec.  446(b)).  The  income 
tax  regulations  also  provide  that,  even  under  the  cash  method  of 
accounting,  an  expense  which  results  in  the  creation  of  an  asset  hav- 
ing a  useful  life  which  extends  substantially  beyond  the  close  of  the 
taxable  year  may  be  deducted  only  in  part  in  the  year  in  which  pay- 
ment is  made. 

No  specific  statutory  provision  has  expressly  permitted  prepaid 
interest  to  be  deducted  in  full  when  paid  by  a  cash  method  taxpayer. 
The  authority  for  deducting  prepaid  interest  rested  on  court  cases 
and  on  administrative  rulings  by  the  Service.  Until  the  late  1960's, 
tax-oriented  investors  were  able  to  prepay  as  much  as  five  years' 
interest  with  apparent  approval  by  the  courts  and  the  Service. 

In  1968,  however,  the  Service  published  a  revenue  ruling  holding 
that  an  interest  prepayment  by  a  cash-basis  taxpayer  for  a  period  ex- 
tending for  more  than  12  months  beyond  the  end  of  the  current  tax- 
able year  would  be  deemed  to  create  a  material  distortion  of  income. 
In  such  a  case  the  interest  would  be  allocated  over  the  taxable  years 
involved.  Deductions  for  interest  paid  in  advance  for  a  period  not  in 
excess  of  12  months  after  the  last  day  of  the  taxable  year  of  payment 
wei'e  considered  on  a  case-by-case  basis  to  determine  whether  a 
material  distortion  of  income  resulted.^  Recent  Tax  Court  cases 
have  disallowed  prepaid  interest  deductions  of  taxpayers  in  situations 
where  the  Internal  Revenue  Service  has  relied  on  this  ruling  as 
authority  to  disallow  the  deduction.  The  Tax  Court  has  indicated, 
however,  that  under  prior  law  it  might  not  be  willing  to  disallow  pre- 
paid interest  in  all  cases  where  the  prepayment  relates  to  periods 
extending  more  than  12  months  beyond  the  end  of  the  current  taxable 
year. 

The  tax  treatment  of  a  loan  re^juiring  prepaid  interest  or  points  has 
contrasted  with  the  tax  treatment  of  a  discount  loan  under  present  law, 
although  in  many  situations  the  economic  substance  of  both  transac- 
tions is  similar.  In  a  discount  loan,  the  lender  delivers  to  tlie  borrower 
an  amount  which  is  smaller  than  the  face  amomit  of  the  loan.  The  dif- 
ference between  the  fac«  amount  and  the  amount  delivered  to  the 
borrower  is  the  charge  for  his  use  of  the  borrowed  funds.  Under  prior 
law,  a  borrower  on  the  cash  method  could  not  deduct  the  entire  interest 
element  in  the  year  in  which  he  received  the  loan  proceeds.  He  could 
deduct  the  interest  element  only  when  and  as  he  actually  repaid  the 
face  amount  of  the  loan.' 

Reasons  for  change 
Prepaid  interest  has  been  extensively  used  in  many  types  of  tax 
shelters  to  defer  tax  on  income  which  would  otherwise  be  taxable  in 
higlier  marginal  tax  brackets.  The  deduction  for  prepaid  interest  has 
become  highly  important  to  investors  seeking  year-end  tax  losses 
who  acquire  their  interests  in  a  property  (such  as  land,  an  apartment 
building,  cattle,  computers,  motion  pictures  and  the  like),  or  in  a 

1  The  ruling  (Rev.  Rul.  68-643.  1968-2  C.B.  76)  sets  forth  several  factors  which  may  be 
considered  in  determining'  whether  there  is  a  material  distortion  of  income  :  the  amount 
of  the  taxpayer's  income  in  the  taxable  year  of  payment ;  his  Income  in  previous  years ; 
the  amount  of  prepaid  interest :  the  time  of  payment ;  the  reason  for  the  prepayment ;  and 
the  presence  of  a  varying  rate  of  interest  over  the  term  of  the  loan. 

*  See  Rev.  Rul.  75-12,  1975-1  C.B.  62. 


99 

partnership  which  will  own  the  property,  toward  the  end  of  the  calen- 
dar year.  In  such  cases,  the  investors  may  not  have  been  able  to  operate 
the  property  long  enough  in  that  taxable  year  to  generate  either  in- 
come or  a  large  amount  of  ordinary  and  necessary  business  expenses: 
Therefore,  deductions  arising  from  prepaying  as  much  of  the  financing 
costs  as  possible  have  been  central  to  the  creation  of  year-end  tax 
losses.  If  the  investors  had  income  from  other  sources,  the  interest 
deductions  were  used  to  offset  this  other  income  (rather  than  off- 
setting income  from  the  property  itself,  which  would  be  realized  in  a 
later  year).  Prepaid  interest  thus  has  given  a  taxpayer  the  time  value 
of  deferring  taxes  on  his  other  sources  of  income.^ 

The  advantages  of  prepaying  interest  have  been  especially  attractive 
to  persons  who  have  unusually  high  income  in  a  particular  year  and 
who  are  in  a  higher  effective  tax  bracket  that  year  than  they  expect  to 
be  in  during  later  years. 

In  many  cases  a  deduction  for  prepaid  interest  was  generated  with- 
out adverse  cash  flow  consequences  by  borrowing  more  than  was 
needed  and  promptly  repaying  the  excess  as  "prepaid  interest."  * 

A  recent  technique  used  to  justify  larger  amounts  of  prepaid  in- 
terest within  the  Service's  present  guidelines  than  could  be  obtained 
under  conventional  financing  is  the  "wraparound''  mortgage  (some- 
times referred  to  as  an  all-inclusive  deed  of  trust).  Often,  a  farm, 
shopping  center  or  other  property  whicli  investors  are  purchasing 
is  encumbered  by  an  existing  first  mortgage.  In  a  situation  involving 
a  wraparound  mortgage,  the  investors  would  execute  to  the  seller  a 
new  purchase  money  obligation  whose  face  amomit  included  both  the 
unpaid  balance  of  the  first  mortgage  and  the  new  financing  supplied 
by  the  seller  (which  would  ordinarily  take  the  form  of  a  second 
mortgage).  The  buyere  would  agi-ee  to  pay  (and  to  prepay)  interest 
on  the  face  amount  of  the  "wraparound"  note,  while  the  seller  would 
agree  to  continue  paying  the  interest  on  the  first  mortgage  out  of 
the  interest  payments  which  he  would  receive  from  the  buyers.  Since  a 
wraparound  mortgage  usually  bears  a  higher  rate  of  interest  than  the 
first  mortgage  (and  in  some  cases  the  additional  prepaid  interest 
which  the  buyers  have  claimed  on  the  note  has  been  negotiated  as  a 
substitute  for  a  larger  downpayment),  this  type  of  arrangement  has 
been  widely  used  to  increase  the  amount  of  interest  which  could  be 
prepaid  in  the  initial  year  of  a  purchase  of  property  and  claimed  as  a 
deduction  for  one  year's  prepaid  interest  within  the  Service's 
guidelines.^ 


3  In  some  cases  the  investors  (or  their  partnership)  execute  a  purchase  money  mortgage 
note  to  the  person  who  is  selling  the  property  to  them.  Although  most  sellers  would  ordi- 
narily desire  to  receive  a  larger  purchase  price  (capital  gain)  and  less  interest  (ordinary 
income),  many  sellers  are  not  adversely  affected  by  receiving  ordinary  income.  Some  sellers 
may  have  expiring  loss  carryovers  to  absorb  the  interest  income.  Others  are  dealers  who 
would  realize  ordinary  income  on  the  sale  in  any  event ;  other  sellers  are  pension  funds, 
charities  or  other  tax-exempt  organizations. 

*  In  some  cases  an  interest  prepayment  reduces  the  taxpayer's  cash  flow  (net  of  tax 
savings).  However,  as  long  as  the  deduction  lowers  the  taxpayer's  eBfectlve  tax  rate  by 
more  than  the  market  rate  of  interest  which  he  could  earn  on  the  cash  he  invests,  the  tax- 
payer will  find  It  to  his  advantage  to  shelter  his  income  by  prepaying  interest.  (Generall.v, 
the  largest  reductions  in  effective  tax  rate  will  accrue  to  taxpayers  in  the  higher  mar- 
ginal tax  brackets.) 

5  The  seller  of  property  has  been  motivated  to  use  a  wraparound  mortgage  because  he 
is  relending  the  balance  of  the  first  mortgage  to  the  investor  at  a  higher  rate  of  interest 
than  he  pays  to  his  lender.  Thus,  the  amount  received  as  a  result  of  the  difference  between 
the  interest  rates  is  additional  profit  to  him. 

A  wraparound  mortgage  is  also  often  used  as  a  refinancing  device  by  an  owner  of  mort- 
gaged property  who  desires  to  receive  a  new  loan  from  a  third  party,  who  agrees  to  pay 
oflf  the  existing  lien  out  of  the  payments  which  he  receives  from  the  borrower. 


100 

Congress  believed  that  the  creation  of  a  tax  shelter  with  prepaid 
interest  could  not  be  justified  even  under  the  cash  method  of  ac- 
counting. The  policies  underlying  the  cash  method,  namely,  simplicity 
and  avoidance  of  complex  recordkeeping  or  computations,  do  not 
apply  to  prepaid  interest,  which  can  be  allocated  over  the  term  of  a 
loan. 

Under  prior  law  there  has  been  considerable  uncertainty  as  to  the 
deductibility  of  prepaid  interest.  Under  the  Tax  Court's  holdings,  the 
deductibility  of  prepaid  interest  depends  on  a  case-by-case  deter- 
mination. Even  under  the  Internal  Revenue  Service  position,  a  case- 
by-case  deteiTnination  must  be  made  in  all  c^ses  where  interest  is 
prepaid  for  a  period  which  does  not  extend  more  than  12  months 
beyond  the  taxable  year  in  which  the  prepayment  is  made.  Conse- 
quently, a  deduction  of  prepaid  interest  by  the  same  taxpayer  might 
have  been  allowed  in  one  year  and  perhaps  not  in  another  year.  Also, 
prepaid  interest  might  have  been  deductible  by  one  taxpayer  who  has 
a  large  amount  of  income  in  a  given  year  after  the  deduction  (so  that 
the  deduction  arguably  has  not  "distorted"  his  income)  but  possibly 
not  have  been  deductible  by  another  taxpayer  who  had  little  or  no  tax- 
able income  after  taking  the  deduction.  In  the  case  of  prepaid  interest, 
the  clear  reflection  of  income  test  should  focus  less  on  comparing  the 
interest  deduction  with  the  taxpayer's  general  income  stream  from 
year  to  year  than  on  matching  interest  and  other  costs  of  carrying  a 
particular  property  against  its  income  or  loss  over  the  term  of  the  loan, 

ExplanMion  of  provision 

The  Act  permits  a  cash  method  taxpayer  to  deduct  prepaid  interest 
no  earlier  than  in  the  taxable  year  in  which  (and  to  the  extent  that) 
the  interest  represents  a  charge  for  the  use  or  forbearance  of  borrowed 
money  during  that  period. 

Under  this  provision,  if  a  taxpayer  uses  the  cash  receipts  and  dis- 
bursements method  to  compute  his  taxable  income,  interest  which  he 
pays  and  which  is  properly  allocable  to  any  later  taxable  year  must 
be  charged  to  capital  account  and  treated  as  paid  by  him  in  the  periods 
in  which  (and  to  the  extent  that)  the  interest  represents  a  charge  for 
the  use  or  forbearance  of  borrowed  money  during  each  such  taxable 
year.  In  determining  whether  an  interest  prepayment  is  properly  al- 
locable to  one  or  more  taxable  years  after  the  year  of  payment,  the 
allocation  is  to  be  made  to  the  period  or  periods  in  which  the  interest 
represents  a  cost  of  using  the  borrowed  money  in  that  period,  re- 
gardless of  whether  allowing  prepaid  intere-vSt  to  be  deducted  when 
paid  would  materially  distort  the  taxpayer's  income  in  the  year  of 
payment  (or  the  income  of  a  partnership  of  which  the  taxpayer  may 
be  a  member) . 

This  rule  applies  to  all  types  of  taxpayers,  including  individuals, 
corporations,  estates  and  trusts  and  covers  interest  paid  for  personal, 
business  or  investment  purposes. 

The  new  statutory  rule  relates  to  interest  prepayments  by  a  cash 
method  taxpayer.  It  is  intended  to  conform  the  tax  deductibility  of 
prepaid  interest  by  cash  method  taxpayers  to  the  rule  which  Congress 


101 

understands  to  be  proper  under  prior  law  for  interest  prepayments  by 
an  accrual  method  taxpayer.** 

Once  prepaid  interest  has  been  allocated  to  the  proper  periods,  the 
interest  allocable  to  a  given  taxable  year  will  then  become  subject  to 
other  limitations.  For  example,  interest  allocated  to  a  taxable  year 
under  this  provision  of  the  Act  is  then  subject,  in  turn,  to  the  rules 
relating  to  the  capitalization  of  certain  construction  period  interest 
(sec.  189  of  the  Code,  added  in  sec.  201  of  this  Act),  the  limitations 
on  the  deductibility  of  investment  interest  (sec.  163(d),  as  amended 
by  sec.  209  of  this  Act),  and  to  the  limitation  on  activities  not  en- 
gaged in  for  profit  (sec.  183),  in  each  of  the  taxable  year  or  years 
in  which  interest  is  treated  as  paid  under  this  provision. 

In  adopting  the  new  rule.  Congress  does  not  intend  to  change 
prior  law  with  regard  to  defining  "interest." 

Congress  also  does  not  intend  to  prevent  the  Treasury  or  the  tax- 
payer from  continuing  to  be  entitled  to  recharacterize  a  purported 
"interest"  payraent  as  not  true  interest  in  the  circumstances.^  Con- 
versely, the  Treasury  will  have  full  authority  under  new  section 
461(g)  to  recharacterize  as  "interest"  a  payment  made  by  a  taxpayer 
and  labeled  otherwise  than  is  interest  on  a  loan.  Wliere  this  reclassify- 
ing is  appropriate,  it  may  also  be  appropriate  to  treat  the  payment 
as  being  a  prepayment  of  interest,  thereby  making  the  payment 
subject  to  section  461(g). 

In  certain  cases,  the  Treasury  is  authorized  to  treat  interest  pay- 
ments under  a  variable  interest  rate  as  consisting  partly  of  interest 
computed  under  an  average  level  effective  rate  of  interest  and  partly 
of  an  interest  prepayment  allocable  to  later  years  of  the  loan.^ 

The  Act  does  not  contemplate  that  interest  is  to  be  treated  as  paid 
in  level  payments  over  the  term  of  every  loan.  Thus,  interest  paid  as 
part  of  a  level  constant  payment  (including  principal  and  interest) 
is  not  to  be  subject  to  this  provision  merely  because  the  payments  con- 
sist of  a  larger  interest  portion  in  the  earlier  years  of  the  loan  than  in 
the  later  years. 

Prepaid  interest  on  an  indebtedness  secured  by  a  "wraparound  mort- 
gage" will  be  subject  to  the  general  rule  of  this  provision.^ 

Congress  does  not  intend  the  new  rule  to  change  the  treatment  of 
a  discount  loan  by  a  cash  method  taxpayer.  Nor  does  the  new  rule 
prevent  the  Treasury  from  treating  interest  as  paid  under  the  terms 
of  a  discount  loan  rather  than  as  prepaid  interest  under  a  conventional 
loan. 


•  An  accrual  method  taxpayer  can  deduct  prepaid  Interest  only  In  the  period  In  which 
the  use  of  money  occurs  and  only  to  the  extent  of  tht?  interest  cost  of  using  the  bor- 
rowed funds  during  that  period.  It  is  not  material  when  actual  payment  occurs,  nor  is 
the  existence  of  a  fixed  liability  to  make  a  prepayment  of  interest  sufficient  to  justify  a 
deduction.  Rev.  Rul.  68-643,  1968-2  C.B.  76. 

^  It  may  thus  be  appropriate  In  some  cases  to  treat  a  payment  denominated  "interest" 
as.  In  substance,  additional  purchase  price  of  property,  as  a  dividend,  as  payment  for  an 
option,  etc. 

'  Congress  does  not  intend,  however,  that  a  loan  calling  for  interest  at  a  stated 
rate  tied  to  the  "prime  rate"  necessarily  involves  prepaid  interest,  or  that  variations 
in  the  rate  of  interest  as  the  prime  rate  (or  some  other  objective  measurement)  varies 
necessarily  subjects  the  interest  payments  to  disallowance  under  this  provision. 

»  Since  the  provision  focuses  on  the  fact  of  prepayment  as  such,  it  is  immaterial  whether 
the  borrower  prepays  interest  (either  voluntarily  of  contractually^  to  a  third-party 
lender  under  the  first  mortgage  rather  than  to  the  seller  of  the  property.  In  appropriate 
cases,  however,  the  Congress  does  not  intend  to  prevent  the  Service  from  recharacterlziug 
part  or  all  6t  a  buyer's  (or  borrower's)  "interest"  payment  on  a  wraparound  mortgage 
as,  in  substance,  an  additional  down  payment  of  principal  or  as  a  nondeductible  deposit 
of  interest  with  a  third  party.   See  Rev.  Rul.   75-99,   1975-1    C.B.    197. 


234-120  O  -  77  -  i 


102 

Points  are  additional  interest  charges  which  are  usually  paid  when  a 
loan  is  closed  and  which  are  generally  imposed  by  the  lender  in  lieu 
of  a  higher  interest  rate.  Where  points  are  paid  as  compensation  for 
the  use  of  borrowed  money  (and  thus  qualify  as  interest  for  tax  pur- 
poses) rather  than  as  paj^ment  for  the  lender's  services,  the  points  are 
substituted  for  a  higher  stated  annual  interest  rate.  As  such,  points  are 
similar  to  a  prepayment  of  interest  and  under  the  Act  are  generally 
to  be  treated  as  paid  over  the  term  of  the  loan.  This  rule  also  applies 
to  charges  similar  to  points,  whether  called  a  loan-processing  fee  or 
a  premium  charge  (if  such  fee  or  charge  is  compensation  for  the  use 
of  borrowed  money) . 

The  Act  permits  points  paid  by  a  cash  method  taxpayer  on  an 
indebtedness  incurred  in  connection  with  the  purchase  or  improve- 
ment of  (and  secured  by)  his  principal  residence  to  be  treated  as 
paid  in  the  taxable  year  of  actual  payment.  A  loan  will  not  qualify 
under  this  exception,,  however,  if  the  loan  proceeds  are  used  for  pur- 
poses other  than  purchasing  or  improving  the  taxpayer's  principal 
residence,  or  if  loan  proceeds  secured  by  property  other  than  fiis 
principal  residence  are  used  to  purchase  or  improve  his  residence.  The 
exception  applies  only  to  points  on  a  home  mortgage,  and  not  to  other 
interest  costs  on  such  a  mortgage.  However,  in  order  to  qualify 
under  this  exception,  the  charging  of  points  nmst  reflect  an 
established  business  practice  in  the  geographical  area  where  the 
loan  is  made,  and  the  deduction  allowed  under  this  exception  may  not 
exceed  the  number  of  points  generally  charged  in  the  area  for  this  type 
of  transaction. 

E-ffective  dates 

The  rules  in  this  provision  apply  generally  to  any  prepaj'^ment  of 
interest  (including  points)  after  December  31,  1975.  However,  a 
transition  rule  excepts  interest  paid  before  January  1,  1977  (even  ff 
the  taxpayer's  taxable  year  ends  after  that  date)  if  there  existed  on 
September  16,  1975,  and  at  all  times  thereafter,  either  (1)  a  binding 
written  contract  for  a  prepayment  of  interest  by  the  taxpayer,  or  (2)  a 
written  loan  commitment  for  a  loan  to  the  taxpayer  and  if  the  con- 
tract or  loan  commitment  required  the  prepayment  of  this  amount  of 
interest.  In  either  of  these  situations,  however,  if  the  interest  is  paid 
on  or  after  January  1,  1977,  the  payment  will  be  subject  to  this 
provision. 

Congress  intends  that  no  inference  should  be  drawn  concerning 
the  deductibility  of  prepaid  interest  paid  before  the  effective  dates  of 
the  new  rule.  It  is  expected  that  deductions  for  such  prepayments  will 
be  determined  according  to  the  criteria  of  prior  law. 

ReveTwe  e-ffect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in  budget 
receipts  of  less  than  $5  million  annually. 

6.  Limitation  on  the  Deduction  for  Investment  Interest  (sec.  209 
of  the  Act  and  sec.  163(d)  of  the  Code) 

Prior  law 
Section  163  of  the  Internal  Revenue  Code  provides,  in  oeneral,  that 
a  taxpayer  who  itemizes  his  deductions  may  deduct  all  interest  paid 
or  accrued  within  the  taxable  year  on  his  indebtedness.  A  limitation 


103 

is  imposed  under  section  163(d)  on  interest  on  investment  indebted- 
ness. Under  prior  law  the  deduction  for  such  interest  was  limited  to 
$25,000  per  year,  plus  the  taxpayer's  net  investment  income  and  his 
long-term  capital  gain,  plus  one-half  of  any  interest  in  excess  of  these 
amounts.  Any  remaining  amount  could  be  carried  over  to  future  years. 

Reasons  for  change 
As  indicated  above,  in  connection  with  the  discussion  of  problems 
which  occur  with  tax  shelters,  there  is  a  question  as  to  the  extent  to 
which  a  taxpayer  should  be  permitted  to  shelter  or  reduce  tax  on  in- 
come from  the  taxpayer's  professional  or  income-producing  activities 
by  incurring  an  unrelated  deduction.  The  Congress  felt  that  the  lim- 
itation on  the  deductibility  of  investment  interest  should  be  strength- 
ened, in  order  to  reduce  the  possibility  that  this  deduction  could  be 
used  to  shelter  noninvestment  types  of  income.  It  was  also  felt  that 
this  provision  may  have  some  economic  benefits  by  encouraging  tax- 
payers to  focus  on  the  economic  viability  of  particular  investments 
(rarher  than  possible  tax  advantages  resulting  from  the  interest  deduc- 
tion) before  borrowing  funds  in  order  to  make  those  investments. 

Explanation  of  provisions 

Under  the  Act,  interest  on  investment  indebtedness  is  limited  to 
$10,000  per  year,  plus  the  taxpayer's  net  investment  income.  No  offset 
of  investment  interest  in  permitted  against  long-term  capital  gain.  An 
additional  deduction  of  up  to  $15,000  more  per  year  is  permitted  for 
interest  paid  in  connection  with  indebtedness  incurred  by  the  taxpayer 
to  acquire  the  stock  in  a  corporation,  or  a  partnership  interest,  where 
the  taxpayer,  his  spouse,  and  his  children  have  (or  acquired)  at  least  50 
percent  of  the  stock  or  capital  interest  in  the  enterprise.  Interest  de- 
ductions which  are  disallowed  under  these  rules  are  subject  to  an 
unlimited  carryover  and  may  be  deducted  in  future  years  (subject  to 
the  applicable  limitation).  Under  the  Act,  no  limitation  is  imposed 
on  the  deductability  of  personal  interest  or  on  interest  on  funds  bor- 
rowed in  connection  with  the  taxpayer's  trade  or  business. 

As  under  prior  law,  investment  income  (against  which  investment 
interest  may  be  deducted)  means  income  from  interest,  dividends, 
rents,  royalties,  short-term  capital  gains  arising  from  the  disposition 
of  investment  assets,  and  any  amount  of  gain  treated  as  ordinary  in- 
come pursuant  to  the  depreciation  recapture  provisions  (sees.  1245 
and  1250  of  the  Code),  but  only  if  the  income  is  not  derived  from  the 
conduct  of  a  trade  or  business. 

As  indicated  above,  interest  on  funds  borrowed  in  connection  with  a 
trade  or  business  is  not  affected  by  the  limitation.  In  this  connection, 
rental  property  is  (as  under  prior  law)  generally  considered  an  invest- 
ment property  subject  to  the  limitation,  rather  than  as  property  used 
in  a  trade  or  business,  if  the  property  is  rented  under  a  net  lease 
arrangement.  The  determination  of  whether  property  is  rented  under 
a  net  lease  arrangement  is  made  separately  for  each  year.  For  this 
purpose,  a  lease  is  considered  to  be  a  net  lease  for  a  taxable  year  either 
if  the  taxpayer's  trade  or  business  expenses  with  respect  to  the  property 
which  are  deductible  solely  by  reason  of  section  162  of  the  code  are 
less  than  15  percent  of  the  rental  income  from  the  property,  or  if  the 
taxpayer  is  guaranteed  a  specified  return,  or  is  guaranteed,  in  whole  or 
in  part,  against  loss  of  income. 

In  determining  net  investment  income,  the  investment  expenses 


104 

taken  into  account  are  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  purposes  of 
this  determination,  depreciation  or  depletion  with  respect  to  any 
property  is  taken  into  account  on  a  straight-line  or  cost  basis, 
respectively. 

In  the  case  of  partnerships,  the  limitation  on  the  deduction  of  inter- 
est is  applied  only  at  the  partner  level.  In  other  words,  each  partner 
separately  takes  into  account  his  share  of  the  partnership's  investment 
interest  and  other  items  of  income  and  expense  taken  into  account  for 
purposes  of  the  limitation.  Similar  treatment  is  provided  in  the  case 
of  subchapter  S  corporations.  In  this  case,  each  shareholder  of  the 
corporation  takes  into  account  the  investment  interest  of  the  corpora- 
tion and  the  other  items  of  income  and  expense  w^hich  are  taken  into 
account  for  purposes  of  the  limitation  on  a  pro-rata  basis  in  a  manner 
consistent  with  the  way  in  which  the  shareholders  of  the  coi-poration 
take  into  account  a  net  operating  loss  of  the  corporation. 

Generally,  these  rules  are  applicable  to  taxable  years  beginning  after 
December  31,  1975.  However,  under  a  transition  rule,  prior  law  (sec. 
163(d)  before  the  amendments  made  under  the  Act)  continues  to 
apply  in  the  case  of  intei-est  on  indebtedness  which  is  attributable  to 
a  specific  item  of  projDerty,  is  for  a  specified  term,  and  was  either  in- 
curred before  September  11,  1975,  or  is  incurred  after  that  date  under 
a  binding  written  contract  or  commitment  in  eifect  on  that  date  and  at 
all  time^  thereafter  (hereinafter  referred  to  as  "pre-1976  interest"). 
As  under  prior  law,  interest  incurred  before  December  17,  1969  ("pre- 
1970  interest")  is  not  subject  to  a  limitation. 

Under  the  Act,  carryovers  are  to  retain  their  character.  Thus, 
carry ovei-s  of  pre-1976  interest  will  continue  to  be  deductible  under 
the  limitation  of  prior  law.  Cai-ryovers  of  post-1975  interest  will  be 
subject  to  the  new  rules  adopted  imder  the  Act. 

In  a  case  where  the  taxpayer  has  interest  which  is  attributable  to 
more  than  one  period  (pre-1970,  pre-1976,  and  post-1975),  the  tax- 
payer's net  investment  income  is  to  be  allocated  between  (or  among) 
these  periods.  For  example,  assume  a  taxpayer  has  $30,000  of  pre-1976 
interest  and  $60,000  of  post-1975  interest ;' also  assume  that  the  tax- 
payer has  $45,000  of  investment  income.  Under  the  Act,  one-third 
of  the  investment  income  ($15,000)  is  to  be  allocated  to  the  pre-1976 
mterest,  which  would  be  fully  deductible  (the  $25,000  allowance,  plus 
the  $15,000  of  net  investment  income— exceeds  the  $30,000  of  pre-1976 
interest,  wliich  is  therefore  fully  deductible).  Two-thirds  of  the  net 
m vestment  income  ($30,000)  is  allocated  to  the  post- 1975  interest;  this 
amount,  added  to  the  $10,000  allowance  provided  under  the  Act,  would 
result  in  a  total  deduction  of  $40,000  for  the  post-1975  interest.  The 
remaining  amount,  ($20,000)  could  be  carried  forward. 

Effective  date 
Generally,  these  rules  apply  to  taxable  years  beginning  after  De- 
cember 31,  1975,  subject  to  certain  transition  rules  discussed  above. 
Revenue  effect 
It  is  estimated  that  tliese  provisions  will  result  in  a  revenue  gain  of 
$100  million  for  fiscal  year  1977,  $110  million  for  fiscal  year  1978,  and 
$145  million  for  fiscal  j^ear  1981. 


B.  MINIMUM  AND  MAXIMUM  TAX 

1.  Minimum  Tax  for  Individuals  (sec.  301  of  the  Act  and  sees.  56- 
58  of  the  Code) 

Prior  law 
Under  prior  law,  individuals  and  corporations  paid  a  minimum  tax, 
in  addition  to  their  regular  income  tax,  equal  to  10  percent  of  their 
items  of  tax  preference,  reduced  by  a  $30,000  exemption  and  their 
regular  tax  liability.  The  tax  preferences  subject  to  the  minimum  tax 
were :  ( 1 )  the  excluded  one-half  of  capital  gains ;  (2)  the  excess  of  per- 
centage depletion  over  the  basis  of  the  property;  (3)  accelerated  de- 
preciation on  real  property;  (4)  the  bargain  element  of  stock  options; 
(5)  accelerated  depreciation  on  personal  property  subject  to  a  net 
lease;  (6)  the  excess  of  amortization  of  on-the-job  training  and  child 
care  facilities  over  regular  depreciation ;  (7)  the  excess  of  amortization 
of  pollution  control  facilities  over  regular  depreciation;  (8)  the  excess 
of  amortization  of  railroad  rolling  stock  over  regular  depreciation; 
and  (9)  excess  bad  debt  reserves  of  financial  institutions.  Regular  taxes 
not  used  to  offset  preferences  in  the  current  year  could  be  carried 
over  for  up  to  7  additional  years. 

Reasons  for  change 

The  minimum  tax  was  enacted  in  the  Tax  Reform  Act  of  1969  in 
order  to  make  sure  that  at  least  some  minimum  tax  was  paid  on  tax 
preference  items,  especially  in  the  case  of  high-income  persons  who 
were  not  paying  their  fair  share  of  taxes.  However,  the  previous  mini- 
nmm  tax  did  not  adequately  accomplish  these  goals,  so  the  Act  con- 
tains a  substantial  revision  of  the  minimum  tax  for  individuals  to 
achieve  this  objective. 

Congress  intended  these  changes  to  raise  the  effective  tax  rate  on  tax 
preference  items,  especially  for  high-income  individuals  who  are  pay- 
ing little  or  no  regular  income  tax. 

Explanation  ^f  pi^avision 

The  Act  raises  the  minimum  tax  rate  from  10  percent  to  15  percent. 
The  Act  replaces  the  $30,000  exemption  and  deduction  for  regular 
taxes  allowed  under  prior  law  with  an  exemption  equal  to  the  greater 
of  $10,000  or  one-half  of  regular  tax  liability.  In  addition,  the  Act 
repeals  the  carryover  of  regular  taxes  paid.  These  changes  are  intended 
to  raise  the  effective  rate  of  the  minimum  tax  on  tax  preferences. 

The  Act  also  adds  two  new  items  of  tax  preference  to  the  minimum 
tax  base  for  individuals  and  modifies  one  existing  preference  item. 
The  new  preferences  are  excess  itemized  deductions  and  intangible 
drilling  costs. 

The  new  preference  for  excess  itemized  deductions  equals  the  amount 
by  which  itemized  deductions  (other  than  medical  and  casualty  deduc- 
tions) exceed  60  percent  of  adjusted  gross  income.  (Itemized  deduc- 

(105) 


106 

tions  in  excess  of  100  percent  of  adjiisted  gross  income  are  not  taken 
into  account  in  this  computation.)  This  preference  is  intended  to. re- 
duce the  number  of  situations  in  which  a  person  with  a  large  adjusted 
gross  income  is  able  to  avoid  paying  any  income  tax.  Medical  and 
casualty  deductions  are  excluded  from  this  preference  item  because 
they  are  limited  to  expenses  that  are  beyond  the  control  of  the 
taxpayer. 

The  new  preference  for  intangible  drilling  costs  applies  to  those 
expenses  in  excess  of  the  amount  which  could  have  been  deducted  had 
the  intangibles  been  capitalized  and  either  (1)  deducted  over  the  life 
of  the  well  as  cost  depletion  or  (2)  deducted  ratably  over  10  years; 
the  taxpayer  may  choose  whichever  of  these  two  methods  of  capitaliza- 
tion is  most  favorable.  The  calculation  of  the  amount  which  could  have 
been  deducted  under  capitalization  in  a  taxable  year  is  to  be  made 
for  those  intangible  drilling  costs  which  were  paid  or  incurred  in  the 
taxable  year.  This  preference  does  not  apply  to  taxpayers  wlio  elect 
to  capitalize  their  intangible  drilling  costs. 

The  new  preference  does  not  apply  to  nonproductive  wells.  For  this 
purpose,  nonproductive  wells  are  those  which  are  plugged  and  aban- 
doned without  having  produc^ed  oil  and  gas  in  conunercial  quantities 
for  any  substantial  penod  of  time.  Thus,  a  well  which  has  been  plugged 
and  abandoned  may  have  produced  some  relatively  small  amount  of  oil 
and  still  be  considered  a  non-productive  well,  depending  on  the  amount 
of  oil  produced  in  relation  to  the  costs  of  drilling. 

In  some  cases  it  may  not  be  possible  to  determine  whether  a  well  is 
in  fact  nonproductive  until  after  the  close  of  the  taxable  year  in 
question.  In  these  cases,  no  preference  is  included  in  the  minimum  tax 
base  with  respect  to  any  wells  which  are  subsequently  determined  to  be 
nonproductive.  Thus,  if  a  well  is  proved  to  be  nonproductive  after  the 
end  of  the  taxable  year  but  before  the  tax  return  for  the  year  in  ques- 
tion is  filed,  that  well  can  be  treated  as  nonproductive  on  that  return. 
If  a  well  is  not  determined  to  be  nonproductive  by  the  time  the  return 
for  the  year  in  question  is  filed,  the  intangible  expenses  with  respect 
to  that  well  are  to  be  subject  to  the  minimum  tax.  However,  the  tax- 
payer may  later  file  an  amended  return  and  claim  a  credit  or  refund 
for  the  amount  of  any  minimum  tax  paid  with  respect  to  that  well 
if  the  well  subsequently  proves  to  be  nonproductive. 

The  preference  for  accelerated  depreciation  on  personal  property 
is  expanded  in  two  ways.  Under  prior  law,  it  applied  only  to  net  leases : 
the  Act  expands  it  to  all  leases.  Also,  the  definition  of  accelerated 
depreciation  is  expanded  to  include  the  acceleration  that  results  from 
the  20-percent  variance  under  the  Asset  Depreciation  Range  (ADR) 
system.  The  preference  for  accelerated  depreciation  on  personal  prop- 
erty is  not  intended  to  apply  to  personal  property  which  is  leased  as 
an  incidental  part  of  a  real  property  lease.  For  example,  the  inclusion 
of  a  refrigerator  in  the  lease  of  an  unfurnished  apartment  is  not  to  be 
treated  as  a  lease  of  personal  property. 

There  are  certain  cases  in  which  a  person  derives  no  tax  benefit  from 
an  item  of  tax  preference  because,  for  example,  the  item  is  disallowed 
as  a  deduction  under  other  provisions  of  the  Code  or  because  the 
taxpayer  has  sufficient  deductions  relating  to  nonpreference  items  to 


107 

eliminate  his  taxable  income.^  To  some  extent,  the  Internal  Revenue 
Service  has  been  able  to  deal  with  this  issue  through  regulations.  To 
deal  with  this  problem  specifically,  the  Act  instructs  the  Secretary  of 
the  Treasury  to  prescribe  regulations  under  which  items  of  tax  pref- 
erence (of  both  individuals  and  corporations)  are  to  be  properly  ad- 
justed when  the  taxpayer  does  not  derive  any  tax  benefit  from  the 
preference.  For  this  purpose,  a  tax  benefit  includes  tax  deferral,  even 
if  only  for  one  year.  Congress,  by  adding  this  provision  to  the  Act,  does 
not  intend  to  make  any  judgment  about  the  authority  of  the  Treasury 
to  issue  these  regulations  under  prior  law. 

The  minimum  tax  is  not  imposed  on  tax  preferences  that  make  up 
a  net  operating  loss  that  is  carried  forward  to  a  succeeding  taxable 
year.  Instead,  the  minimum  tax  is  imposed  on  those  preferences  when 
the  net  operating  loss  reduces  taxable  income.  For  preferences  from 
taxable  years  prior  to  January  1,  1976,  this  tax  rate  will  continue  at 
10  percent  even  if  the  net  operating  loss  is  deducted  in  a  taxable  year 
beginning  after  December  31,  1975.  For  preferences  for  taxable  years 
beginning  after  December  31,  1975,  the  tax  rate  will  be  15  percent. 
Thus,  the  year  of  the  preferences,  not  the  year  when  the  net  operating 
loss  is  deducted,  is  to  determine  whether  the  10-percent  or  the  15- 
percei;it  rate  applies. 

These  changes  all  apply  to  individuals,  estates,  trusts,  subchapter 
S  corporations  and  personal  holding  companies. 

Effective  date 
These  changes  are  eflPective  for  taxable  years  beginning  after  De- 
cember 31,  1975.  Carryovers  of  regular  taxes  from  taxable  years 
beginning  before  January  1,  1976,  will  not  be  allowed  in  years  be- 
ginning after  December  31, 1975. 

Revenue  effect 
The  changes  in  the  minimum  tax  for  individuals  will  raise  $1.0 
billion  in  fiscal  year  1977,  $1.1  billion  in  fiscal  year  1978  and  $1.5  bil- 
lion in  fiscal  year  1981. 

2.  Minimum  Tax  for  Corporations  (sec.  301  of  the  Act  and  sees.  56- 
58  of  the  Code) 

Prior  law 

The  minimum  tax  for  corporations  was  the  same  as  that  for  indi- 
viduals except  that  the  capital  gains  preference  equalled  18/48  of  net 
long-term  capital  gains  (rather  than  one-half  of  such  gains)  and  the 
preference  for  accelerated  depreciation  on  personal  property  subject 
to  a  net  lease  did  not  apply. 

Rea^^mis  for  chwnge 
Congress  believed  that,  as  in  the  case  of  individuals,  it  was  appro- 
priate to  raise  the  effective  tax  rate  on  corporate  tax  preferences  sub- 
ject to  the  minimum  tax.  Howev^er,  because  corporate  income  is  already 
subject  to  two  taxes — ^the  corporate  income  tax  and  the  individual 
income  tax — Congress  felt  that  it  was  appropriate  to  retain  the  deduc- 
tion for  regular  taxes  in  computing  the  corporate  minimum  tax. 


1  For  example,  preference  items  giving  rise  to  losses  which  are  suspended  under  at  risk 
provisions  (see.  465  or  sec.  704(d)  of  the  Code)  are  not  to  be  considered  to  give  rise  to 
a  tax  benefit  until  the  year  in  which  the  suspended  deduction  is  allowed.  Similarly,  in- 
vestment interest  which  Is  disallowed  (under  sec.  163(d))  Is  to  be  treated  as  an  itemized 
deduction  for  purposes  of  that  preference  only  in  the  year  in  which  it  is  allowed  (under 
sec.  163(d)). 


108 

Explanation  of  provision 

The  Act  raises  the  minimum  tax  rate  for  corporations  to  15  percent. 
In  place  of  the  $30,000  exemption  and  deduction  for  reg:ular  taxes 
under  prior  law,  it  substitutes  an  exemption  equal  to  the  greater  of 
$10,000  or  reo^ilar  taxes.  It  also  eliminates  the  carryover  of  regular 
taxes.  The  "tax  'benefit"  rule  applies  to  corporations  as  well  as  to  other 
taxpayers. 

Personal  holding  companies  are  generally  treated  as  individuals 
under  the  minimum  tax,  and  generally  where  the  Act  makes  a  change 
in  the  minimum  tax  that  is  different  for  individuals  than  for  corpora- 
tions, the  rule  for  individuals  is  used  for  personal  hokling  companies. 
Preferences  of  subchapter  S  corporations  are  generally  attributed  to 
shareholders  under  the  minimum  tax.  However,  the  preference  ,for 
itemized  deductions  will,  of  course,  not  apply  to  personal  holding  com- 
panies or  to  subchapter  S  corporations  since  these  entities  have  no 
adjusted  gross  income  from  which  to  calculate  their  prefei-ence. 

The  Act  provides  special  rules  for  timl>er  income  of  corporations, 
including  both  gains  from  the  cutting  of  timb(^r  and  long-term  gains 
from  the  sale  of  timber.  These  rules  have  the  effe-ct  of  exempting  tim- 
ber income  from  the  increase  in  tlie  minimum  tax  for  corporations. 
These  rules  provide  that  the  item  of  tax  preference  for  timber  gains 
is  to  be  reduced  by  one-third  and  then  fui-ther  reduced  by  $20,000. 
Also,  tlie  deduction  for  regular  taxes  is  to  bo  i-educed  by  the  lesser  of 
(a)  one-third  or  (b)  the  preference  reduction  described  alx)ve.  In  ef- 
fect, the  adjustments  compensate  for  the  general  minimum  tax  rate 
increases  fi'om  10  percent  to  15  percent  by  scaling  down  the  entire 
minimum  tax  base,  as  it  i-elates  to  timber,  by  one-third  and  then  sub- 
jecting that  lower  base  to  a  15-percent  rate.  This  gives  the  same  result 
as  subjecting  the  normal  tax  base  to  a  10-percent  rate.  The  reduction 
in  timber  preferences  by  $20,000  (two-thirds  of  $80,000),  in  effect, 
compensates  timber  for  the  loss  of  the  $30,000  exemption. 

The  Act  also  retains  a  regular  tax  carryover  for  timber.  Taxpayers 
will  first  have  to  determine  how  much  of  their  corporate  income  tax 
is  attributable  to  timber  income  (including  both  gains  from  the  cutting 
of  timber  and  long-teiTn  gains  from  the  sale  of  timber).  This  alloca- 
tion is  to  be  made  under  regulations  prescribed  by  the  Secretary  of 
the  Treasury.  This  allwation  must  be  made  for  vears  prior  to  1976 
as  well  as  futui-e  years,  in  order  to  deteiTnine  how  much  of  a  corpora- 
tion's existing  regular  tax  carryover  remains  available  for  use  in  1976 
and  subsequent  years.  Congress  does  not  intend  that  there  be  a  carry- 
over of  regidar  taxes  not  attributable  to  timl>er  income.  To  the  extent 
that  regular  corporate  income  taxes  attributable  to  timber  exceed  the 
items  of  tax  preference  in  a  taxable  year,  they  may  be  carried  forward 
for  up  to  7  additional  years.  The  amount  of  the  carryover  that  may 
be  deducted  in  a  subseouent  year  is  limited  to  timber  tax  pi-eferences 
in  that  year,  reduced  b}^  the  timber  preference  reduction  desci'ibed 
above,  minus  the  regular  tax  deduction  for  the  vear  (as  ivduced  by 
the  regular  tax  adjustment  described  above) .  This  has  the  effect  of  per- 
mitting a  cam'forward  of  timber-related  regular  taxes  that  are  not 
used  in  the  current  year  and  limiting  the  use  of  that  carryforward  to 
the  part  of  the  minimum  tax  base  tliat  is  attributable  to  timber-related 
capital  gains  income. 


109 

E-ffectwe  date 

Generally,  the  minimum  tax  changes  are  effective  for  taxable  years 
beginning  after  December  31,  1975.  However,  for  taxable  years  be- 
ginning in  1976,  corporations  are  to  compute  their  minimum  tax  under 
both  prior  law  and  the  new  law  and  pay  the  average  of  the  two 
minimum  taxes.  Also,  regular  tax  carryovers  from  prior  years  can  be 
deducted  in  taxable  years  beginning  before  July  1,  1976  (as  changed 
by  later  legislation).^ 

For  financial  institutions  who  are  eligible  for  excess  bad  debt  reserve 
deductions,  the  effective  date  is  delayed  until  December  31, 1977. 

Revenue  effect 
The  increases  in  the  minimum  tax  for  corporations  will  increase 
budget  receipts  by  $59  million  in  fiscal  year  1977,  $124  million  in  fiscal 
year  1978  and  $204  million  in  fiscal  year  1981. 

3.  Maximum  Tax  Rate  (sec.  302  of  the  Act  and  sec.  1348  of  the 
Code) 

Prior  la/w 

Under  prior  law,  the  maximum  marginal  tax  rate  on  taxable 
income  from  personal  services  was  50  percent.  For  this  purpose, 
income  from  personal  services  (in  the  past  this  was  referred  to  as 
"earned  income")  included  wages,  salaries,  professional  fees  or  com- 
pensation for  personal  services  (including  royalty  payments  to  au- 
thors or  inventors)  and,  for  an  individual  engaged  in  a  trade  or  busi- 
ness where  both  personal  services  and  capital  are  material  income- 
producing  factore,  a  reasonable  amount  (not  to  exceed  30  percent)  of 
his  share  of  the  net  profits  from  the  business.  Personal  service  income 
for  this  purpose  did  not  include  deferred  compensation,  penalty 
distributions  from  owner-employee  plans,  lump-sum  distributions 
from  pension  plans  or  distributions  from  employee  annuity  plans. 

The  amount  of  personal  service  income  eligible  for  the  50-percent 
maximum  tax  was  reduced  in  three  ways.  First,  it  was  reduced  by  trade 
or  business  deductions  allowable  under  section  62  (which  excludes  most 
trade  or  business  deductions  of  employees)  properly  allocable  to  per- 
sonal service  income.  Second,  it  was  reduced  by  a  pro  rata  share  of 
deductions  from  adjusted  gross  income  used  in  computing  taxable 
income  (including  all  itemized  deductions,  the  standard  deduction 
and  the  deduction  for  personal  exemptions).  Third,  it  was  reduced  by 
the  taxpayer's  items  of  tax  preference  (as  defined  under  the  minimum 
tax)  or  the  average  of  the  taxpayer's  tax  preferences  over  the  current 
year  and  the  four  preceding  vears,  whichever  is  greater,  in  excess  of 
$30,000. 

For  married  couples,  the  maximum  tax  only  applies  if  they  file 
a  joint  return,  and  taxpayers  cannot  use  the  maximum  tax  provision 
if  they  use  income  averaging. 

Reasons  for  change 
Congress  lielieved  that  one  way  to  reduce  the  incentive  for  making 
use  of  tax  preferences  was  to  continue  the  lower  top  bracket  rate  (i.e., 

1  The  Tax  Reform  Act  of  1976  included  an  effective  date  of  January  1.  1976,  for  the  repeal 
of  the  carryover,  but  H.R.  1144  (P.L.  94-568)  amended  this  to  July  1,  1976. 


no 

50  percent)  on  personal  service  income  but  to  reduce  the  amount  of 
personal  service  income  eligible  for  this  benefit  to  the  extent  that  the 
taxpayer  uses  tax  preferences.  This  "preference  offset"  in  prior  law, 
however,  was  considerably  weakened  by  the  $30,000  exemption. 

Also,  Congress  thought  it  was  appropriate  to  extend  the  benefits 
of  the  50-percent  maximum  tax  rate  to  deferred  compensation.  Under 
prior  law,  there  were  cases  where  an  individual  could  retire  on  a  pen- 
sion ;  and,  even  though  his  before-tax  income  would  fall,  his  after-tax 
income  would  rise  because  he  would  lose  the  benefit  of  the  maximum 
tax. 

Explanation  of  provision 

The  Act  eliminates  the  $30,000  exemption  to  the  preference  offset 
and  the  five-year  averaging  provision.  These  changes  will  make  the 
maximum  tax  a  more  effective  deterrent  to  use  of  tax  preferences  and 
also  will  considerably  simplify  it. 

Also,  the  Act  extends  the  benefits  of  the  maximum  tax  to  deferred 
compensation  including  pensions  and  annuities.  This  extension  applies 
to  pensions  and  annuities  that  are  personal  services  income.  For  exam- 
ple, it  excludes  those  pensions  and  annuities  in  which  an  individual 
buys  the  pension  or  annuity  for  himself  wher-e  there  is  no  connection 
with  earning  income  with  personal  services.  Income  deferred  under 
individual  retirement  accounts  will  also  qualify  for  the  maximum  tax. 
Lump-sum  distributions  which  are  taxed  under  special  rules  and  cer- 
tain distributions  from  H.R.  10  pension  plans  or  Individual  Retire- 
ment Accounts  (IRA's)  do  not  qualify  for  the  maximum  tax. 

Effective  date 
The  changes  in  the  maximum  tax  are  effective  for  taxable  yeare 
beginning  after  December  31, 1976. 

Revenue  effect 
The  changes  in  the  maximum  tax  will  increase  revenues  by  $4  mil- 
lion in  fiscal  year  1977,  $24  million  in  fiscal  year  1978  and  $43  million 
in  fiscal  vear  1981. 


C.  EXTENSION  OF  INDIVIDUAL  INCOME  TAX 
REDUCTIONS 

(Sees.  401-402  of  the  Act  and  Sees.  42,  43,  and  141  of  the  Code) 

Prior  l^w 

The  Tax  Reduction  Act  of  1975  (Public  Law  94-12)  enacted  thre^ 
individual  income  tax  cuts  for  the  first  six  months  of  1975.  These 
were  an  increase  in  the  standard  deduction,  a  general  tax  credit  and  an 
earned  income  credit.  The  Revenue  Adjustment  Act  of  1975  (Public 
Law  94-164)  enacted  somewhat  larger  tax  cuts  for  the  first  six  months 
of  1976. 

Prior  to  the  1975  tax  reduction,  the  minimum  standard  deduction 
(or  low-income  allowance)  was  $1,300.  The  Tax  Reduction  Act  in- 
creased it  to  $1,600  for  single  returns  and  to  $1,900  for  joint  returns  for 
the  year  1975.  The  tax  reduction  in  the  Revenue  Adjustment  Act  of 
1975,  on  a  full-year  basis,  would  have  increased  the  minimum  standard 
deduction  to  $1,700  for  single  returns  and  to  $2,100  for  joint  returns. 

The  percentage  standard  deduction  was  15  percent  prior  to  1975. 
The  Tax  Reduction  Act  of  1975  and  the  Revenue  Adjustment  Act  in- 
creased it  to  16  percent  for  1975  and  the  first  half  of  1978,  respectively. 

The  maximum  standard  deduction  was  $2,000  before  1975.  The  Tax 
Reduction  Act  of  1975  increased  it  to  $2,300  for  single  returns  and  to 
$2,600  for  joint  returns  for  1975.  On  a  full-year  basis,  the  Revenue 
Adjustment  Act  of  1975  would  have  increased  it  to  $2,400  for  single 
returns  and  to  $2,800  for  joint  returns  for  1976. 

The  Tax  Reduction  Act  of  1975  also  provided  a  nonrefundable  credit 
of  $30  for  each  taxpayer  and  dependent  for  1975.  The  Revenue  Adjust- 
ment Act  of  1975,  on  a  full-year  basis,  would  have  increased  this  credit 
to  the  greater  of  $35  per  capita  or  2  percent  of  the  first  $9,000  of  tax- 
able income. 

In  addition,  the  Tax  Reduction  Act  of  1975  included  a  refundable 
tax  credit  equal  to  10  percent  of  the  first  $4,000  of  earned  income, 
phased  out  as  adjusted  gross  income  rises  from  $4,000  to  $8,000.  This 
earned  income  credit  applied  only  to  families  who  maintained  a  house- 
hold for  at  least  one  dependent  child  for  whom  they  were  entitled  to 
claim  a  personal  exemption.  The  earned  income  credit  was  extended 
for  the  first  six  months  of  1976  in  the  Revenue  Adjustment  Act  of  1975. 
Also,  the  credit  for  1975  was  modified  to  provide  that  it  be  disregarded 
in  detennining  eligibility  for,  or  benefits  under.  Federal  or  federally- 
assisted  aid  programs,  as  long  as  the  individual  was  a  recipient  of  bene- 
fits under  the  program  in  the  month  before  receiving  a  tax  re,fund 
resulting  from  the  earned  income  credit. 

The  Tax  Reduction  Act  of  1975  provided  that  the  changes  in  the 
standard  deduction  and  the  general  tax  credit  be  reflected  in  lower 
withheld  and  estimated  taxes  for  the  last  eight  months  of  1975.  The 
Revenue  Adjustment  Act  of  1975  extended  those  same  withholding 

(111) 


112 

rates  and  estimated  tax  requirements  through  June  30,  1976.  Subse- 
quent leoislation  extended  the  withholding  rates  through  Septem- 
ber 30, 19t6. 

The  Revenue  Adjustment  Act  of  1975  reduced  taxes  only  for  the 
first  half  of  1976.  This  was  achieved  by  enacting  a  reduction  in  tax 
liability  approximately  equal  to  one-half  of  the  full-year  reduction  de- 
scribed above  and  by  providing  that  this  tax  cut  be  entirely  reflected 
in  lower  withheld  and  estimated  tax  payments  in  the  first  six  months 
of  1976.1 

Reasons  fm'  change 

Without  new  legislation,  income  tax  withholding  rates  would  have 
risen  by  $13  billion  on  October  1,  1976.  Congress  believed  that  eco- 
nomic conditions  did  not  warrant  this  tax  increase.  Wliile  the  recovery 
from  the  1974—75  recession  has  proceeded  far  enough  that  we  have  now 
exceeded  the  level  of  output  that  existed  prior  to  the  recession,  which 
began  at  the  end  of  1973,  there  is  still  a  large  gap  between  what  the 
economy  is  capable  of  producing  and  what  it  actually  produces.  The 
unemployment  rate  was  7.8  percent  in  September  1976,  as  compared  to 
its  pre  recession  level  of  less  than  5  percent,  while  capacity  utilization 
in  manufacturing  was  onlv  73  percent,  as  compared  to  83  percent  in 
1973. 

An  extension  of  the  expiring  1975  income  tax  cuts  at  least  through 
1977  is  needed  to  permit  a  continuation  of  the  economic  recovery. 
This  extension  does  not  provide  any  new  fiscal  stimulus  to  the  econ- 
omy; it  only  prevents  the  withdrawal  of  existing  stimulus.  In  1977, 
Congress  plans  to  review  the  economic  situation  to  see  if  a  further 
income  tax  cut  extension  is  appropriate. 

The  extension  of  the  tax  cuts  also  serves  purposes  other  than  eco- 
nomic stimulus.  The  increase  in  the  standard  deduction  represents  a 
major  simplification  of  the  tax  law  because  it  will  encourage  taxpayers 
who  file  over  9  million  tax  returns  to  switch  from  itemizing  their 
deduction  to  using  the  standard  deduction.  Also,  the  increase  in  the 
standard  deduction  creates  greater  equity  between  users  of  the  stand- 
ard deduction  and  itemizers,  since  itemized  deductions  have  risen  in 
recent  years  as  a  result  of  inflation  while  there  has  been  no  comparable 
increase  in  the  standard  deduction.  For  these  reasons,  Congress  be- 
lieved the  increases  in  the  standard  deduction  should  be  made 
permanent. 

The  income  tax  cuts  also  raised  the  income  level  at  which  people 
begin  to  pay  income  taxes  (the  tax  threshold)  above  the  current  pov- 
erty level.  If  taxes  were  allowed  to  rise  after  September  30,  the  income 


1  For  the  minimum  standard  deduction,  the  half-year  tax  cut  for  1976  involved  an 
increase  from  ?1,S00  to  $1,500  for  single  returns  and  to  $1,700  for  joint  returns  (compared 
with  increases  to  $1,700  and  $2,100  respectively  in  the  full-year  version  of  the  tax  cuts). 
T'he  maximum  standard  deduction  was  increased  in  the  half-year  version  from  $2,000  to 
$2,200  for  single  returns  and  to  $2,400  for  joint  returns  (compared  with  increases  to 
$2,400  and  $2,800  respectively  in  the  full-year  version).  The  percentage  standard  deduc- 
tion was  increased  from  1-5  percent  to  16  percent  in  the  half-year  version,  which  is  the  same 
level  as  in  the  full-year  version. 

For  the  general  tax  credit,  the  half-year  variant  was  a  credit  equal  to  the  greater  of 
$17..50  per  capita  or  one  percent  of  the  initial  $9,000  of  taxable  income  (compared  with 
a  credit  equal  to  the  greater  of  $3,'i  per  capita  or  2  percent  of  the  first  $9,000  of  taxable 
income  In  the  full-year  version). 

For  the  earned  "income  credit,  the  half-year  version  was  5  percent  of  the  initial  $4,000 
of  earnings  (compared  with  a  10-percent  rate  in  the  full-year  version)  with  the  same 
income  phaseout  as  mentioned  above. 


113 

tax  threshold  would  have  fallen  substantially  below  the  poverty  level. 
This  is  shown  in  Table  1,  which  compares  the  poverty  level  in  1976 
with  the  income  tax  threshold  with  and  without  the  tax  cuts.  If  the 
tax  cuts  had  expired,  the  poverty  level  would  be  $1,550  above  the 
threshold  for  a  family  of  four;  thus,  such  a  family  could  be  liable 
for  a  Federal  income  tax  burden  as  high  as  $222. 

TABLE  1.— POVERTY  LEVELS  AND  FEDERAL  INCOME  TAX  THRESHOLDS,  1976 


Income  lax 

threshold 

1976  poverty 

Without  tax 

With  tax 

level 

cuts' 

cuts' 

$2, 970 

12, 050 

$2, 700 

3,840 

2,800 

4,100 

4,570 

3,550 

5,100 

5,850 

4,300 

6,100 

6,900 

5,050 

7,083 

7,770 

5,800 

8,067 

Family  size: 

1 

2.... - 

3 

4.. 

5 

6 

»  Personal  exemption  of  $750  and  minimum  standard  deduction  of  $1,300. 

'Personalexemptionof  $750,  minimum  standard  deduction  of  $1,700  for  single  returns  and  $2,100  for  joint  returns,  and 
$35  tax  credit  for  each  taxpayer  and  dependent. 

Congress  also  decided  to  extend  the  earned  income  credit.  This  pro- 
vides needed  tax  relief  to  a  hard-pressed  group  in  the  population — 
the  lower  income  worker.  It  also  provides  a  work  incentive,  since  the 
credit  is  based  on  the  amount  of  earned  income.  In  effect,  it  offsets  the 
social  security  payroll  taxes  payable  with  respect  to  those  who  are 
working  but  whose  incomes  are  slightly,  if  any,  above  the  levels  of 
those  on  welfare.  This  is  designed  to  improve  the  financial  position 
of  those  who  work  relative  to  those  remaining  on  welfare. 

Ex'ptanation  of  provisions 

(a)  Standard  deduction. — The  Act  makes  permanent  the  increases 
in  the  standard  deduction  from  the  Revenue  Adjustment  Act  of  1975, 
thus,  making  the  increases  effective  for  1976  and  subsequent  years.  It 
increases  the  minimum  standard  deduction  (or  low-income  allowance) 
to  $1,700  for  single  returns  and  $2,100  for  joint  returns;  increases 
the  percentage  standard  deduction  to  16  percent;  and  increases  the 
maximum  standard  deduction  to  $2,400  for  single  returns  and  $2,800 
for  joint  returns.  It  also  modifies  the  income  tax  filing  requirements  to 
reflect  the  increases  in  the  minimum  standard  deduction. 

(b)  General  tax  credit. — The  Act  continues  the  general  tax  credit 
from  the  Revenue  Adjustment  Act  of  1975  through  the  last  6  months 
of  1976  and  for  all  of  1877.  This  credit  is  the  greater  of  $35  per  tax- 
payer and  dependent  or  2  percent  of  the  initial  $9,000  of  taxable 
income. 

(c)  Ean}^d  income  credit. — ^The  Act  extends  the  earned  income 
credit  through  1977,  and  also  extends  the  provision  that  the  credit  be 
disregarded  in  determining  eligibility  for  benefits  under  Federal  or 
federally-assisted  aid  programs.  Also,  the  eligibility  for  the  credit  is 
broadened  in  two  ways.  The  Act  makes  the  credit  available  to  a  parent 
who  maintains  a  household  for  a  child  who  is  either  under  19  or  a 
student  even  though  the  parent  is  not  entitled  to  a  personal  exemption 


114 

for  the  child.  Also,  it  extends  the  credit  to  a  parent  who  maintains  a 
household  for  an  adult  disabled  dependent  for  whom  he  is  entitled  to 
claim  a  pereonal  exemption. 

(d)  Withholding  rates. — The  Act  extends  the  income  tax  withhold- 
ing rates  that  have  been  in  use  since  May  1975  through  the  end  of 
1977.  After  that,  it  insti*ucts  the  Secretary  of  the  Treasury  to  issue  new 
withholding  tables  that  are  to  be  the  same  as  those  which  were  in  effect 
prior  to  May  1975,  except  that  they  are  to  be  adjusted  to  reflect  the 
permanent  increases  in  the  standard  deduction  made  by  the  Act. 

Effective  dates 
The  changes  in  the  standard  deduction  are  effective  for  taxable  years 
beginning  after  December  81, 1975.  The  general  tax  credit  and  changes 
in  the  earned  income  credit  are  effective  for  taxable  years  beginning 
after  December  81,  1975,  and  before  Januar}^  1,  1978.  The  "disregard" 
applies  to  refunds  received  after  December  81,  1975.  The  extension  of 
the  withholding  rates  is  effective  for  wages  paid  after  September  14, 
1976. 

Revenue  effect 
These  tax  reductions  will  reduce  receipts  by  $14.4  billion  in  fiscal 
year  1977,  $9.3  billion  in  fiscal  year  1978,  and  $5.0  billion  in  fiscal 
year  1981. 


D.  TAX  SIMPLIFICATION  IN  THE  INDIVIDUAL 
INCOME  TAX 

1.  Revision  of  Tax  Tables  for  Individuals  (sec.  501  of  the  Act 
and  sees.  3,  4,  36, 144,  1211,  1304  and  6014  of  the  Code) 

Prior  Jaiv 
Under  prior  law,  a  taxpayer  whose  adjusted  ^oss  income  was  under 
$10,000  ($15,000  for  1975  only)  and  who  claimed  the  standard  deduc- 
tion was  required  to  use  the  optional  tax  tables.  These  tables  had  AGI 
brackets  as  horizontal  row^  designations ;  marital  status  and  number  of 
exemptions  as  vertical  column  headings;  and  the  amount  of  tax  in  the 
resulting  cell,  xl  taxpayer  whose  income  was  greater  than  $10,000 
($15,000  for  1975  only)  or  who  itemized  his  deductions  was  required  to 
compute  his  tax  using  the  tax  rates. 

Reasons  for  change 
The  optional  tax  table  set-up  which  provided  a  diiferent  table  for 
each  number  of  exemptio-.s  claimed  by  the  taxpayer  just  to  cover  up 
to  $10,000  of  AGI  resulted  in  6  pages  of  fine  print,  representing  12 
optional  tax  tables  in  the  instructions  accompanying  the  income  tax 
return.  The  1975  tables  extending  up  to  $15,000  of  AGI  covered  10 
pages  in  the  instructions.  In  addition,  a  separate  publication  was 
required  for  taxpayers  claiming  13  or  more  exemptions.  This  system 
was  a  considerable  source  of  taxpayer  error  since  taxpayers  were  not 
always  sure  which  table  to  use  or,  because  of  the  necessarily  small  size 
of  the  print,  which  was  the  proper  tax  figure  to  enter  on  their  returns. 
In  the  interest  of  taxpayer  compliance  and  simplification  of  the  in- 
structions as  well  as  increased  accuracy  in  the  determination  of  the 
proper  tax  by  taxpayers,  the  Congress  believed  it  desirable  to  elim- 
inate the  existing  optional  tax  table  system  and  to  adopt  a  table  based 
on  taxable  income.  This  should  make  it  possible  to  print  the  tax  table 
on  three  pages. 

Explanation  of  provision 

The  Act  revises  the  existing  optional  tax  tables  by  providing  that 
taxpayers  with  taxable  incomes  of  $20,000  or  less  are  to  use  a  tax  table 
based  on  taxable  income  which  is  to  be  prescribed  by  the  Secretary  of 
the  Treasury  on  the  basis  of  the  existing  tax  rates.  This  table  is  to  be 
used  by  individuals,  estates,  and  trusts. 

In  construc<-ing  such  a  taxable  income  table,  the  Secretary  has  the 
authority  to  design  a  bracket  system  analogous  to  that  in  the  prior 
optional  tax  table  (including  a  zero-tax  bracket  for  rounding  pur- 
poses). In  order  to  limit  the  taxable  income  bracket  table  to  three 
pages  and  to  have  the  tax  table  run  to  $20,000  of  taxable  income, 
the  tax  liability  of  an  individual  may  have  to  be  several  dollars 
higher  at  the  bottom  of  one  bracket  than  at  the  top  of  the  next  lower 

(115) 


116 

bracket.  (This  was  the  case  with  the  optional  tax  table  under  prior 
law.)  However,  the  amount  involved  is  only  a  small  portion  of  the 
existing  tax.  This  chan<ire  is  necessary  to  achieve  the  simplification 
and  taxpayer  accuracy  that  is  oenerally  believed  to  be  desirable. 

In  order  to  use  the  tax  table,  the  taxpayer  must  subtract  from  his 
adjusted  g:ross  income  the  amount  of  his  personal  exemptions  and 
itemized  deductions  oi-  standard  deduction  (either  percentage  or  mini- 
mum standard  deduction).  The  amount  of  tax  deteimined  from  the 
table  is  tax  before  credits  and  is  to  be  reduced  by  any  tax  credits 
(such  as  the  $3i5  per  capita  or  2  j^ercent  of  taxable  income  credit  pro- 
vided by  the  Act  as  well  as  other  credits).  This  will  entail  additional 
computations  for  some  taxpayers  but  should,  on  balance,  result  in 
improved  taxpayer  compliance  and  greater  accuracy  than  was 
achieved  under  the  prior  system.  (It  is  estimated  that  over  90  percent 
of  taxpayers  will  use  the  new  tables.) 

The  cojnputation  of  the  16-pei-cent  standard  deduction  is  not  ex- 
pected to  cause  significant  difficulty  because  it  applies  at  an  income 
level  where  (prior  to  1975)  taxpayers  would  not  have  been  able  to 
use  the  optional  tax  table.  They  would  have  had  to  use  the  tax  rates 
for  a  computation  which  involves  the  same  type  of  multiplication  as 
the  standard  deduction  computation. 

In  the  case  of  a  taxpayer  with  a  short  taxable  year,  the  taxpayer 
still  annualizes  as  he  did  under  section  448  (b) . 

Effective  date 

This  provision  applies  to  taxable  years  beginning  after  December  31, 

1975. 

Revenue  effect 
This  provision  will  not  have  any  revenue  effect. 

2.  Alimony  Payments  (sec.  502  of  the  Act  and  sees.  62  and  3402(m) 
(2)  of  the  Code) 

Prior  law 
Under  prior  law,  a  deduction  for  alimony  could  be  taken  as  an 
itemized  deduction  from  adjusted  gross  income  in  the  year  paid 
in  arriving  at  taxable  income.  The  recipient  of  alimony  Avas  re- 
quired to  include  such  payments  in  his  or  her  income  and  to  pay  tax 
on  them.  Payments  for  the  support  of  a  spouse  which  were  not  re- 
quired by  a  divorce  or  separation  agreement  and  payments  for  the 
support  of  children  were  considered  normal  living  expenditures  on 
the  part  of  a  taxpayer.  Such  expenditures  wei-e  not  deductible  and 
were  not  included  in  the  income  of  the  recipients. 

Reasons  for  change 
The  Congress  believes  that  the  splitting  of  income  or  assignment 
of  income  through  the  payment  of  alimony  was  not  properly  treated 
under  prior  law  which  permitted  only  an  itemized  deduction  for  ali- 
mony. Instead,  the  Congress  believes  it  is  more  appropriate  to  take 
the  payment  of  alimony  into  account  as  a  deduction  in  arriving  at 
adjusted  gross  income,  rather  than  as  one  of  the  itemized  deductions 
which  are  generally  limited  to  personal  expenses.  As  a  deduction  from 


117 

gross  income,  the  alimony  deduction  would  be  available  to  taxpayers 
who  elect  the  standard  deduction  as  well  as  to  those  taxpayers  who 
elect  to  itemize  their  deductions. 

Exflanation  of  provision 

The  Act  takes  the  payment  of  alimony  into  account  in  determining 
adjusted  gross  income. 

The  Act  moves  the  deduction  of  alimony  payments  from  an  itemized 
deduction  to  a  deduction  from  gross  income  to  arrive  at  adjusted  gross 
income  (sec.  62).  The  Act  also  makes  a  conforming  change  in  the  sec- 
tion providing  a  withholding  allowance  for  itemized  deductions  (sec. 
3402 (m)  (2) ).  This  change  includes  the  deduction  for  alimony  as  one 
of  the  deductions  taken  into  account  for  determining  withholding  al- 
lowances in  order  to  avoid  overwithholding.  Previously  such  allow- 
ances, which  were  based  on  estimated  itemized  deductions,  could  not 
take  alimony  into  account. 

Effective  date 
This  provision  is  to  apply  to  taxable  years  beginning  after  Decem- 
ber 31,  1976. 

Revenue  effect 
This  provision  Avill  reduce  budget  receipts  by  $7  million  in  fiscal 
year  1977,  $44  million  in  fiscal  year  1978,  and^$59  million  in  fiscal 
year  1981. 

3.  Retirement  Income  Credit  (sec.  503  of  the  Act  and  sec.  37  of 
the  Code) 

Prior  law 

Under  prior  law,  individuals  who  were  65  years  of  age  or  over 
could  receive  a  tax  credit  based  on  the  first  $1,524  of  retirement 
income.  The  credit  was  15  percent  of  this  retirement  income.  Each 
spouse  who  was  65  or  over  could  compute  his  tax  credit  on  up  to  $1,524 
of  his  own  retirement  income  (whether  the  couple  filed  separate  or 
joint  returns) .  Alternatively,  spouses  65  or  over  who  filed  joint  returns 
could  compute  their  credit  on  up  to  $2,286  of  retirement  income  (one 
and  one-half  times  $1,524)  even  though  one  spouse  received  the  entire 
amount  of  the  retirement  income. 

To  be  eligible  for  the  credit  an  individual  had  to  receive  more  than 
$600  of  earned  income  in  each  of  10  prior  years.  (A  widow  or 
widower  whose  spouse  had  received  such  earned  income  was  con- 
sidered to  have  met  this  earned  income  test) . 

Retirement  income,  for  purposes  of  this  credit,  included  taxable 
pensions  and  annuities,  interest,  rents,  dividends,  and  interest  on  Gov- 
ernment bonds  issued  especially  for  the  self-employed  setting  aside 
amounts  under  "H.R.  10"  retirement-type  plans. 

The  maximum  amount  of  retirement  income  which  an  individual 
could  claim  ($1,524,  or  $2,286  for  certain  married  couples)  had  to  be 
reduced  by  two  broad  categories  of  receipts.  First,  it  was  reduced  on 
a  dollar-for-dollar  basis  by  the  amount  of  social  security,  railroad 
retirement,  or  other  exempt  pension  income  received  by  the  taxpayer. 


234-120  O  -  77  -  9 


118 

Second,  the  maximum  amount  of  retirement  income  eligible  for  the 
credit  was  further  reduced  by  one-half  of  the  annual  amount  of  earned 
income  over  $1,200  and  under  $1,700  and  by  the  entire  amount  of 
earned  income  in  excess  of  $1,700.  This  reduction  for  earned  income 
did  not  apply  to  individuals  who  had  reached  age  72. 

Individuals  under  age  65  also  were  eligible  for  tax  credits  for  retire- 
ment income  but  only  with  respect  to  pensions  received  under  a  public 
retirement  system.  Only  income  from  a  pension,  annuity,  retirement, 
or  similar  fund  or  system  established  by  the  United  States,  a  State, 
or  a  local  government,  qualified  under  this  provision.  This  resitriction 
of  retirement  income  for  purposes  of  the  credit  to  income  from  a  public 
retirement  system  applied  only  until  the  individual  reached  the  age 
of  65 ;  thereafter,  he  was  entitled  to  take  the  credit  on  the  same  basis 
as  other  individuals  who  had  reached  that  age. 

Reasons  for  change 

The  Congress  concluded  that  there  was  a  need  to  redesign  the  retire- 
ment income  credit  for  several  basic  reasons.  One  reason  was  that  the 
credit  needed  updating.  Most  of  the  features  of  the  credit  had  not  been 
revised  since  1962  when  the  maximum  level  of  income  on  which  the 
credit  was  computed  was  set  and  when  the  earnings  limits  were  estab- 
lished.^ Since  then,  there  have  been  numerous  revisions  of  the  social 
security  law  which  substantially  liberalized  the  social  security  benefits. 
As  a  result,  the  maximum  amount  of  income  eligible  for  the  credit  was 
considerably  below  the  average  annual  social  security  primary  benefit 
received  by  a  retired  worker  and  the  average  social  security  primary 
and  supplementary  benefit  that  could  be  received  by  a  retired  worker 
and  spouse  (one  and  one-half  times  the  primary  benefit). 

In  addition,  the  complexity  of  the  retirement  income  credit  pre- 
vented it  from  providing  the  full  measure  of  relief  it  was  intended 
to  grant  to  elderly  people.  This  complexity  stemmed  from  an  attempt 
to  pattern  the  credit  after  the  social  security  law.  For  example,  to 
claim  the  credit  on  his  tax  return,  a  taxpayer  had  to  show  that  he 
met  the  test  of  earning  $600  a  year  for  10  years ;  he  also  had  to  segre- 
gate his  retirement  income  from  his  other  income;  he  had  to  reduce 
the  maximum  amount  of  retirement  income  eligible  for  the  credit  by 
the  amount  of  his  social  security  income  and  by  specified  portions  of 
his  earned  income  under  the  work  test ;  a  credit  of  one  and  one-half 
times  the  basic  credit  was  available  for  a  man  and  his  wife ;  and  a  credit 
was  available  for  each  spouse  separately  if  each  spouse  independently 
met  the  eligibility  tests. 

The  purpose  of  all  these  provisions  was  to  treat  taxpayers  who  re- 
ceived little  or  no  social  security  benefits  on  as  equal  a  basis  as  possible 
to  that  provided  for  recipients  of  tax-exempt  social  security  benefits. 
However,  the  result  was  to  impose  severe  compliance  burdens  on  large 
numbers  of  elderly  people,  many  of  whom  are  not  skillful  in  filing  tax 
returns.  Such  individuals  had  to  compute  their  retirement  income 
credit  on  a  separate  schedule,  which  occupied  a  full  page  in  the  tax  re- 
turn packet,  with  19  separate  items,  some  of  which  involved  computa- 

1  One  other  feature  of  the  credit  was  adopted  in  the  1964  Revenue  Act.  This  provision 
allowed  spouses  65  and  over  who  file  joint  returns  to  claim  a  credit  on  up  to  $2,286  of 
retirement  income  (one  and  one-half  times  the  $1,524  maximum  base  for  single  people) 
even  If  one  spouse  received  the  entire  amount  of  the  married  couple's  retirement  income. 


119 

tions  in  three  separate  columns  (see  the  form  shown  below) .  It  is  these 
complexities  which  undoubtedly  accounted  for  the  fact  that  some  of  the 
organizations  representing  retired  people  estimated  that  as  many  as 
one-half  of  all  elderly  individuals  eligible  to  use  the  retirement  income 
credit  did  not  claim  this  credit  on  their  tax  returns. 


sch.duiM  E«.R  (Form  1040)  >»75     Schedule  R — Retirement  Income  Credit  Computatton 


)>•(•  2 


«(s)  •»  shown  on  Form  1040  (Do  not  ent0r  i 


I  and  •odal  vecuri^  numbv  If  shown  on  other  side) 


Your  social  saciiil^  numbar 


If  you  received  earned  income  in  excess  of  $600  In  each  of  any  10  calendar  years  before  1975, 
you  may  be  entitled  to  a  retirement  income  credit.  If  you  elect  to  have  the  Service  compute  your 
tax  (see  Form  1040  instructions,  page  5),  answer  the  question  for  coJumns  A  and  B  below/  and 
fill  in  lines  2  and  5.  The  Service  will  figure  your  retirement  income  credit  and  allow  it  In  com* 
puting  your  tax.  Be  sure  to  attach  Schedule  R  and  write  "RIC"  on  Form  1040,  lino  17.  If  you 
compute  your  own  tax,  filj  out  all  applicable  lines  of  this  schedule. 
Married  residents  of  Community  Property  States  see  Schedule  R  instructions. 


Joint  return  filers  use  column  A  for  wife  and  column  B  for  husband.  Atl  other  filers 
use  coK*mn  B  only. 

Did  you  receive  earned  Income  In  excess  of  $600  In  each  of  any  10  calendar  yeare 
before  1975?  (Widows  or  widowers  see  Schedule  R  Instructions.)  If  "Yes"  In  either 
column,  furnish  all  Information  below  In  that  column.  Also  furnish  the  combined 
information  called  for  in  column  C  for  both  husband  and  wife  If  Joint  return,  both  65 
or  over,  even  if  only  one  answered  "Yes"  In  column  A  or  B. 


n  Yes  a  No 


B 


D  Yes  D  No 


Inrorrtatlon  of 


both  65  or  ovar) 


1     Maximum  amount  of  retirement  Income  for  credit  computation 


}1.624 


Deduct; 

(a)  Amounts  received  as  pensions  or  annuities  under  the  Social  Security  Act, 
the  Railroad  Retirement  Acts  (but  not  supplemental  annuities),  and  certain 
other  exclusions  from  gross  Income     ,  


(b)  Earned  Income  received  (does  not  apply  to  persons  73  or  over): 

(1)  If  you  are  under  62,  enter  the  amount  In  excess  of  $900 

(2)  If  you  are  62  or  over  but  under  72,  enter  amount  determined  as  follows: 

If  $1,200  or  less,  enter  zero 

if  over  $1,200  but  not  over  $1,700,  enter  Vi  of  amount 
$1,200;  or  If  over  $1,700,  enter  excess  over  $1,450 

Total  of  lines  2(a}  and  2(b) 


tovar    .  \. 


Balance  (subtract  line  3  from  line  1) 

If  column  A,  B,  or  C  is  more  than  zero,  complete  this  schedule.  If  all'Of  these 
columns  are  zero  or  less,  do  not  file  this  ecliedule. 
Retirement  income: 

(a)  If  you  are  under  65: 

Enter  only  Income  received  from  pensions  and  annuities  under  public  retire- 
ment systems  (e.g.  Fed.,  State  Govts.,  etc.)  Included  on  Form  1040, 
line  15 

(b)  If  you  sre-SS  or  olden 

Enter  total  of  pensions  and  annuities.  Interest,  dividends,  proceeds  of  retire 
ment  bonds,  and  amounts  received  from  individual  retirement  accounts 
and  individual  retirement  annuities  that  are  Included  on  form  1040,  line 
15.  and  gross  rents  from  Schedule  E,  Part  II,  column  (b).  Also  Include  your 
share  of  gross  rents  from  partnerships  and  your  proportionate  share  of 
taxable  rents  from  estates  and  trusts 


6  Line  4  or  line  5,  whichever  Is  smaller    .         .    .    . 

7  (a)  Total  (add  amounts  on  line  6,  columns  A  and  8) 
(b)  Amount  from  line  6,  column  C,  If  applicable    . 


00 


tl.624 


00 


(3.286 


00 


Q 


8  Tentative  credit  Enter  15%  of  line  7(a}  or  15%  of  line  7(b),  whichever  Is  greater 

9  Amount  of  tax  shown  on  Form  1040,  line  16e... 


10  Retirement  Income  credit.  Enter  here  end  on  Form  1040,  line  48,  the  amount  on  line  8  or  One  9,  wtilchever  Is 
smaller.  Note:  If  you  claim  credit  for  foreign  taxes  or  tax  free  covenant  twnds,  skip  line  10  and  complete  lines  11, 
12,  and  13,  below 


11  Credit  for  foreign  taxes  or  tax  free  covenant  bonds    .    . 

12  Subtract  line  11  from  line  9  (if  less  than  zero,  enter  Zero) 


■trV.B.  GOTIERNIIENT  PEINTINa  OmCII  I  UTI— O-iTC-TIi     IS4M-I119 


Moreover,  the  retirement  income  credit  discriminated  among  indi- 
viduals depending  on  the  source  of  their  income.  As  indicated  above, 
the  credit  was  avaihible  onlv  to  those  with  retirement  income — that  is, 


120 

some  form  of  investment  or  pension  income.  Elderly  individuals  who 
had  to  support  themselves  by  earning  modest  amounts  and  who  had  no 
investment  or  pension  income  were  not  eligible  for  any  relief  undei- 
the  prior  credit.  This  gave  rise  to  considerable  criticism  as  to  the 
fairness  of  the  tax  law:  many  elderly  individuals  who  relied  entirely 
on  earned  income  maintained  that  they  should  have  been  allowed  the 
same  retirement  income  credit  as  those  who  lived  on  investment  income. 
Under  the  prior  credit,  elderly  people  who  relied  entirely  on  earned 
income  were  required  to  pay  substantially  higher  taxes  than  the  taxes 
paid  by  individuals  who  were  comparable  in  every  respect  except  that 
they  had  significantly  larger  incomes  which  came  from  investments. 
Another  criticism  was  that  higher  taxes  on  earnings  than  on  retirement 
income  served  as  a  disincentive  to  work. 

Explanation  of  provision 

To  deal  with  the  problems  above,  the  Congi-ess  first  updated  the 
amount  on  which  the  credit  is  based.  Then  it  simplified  the  credit  to  the 
extent  practicable  by  eliminating  complicating,  substantive  features 
of  the  credit  which  previously  were  included  in  order  to  parallel  social 
security  treatment.  Thus  the  $600  for  ten-years  earnings  test  is  elimi- 
nated, as  is  the  requirement  that  the  taxpayer  have  "retirement  in- 
come" (that  is,  pension  or  investment  income)  in  order  to  be  eligible 
for  the  credit.  In  addition,  the  variation  in  treatment  of  married  cou- 
ples depending  on  whether  they  are  separately  eligible  for  the  credit 
is  eliminated. 

The  Congress  has  increased  the  equity  of  the  provision  by  making 
the  credit  more  generally  available  to  those  age  65  or  over.  The  major 
change  in  this  area  is  the  elimination  of  the  cutback  of  the  credit  for 
earned  income.  The  Congress  concluded,  however,  that  in  view  of 
the  broadening  of  the  credit  generally  and  the  change  in  its  nature 
to  focus  relief  on  low-  and  middle-income  taxpayers,  it  is  not  necessary 
to  provide  the  credit  to  higher  income  taxpayers.  Consequently,  the 
maximum  amounts  of  the  base  for  the  credit  are  reduced  by  one-half 
of  the  adjusted  gross  income  in  excess  of  $7,500  for  a  single  person  and 
$10,000  for  a  married  couple  filing  a  joint  return  ($5,000  for  a  married 
taxpayer  filing  a  separate  return) .  Thus,  for  a  single  person,  the  credit 
would  no  longer  be  available  when  his  adjusted  gross  income  reaches 
$12,500  ($7,500  plus  two  times  $2,500).  For  a  joint  return  the  credit 
would  be  available  up  to  an  income  level  of  $15,000  if  only  one  spouse 
is  age  65  or  over  and  up  to  $17,500  if  both  spouses  are  age  65  or  over. 

The  most  significant  extension  of  the  credit  provided  by  this  Act 
is  that  it  will  for  the  first  time  benefit  low-income  earners  age  65  or 
over  regardless  of  whether  they  receive  retirement  income  or  earned 
income.  Since  the  credit  is  no  longer  limited  to  retirement  income,  it 
has  been  renamed  the  "credit  for  the  elderly." 

Taxpayers  age  65  and,  over. — More  specifically,  the  credit  for  the 
elderly  provided  by  the  Act  liberalizes  the  retirement  income  credit 
available  under  prior  law  for  those  age  65  and  over  in  four  respects. 
First,  the  amount  of  income  with  respect  to  which  the  15-percent  credit 
may  be  claimed  is  increased  to  $2,500  for  a  single  person  and  for  a 
married  couple  filing  jointly  if  only  one  spouse  is  65  or  over,  and  to 
$3,750  in  the  case  of  a  married  couple  filing  a  joint  return  where 
both  are  65  or  over. 


121 

Second,  all  types  of  income,  including  earned  income,  are  to  be 
eligible  for  the  credit.  Third,  the  maximum  amounts  on  which  the 
credit  is  based  are  reduced  by  one-half  of  adjusted  gross  income  in 
excess  of  $7,500  for  a  single  person  and  $10,000  for  a  married  couple 
filing  a  joint  return  ($5,000  for  a  married  individual  filing  a  separate 
return) .  Because  of  the  cutback  based  on  the  couple's  combined  income, 
the  credit  is  available  to  married  couples  only  if  they  file  a  joint  return, 
except  in  the  case  of  a  husband  and  wife  who  live  apart  at  all  times 
during  the  taxable  year,  which  is  treated  as  a  "nonlegal"  separation 
and  is  evidence  that  filing  a  joint  return  might  not  be  possible.  Fourth, 
the  credit  is  to  be  available  regardless  of  whether  the  individual  has 
had  work  experience  (i.e.,  has  received  earned  income)  in  prior  years. 

Under  the  Act,  the  amount  with  respect  to  which  the  15-percent 
credit  may  be  claimed  (referred  to  in  the  Act  as  the  "section  37 
amount")  may  not  exceed  a  maximum  amount  (referred  to  in  the  Act 
as  the  "initial  amount")  of  $2,500  in  the  case  of  a  single  individual 
age  65  or  over  or  a  married  couple  filing  a  joint  return  where  only  one 
spouse  is  age  65  or  over.  In  the  case  of  a  married  couple  filing  a  joint 
return  where  both  spouses  are  age  65  or  over,  the  maximum  amount  is 
$3,750  and  if  a  married  individual  age  65  or  over  files  a  separate  return 
the  maximmn  amount  is  $1,875.  (As  under  prior  law,  the  age  of  an 
individual  is  to  be  determined  as  of  the  close  of  the  taxable  year  in 
question.)  This  credit  is  available  whether  or  not  the  individual  (or 
his  spouse  in  the  case  of  a  joint  return)  has  received  $600  of  earned 
income  in  ten  prior  years. 

One  feature  of  the  prior  law  parallel  to  social  security  recipients  is 
retained,  however.  As  under  prior  law,  the  maximum  base  for  the 
credit  is  reduced  by  amounts  received  by  the  individual  (and  by  his 
spouse  in  the  case  of  a  married  couple  filing  a  joint  return)  as  a  pension 
or  annuity  under  the  Social  Security  Act,  the  Railroad  Retirement 
Acts,  or  as  a  pension  or  annuity  which  is  otherwise  excluded  from  gross 
income. 

In  conjunction  with  the  minimum  standard  deduction  of  $1,700  for 
single  persons  and  $2,100  for  joint  returns  and  the  $35  per  capita  or 
two  percent  of  taxable  income  up  to  $9,000  tax  credit,  the  credit  for  the 
elderly  will  permit  a  single  elderly  person  to  receive  approximately 
$5,800  of  earned  income  or  pension  income  before  becoming  taxable. 
For  a  joint  return  with  one  spouse  age  65  or  over,  the  tax-free  level  is 
about  $7,300.  With  both  spouses  age  65  or  over,  the  tax-free  income 
level  is  about  $9,200. 

The  change  in  the  retirement  income  credit  to  a  tax  credit  for  the 
elderly  and  the  increase  in  the  base  for  the  credit  will  increase  the 
number  of  returns  with  at  least  one  taxpayer  age  65  or  over  benefiting 
from  about  400  thousand  to  about  2.4  million. 

An  example  of  the  type  of  simplified  tax  credit  form  for  taxpayers 
age  65  and  over  which  these  changes  make  possible  is  shown  below. 
This  form  is  less  than  one-third  as  long  as  the  prior  form  and  in- 
volves only  one  column  instead  of  three.  It  requires  the  taxpayer  to 
select  the  appropriate  amount  on  which  to  compute  the  credit  and  to 
deduct  from  this  amount  his  social  security  or  certain  other  tax-exempt 
income.  It  also  requires  the  taxpayer  to  reduce  the  base  for  the  credit 
by  one-half  the  adjusted  gross  income  above  specified  levels.  On  the 
balance,  the  credit  is  computed  at  a  15  percent  rate,  and  this  is  then 
entered  on  the  basic  form  1040  as  a  tax  credit. 


122 

ScHEDUXE  R. — Credit  far  taxpajfers  age  65  or  over 


MAXIM0M  AMOUNTR  FOR  CREDIT  COMPUTATION 

Then  your  maximum' 

amount  for  credit 

If  you  are :  (check  one  box)  :  computation  %» — 

D  Single    $2,500 

Q  Married  filing  jointly  and  only  one  spouse  is  65  or  over 2,  500 

□  Married  filing  jointly,  both  age  65  or  o%-er 3,  750 

□  Married  filing  a  separate  return  and  age  65  or  over 1,  875 

1.  Enter  (from  above)  your  maximum  amount  for  credit  computat'on. 


2.  Amounts  received  as  pensions  or  annuities  under  the  Social  Security 

Act,  the  Railroad  Retirement  Acts  (but  not  supplemental  annui- 
ties) and  certain  other  exclusions  from  gross  income 

3.  Adjusted  gross  income  reduction.  Enter  one-half  of  adjusted  gross 

income  (line  15  form  1040)  in  excess  of  $7,500  if  single;  $10,000  if 
married  filing  jointly ;  or  $5,000  married  filing  separately 

4.  Total  of  lines  2  and  3 

5.  Balance  (subtract  line  4  from  line  1)  ;  if  more  than  zero  complete 

this  form;  if  zero  or  less,  do  not  file  this  form 

6.  Amount  of  credit;  enter  (here  and  on  form  1040,  line  48)  15  percent 

of  line  5  but  not  more  than  the  total  income  tax  on  form  1040, 
line  18 


Public  retirees  under  age  65. — The  Act  makes  three  changes  in  the 
retirement  income  credit  for  taxpayers  who  are  public  retirees  under 
age  65 ;  otherwise,  the  credit  for  public  retirees  age  65  is  left  generally 
the  same  as  prior  law.  First,  the  maximum  base  for  the  credit  is  in- 
creased (as  in  the  case  of  taxpayers  over  age  65)  to  $2,500  for  a  single 
taxpayer,  $3,750  for  a  married  couple  filing  a  joint  return,  and  $1,875 
for  a  married  individual  filing  a  separate  return.  Because  of  the  re- 
tention of  the  earnings  cutback  of  prior  law,  the  Congress  did  not 
believe  it  necessary  to  apply  the  adjusted  gross  income  phaseout  in 
order  to  limit  the  benefits  of  the  credit  to  the  low-  and  middle-income 
taxpayer  generally.  Second,  the  $600  a  year  of  earnings  for  10  years 
test  is  also  eliminated  for  taxpayers  under  age  65.  Third,  in  the  case 
of  joint  returns  where  one  spouse  is  age  65  or  over  and  therefore 
eligible  for  the  elderly  credit  and  the  other  spouse  is  under  age  65 
with  public  retirement  income,  the  couple  must  elect  for  the  taxable 
year  whether  to  use  the  prior  law  retirement  income  credit  or  the  new 
elderly  credit.  This  election  procedure  was  adopted  principally  to 
avoid  the  serious  complexity  that  would  result  from  a  combination 
of  the  retirement  income  credit  for  public  retirees  and  the  new  elderly 
credit  (especially  the  application  of  the  adjusted  gross  income 
phaseout) . 

Under  this  procedure,  if  the  prior  law  public  retirement  provision 
is  elected,  the  provisions  restricting  the  base  of  the  retirement  income 
to  retirement  income  as  defined  under  prior  law  for  taxpayers  over 
age  65  apply.  The  computation  of  the  credit  in  these  situations  where 


123 

a  couple  elects  to  have  essentially  the  prior  law  procedure  apply  is 
modified  by  peraiitting  the  spouses  to  allocate  the  maximum  base  of 
the  credit,  $3,750,  between  them  in  any  way  they  wish  so  long  as  no 
more  than  $2,500  is  allocated  to  one  spouse.  After  the  allocation,  the 
regular  reductions  provided  by  prior  law  are  to  apply  and  any  re- 
maining credit  base  of  either  spouse  is  to  be  aggregated  as  the  base 
for  the  final  credit  computation  in  essentially  the  same  manner  as  the 
dual  computation  under  prior  law. 

Miscellaneous  provisions. — As  mider  prior  law,  the  Act  provides 
that  the  credit  for  the  elderly  may  not  exceed  the  individual's  (or  the 
married  couple's,  in  the  case  of  a  joint  return)  tax  for  the  year.  For 
this  purpose,  however,  the  Act  provides  that  the  credit  for  the  elderly 
is  to  be  taken  before  the  foreign  tax  credit.  In  other  words,  the  tax 
for  the  year  is  to  be  computed  before  reduction  for  the  foreign  tax 
credit.  A  correlative  change  is  made  by  the  Act  in  the  limitation  on 
the  foreign  tax  credit  to  reflect  this  reordering  of  the  priority  of 
these  two  credits.  Thus,  the  limitation  on  the  foreign  tax  credit  is  to 
be  computed  with  respect  to  the  tax  for  the  year  after  i-eduction  for 
the  retirement  income  credit. 

In  addition,  although  the  credit  is  not  available  to  nonresident  aliens 
generally,  it  is  available  to  nonresident  aliens  who  are  married  to 
citizens  or  residents  of  the  United  States  who  agree  to  be  taxed  on 
their  worldwide  income  and  to  make  records  of  their  combined  income 
available  for  inspection  to  the  IRS  (i.e.,  those  nonresident  aliens 
treated  as  residents  by  section  1012  of  the  Act) . 

Effective  date 
This  provision  is  to  apply  to  taxable  years  beginning  after  Decem- 
ber 31,  1975. 

Revenue  effect 
This  provision  will  reduce  receipts  by  $391  million  in  fiscal  year 
1977,  $340  million  in  fiscal  year  1978,  and  $340  million  in  fiscal  year 
1981. 

4.  Credit  for  Child  Care  Expenses  (sec.  504  of  the  Act  and  sees. 
44A,  214  and  3402(m)(2)  of  the  Code) 

Prior  law 

Under  prior  law,  taxpayer  were  permitted  an  itemized  deduction 
for  expenses  for  the  care  of  a  dependent  child,  incapacitated  depend- 
ent or  spouse,  or  for  household  services  when  the  taxpayer  maintained 
a  household  for  any  of  these  qualifying  individuals.  An  eligible  de- 
pendent child  had  to  be  under  age  15  and  the  taxpayer  had  to  be  able 
to  claim  a  personal  exemption  for  the  child.  These  expenses  had  to  be 
related  to  employment ;  that  is,  they  had  to  be  incurred  to  enable  the 
taxpayer  to  be  gainfully  employed. 

Eligible  expenditures  were  limited  to  a  maximum  of  $400  a  month. 
Services  provided  for  children  outside  the  taxpayer's  home  were  fur- 
ther limited  to  $200  a  month  for  one  dependent,  $300  for  two,  and 
$400  for  three  or  more.  (No  deduction  was  allowed  for  the  care  of  an 
incapacitated  dependent  over  age  14  or  spouse  outside  the  taxpayer's 
home.)  The  amount  of  the  eligible  expenses  which  could  be  deducted 
was  also  reduced  by  one-half  of  adjusted  gross  income  in  excess  of 


124 

$35,000  a  year.  No  deduction  was  allowed,  however,  for  payments  to 
relatives. 

To  claim  this  deduction,  a  husband  and  wife  were  generally  required 
to  file  a  joint  return.  Both  had  to  be  employed  substantially  full  time, 
that  is,  three-quai'ters  or  more  of  the  normal  or  customary  workweek 
or  the  equivalent  on  the  average.  However,  a  spouse  who  had  been 
deserted  for  an  entire  year  could  file  as  a  single  person. 

In  the  case  of  a  disabled  dependent,  the  deductible  expenses  were 
reduced  by  the  dependent's  adjusted  gross  income  plus  disability 
income  in  excess  of  $750. 

Reasons  for  change 

The  Congress  believed  that  the  availability  of  the  child  and  depend- 
ent care  deduction  under  prior  law  was  unduly  restricted  by  its  classifi- 
cation as  an  itemized  deduction  and  by  its  complexityo 

Treating  child  care  expenses  as  itemized  deductions  denied  any 
beneficial  tax  recognition  of  such  expenses  to  taxpayers  who  elected 
the  standard  deduction.  The  Congress  believed  that  such  expenses 
should  be  viewed  more  as  a  cost  of  earning  income  thai)  as  personal 
expenses.  One  method  for  extending  the  allowance  of  child  care 
expenses  to  taxpayers  generally  and  not  just  to  itemizers  was  to  replace 
the  itemized  deduction  with  a  credit  against  income  tax  liability  for  a 
percentage  of  qualified  expenses.  While  deductions  favor  taxpayers 
in  the  higher  marginal  tax  brackets,  a  tax  credit  provides  relatively 
more  benefit  to  taxpayers  in  the  lower  brackets. 

Because  there  was  a  $400  a  month  limit  on  the  deduction  under  prior 
law,  a  complex  child  care  deduction  form  was  necessary.  The  child 
care  allowance  could  be  made  simpler  and  the  form  simplified  if  it 
were  computed  on  an  annual  instead  of  a  monthly  basis.  The  Congress 
also  believed  that  additional  unnecessary  complications  resulted  from 
the  distinction  between  expenses  for  care  of  children  incurred  inside 
and  outside  the  home  and  from  the  requirement  that  the  allowable 
deduction  be  reduced  by  the  dependent's  disability  income.  Allowing 
the  same  amount  for  the  expenses  of  caring  for  children  whether  inside 
or  outside  the  home  and  replacing  the  $200,  $300  and  $400  monthly 
maximum  deductions  for  such  outside  expenses  for  the  care  of  one, 
two,  or  three  children,  with  annual  ceilings  based  on  one  and  two  or 
more  dependents,  would  further  reduce  the  complexity  of  the  pro- 
vision. 

The  rule  allowing  the  deduction  in  the  case  of  joint  returns  only 
where  both  spouses  work  full  time  seemed  unduly  restrictive.  The 
full-time  earnings  test  was  intended  to  prevent  one  spouse  from 
working  part  time,  perhaps  in  a  nominal  capacity,  in  order  to  obtain 
the  benefits  of  a  deduction  which  could  amount  to  $4,800  a  year.  The 
Congress  believed  this  type  of  abuse  could  be  prevented  by  an  alterna- 
tive rule  limiting  the  allowable  expenses  to  the  earnings  of  the  spouse 
with  the  smaller  earnings.  Such  a  limitation  would  enable  a  married 
or  single  taxpayer  with  a  qualifying  dependent  to  treat  child  care 
expenses  as  a  cost  of  earning  income. 

The  Congress  also  believed  that  child  care  expenses  should  be  al- 
lowed when  one  spouse  works  and  the  other  is  a  full-time  student. 
The  spouse  attending  school  cannot  reasonably  be  expected  to  provide 


125 

child  care  to  enable  the  other  spouse  to  work.  In  these  circumstances, 
the  expenses  incurred  to  pay  for  child  care  are,  in  fact,  necessary  for 
the  taxpayer  to  be  gainfully  employed. 

The  Congress  believed  that  the  one-year  waiting  period  before  a 
deserted  spouse  could  claim  child  care  expenses  was  too  long  and 
adopted  a  shorter  qualifying  period  to  mitigate  haixiships. 

Limiting  the  deduction  of  child  care  expenses  to  parents  who  claim 
a  child  as  a  dependent  denied  the  deduction  to  a  divorced  or  separated 
parent  with  custody  of  a  child,  who  did  not  supply  more  than  half  of 
the  child's  support  and  could  not  claim  the  child  as  a  dependent,  but 
who  nevertheless  incurred  child  care  expenses  in  order  to  work.  The 
Congress  believed  that  the  parent  who  has  custody  of  the  child  for 
the  greater  period  of  the  year  should  be  allowed  to  treat  the  child 
care  expenses  as  a  cost  of  earning  income,  provided  the  parent  who  has 
custody  for  the  shorter  period  does  not  claim  such  expenses. 

The  Congress  also  viewed  the  bar  on  deducting  payments  to  rela- 
tives for  the  care  of  children  as  overly  restrictive.  Relatives  generally 
provide  superior  attention.  In  order  to  cover  the  child  oare  expenses 
paid  to  relatives  and  also  to  limit  the  risks  of  abuse  (such  as  splitting 
or  transferring  income  by  gift  to  relatives  who  are  in  lower  brackets 
or  have  incomes  below  taxable  levels)  the  Congress  has  provided  the 
child  care  allowance  only  for  those  payments  made  to  a  relative  who 
is  not  the  taxpayer's  dependent  and  whose  sei-vices  constitute  employ- 
ment for  social  security  purposes. 

The  Congress  views  qualified  child  care  expenses  principally  as  a 
cost  of  earning  income,  but  believes  that  in  view  of  the  disparity  of 
benefits  between  high-income  and  low-income  taxpayei*s  and  the  large 
revenue  cost  of  a  deduction  (in  determining  adjusted  gross  income) 
that  a  tax  credit  is  more  appropriate.  It  also  believes  that  an  income 
ceiling  on  those  entitled  to  the  allowance  has  minimal  revenue  impact 
if  the  allowance  is  in  the  fonn  of  a  credit.  Therefore,  it  considered  it 
appropriate  and  feasible  to  eliminate  the  income  phaseout  and  to  allow 
all  taxpayers  to  claim  such  expenses  regardless  of  their  income  level. 

Explanation  of  provision 

The  Act  replaces  the  itemized  deduction  for  household  and  depend- 
ent care  expenses  with  a  nonrefundable  income  tax  credit.  Taxpayers 
with  qualified  expenses  may  claim  a  credit  against  tax  for  20  percent 
of  the  expenses  incurred  (up  to  certain  limits)  for  the  care  of  a  child 
under  age  15  or  for  an  incapacitated  dependent  or  spouse,  in  order  to 
enable  the  taxpayer  to  work.  The  prior  income  limit  of  $35,000 
beyond  which  the  deduction  was  phased  out  is  removed. 

Although  the  A.Q,t  changes  the  nature  of  a  claim  for  child  care 
expenses  to  a  credit,  it  retains  the  basic  rules  for  determining  quali- 
fied expenses  with  some  modifications  and  extensions. 

Several  changes  simplify  the  child  care  tax  form.  One  such  change 
replaces  the  present  monthly  maximum  allowance  for  expenses  for 
children  outside  the  home  ($200  for  one  dependent,  $300  for  two  de- 
pendents, and  $400  for  three  or  more  dependents)  with  an  annual 
credit  of  20  percent  of  a  maximum  of  $2,000  for  one  dependent  and 
$4,000  for  two  or  more  dependents  whether  the  expenses  are  for  services 
inside  or  outside  the  home.   (No  credit,  however,  is  allowed  for  the 


126 

expenses  for  the  care  of  a  dependent  over  age  14  or  of  a  spouse  outside 
the  home.)  With  a  20-percent  credit,  the  maximum  credit  would  be 
$400  for  one  dependent  and  $800  for  two  or  more. 

The  Act  also  extends  the  credit  to  married  couples  where  the  hus- 
band or  wnfe,  or  both,  work  part-time.  (Previously,  both  were  required 
to  work  full-time.)  The  eligible  expenses  are  limited  to  the  amount 
of  earnings  of  the  spouse  earning  the  smaller  amount  or,  in  the  case 
of  a  single  person,  to  his  or  her  earnings.  The  deduction  also  is  made 
available  to  married  couples  where  one  is  a  full-time  student  and  the 
other  spouse  works.  For  purposes  of  the  earnings  limitation  only,  the 
Act  treats  a  student  as  if  he  or  she  earns  $166  a  month  if  there  is  one 
dependent  and  $333  a  month  if  there  are  two  or  more  dependents  at 
any  time  during  the  year. 

The  credit  is  available  to  married  couples  only  if  they  file  a  joint 
return.  The  credit  is  extended  to  a  divorced  or  separated  parent  who 
has  custody  of  a  child  under  age  15  even  though  the  parent  may 
not  be  entitled  to  a  dependency  exemption  for  the  child,  provided  the 
parent  claiming  the  credit  has  custody  of  the  child  for  a  longer  period 
during  the  year  than  the  other  parent  and  maintains  (i.e.,  provides 
over  half  the  cost  of  maintaining)  a  household  which  includes  the 
child.  A  deserted  spouse  is  eligible  for  the  credit  when  the  deserting 
spouse  is  absent  for  the  last  6  months  of  the  taxable  year  instead  of 
an  entire  year.  Finally,  the  requirement  that  the  allowable  expenses  be 
reduced  by  disability  income  received  by  the  dependent  is  eliminated. 

The  entire  allowance  of  $2,000  or  $4,000  a  vear  is  available  to  a  tax- 
payer who  has  one  or  two  qualifying  dependents,  respectively,  at  any 
time  during  the  course  of  the  taxable  year.  However,  only  those  ex- 
penses incurred  on  behalf  of  a  qualifying  individual  during  the  period 
when  the  individual  was  a  qualifying  individual  are  eligible.  For 
example,  a  taxpayer  whose  child  reaches  age  15  in  April  would  be 
eligible  for  the  entire  $2,000  limit  and  no  prorating  would  be  required. 
However,  only  those  expenses  incurred  prior  to  the  child's  fifteenth 
birthdav  would  be  eligible. 

The  Act  repeals  the  disqualification  of  any  amounts  paid  to  rela- 
tives. The  Act  allows  a  credit  for  child  care  expenses  paid  to  relatives 
who  are  not  dependents  of  the  taxpayer  even  if  they  are  members  of 
the  taxpayer's  household,  provided  the  relative's  services  constitute 
emplovment  within  the  meaning  of  section  3121(b),  that  is,  for  social 
security  purposes.^ 

The  Act  also  makes  a  conforming  chance  to  allow  the  credit  to  be 
considered  for  purposes  of  additional  withholdinR  allowances.  Under 
prior  law  (sec.  3402 (m)  (2) ),  additional  withholding  allowances  were 
permitted  to  be  claimed  for  itemized  deductions.  Changing  the  child 
care  provision  from  a  deduction  to  a  tax  credit  would  have  made  it 
impossible  for  an  employee  to  avoid  i\u\  overwithholdinff  attributable 
to  the  child  care  expenses.  To  avoid  this  overwithholding,  the  Act 
gives  the  Secretary  of  the  Treasury  the  authority  to  provide  withhold- 


^Fcr  social  security  purposes,  the  following  services  are  considered  employment:  (a) 
services  in  tbe  taxpayer's  home  if  performed  by  the  taxpayer's  son  or  daughter  age  21  or 
over,  but  not  the  taxpayer's  spouse:  (b)  domestic  service  by  the  taxpayer's  mother  or 
father  if  (i)  the  taxpayer  has  in  his  home  a  son  or  daughter  Tvho  is  under  age  18  or  who 
has  a  physical  or  mental  condition  requiring  the  personal  care  of  an  adult  for  at  least 
four  continuous  weelcs  In  the  quarter,  and  (il)  the  taxpayer  is  a  widow  or  widower  or  is 
divorced,  or  the  taxpayer  has  a  spouse  in  his  home  who,  because  of  a  physical  or  mental 
condition,  is  incapable  of  caring  for  his  son  or  daughter  for  at  least  four  continuous  weeks 
In  the  quarter  ;  (c)  services  of  all  other  relatives. 


127 

ing  allowance  tables  which  take  into  account  tax  credits  to  which 
employees  are  entitled.  It  is  intended  that  these  tables  may  take  into 
account  the  credit  for  child  care  expenses,  the  new  tax  credit  for  the 
elderly,  and  such  other  tax  credits  as  the  Secretary  may  find  appro- 
priate. Because  the  credit  for  child  care  expenses  is  20  percent  of  the 
eligible  expenses,  the  tables  may  be  designed  to  reflect  the  approximate 
tax  value  of  the  credit  rather  than  the  total  expenses  (as  is  the  case  with 
itemized  deductions)  to  make  the  withholding  change  closely  approxi- 
mate the  reduction  in  tax  liability.  (Similarly,  the  full  amount  of  the 
tax  credit  for  the  elderly  might  not  be  reflected  in  such  tables,  particu- 
larlj'^  where  the  income  phaseout  is  operative.) 

It  is  estimated  that  the  number  of  returns  benefiting  from  the  child 
care  provision  will  approximately  double  from  about  2  million  to 
nearly  4  million.  Of  the  4  million,  approximately  ^5  million  will  benefit 
compared  to  prior  law  and  about  1  million  will  lose  relatively  small 
amounts  because  of  the  change  from  an  itemized  deduction  to  a  20- 
percent  credit. 

Effective  date 
This  provision  is  to  apply  to  taxable  years  beginning  after  Decem- 
ber 31,  1975. 

Revenue  effect 
This  provision  will  reduce  tax  receipts  by  $384  million  in  fiscal 
year  1977,  $368  million  in  fiscal  year  1978,  and  $488  million  in  fiscal 
year  1981. 

5.  Sick  Pay  and  Certain  Military,  etc.  Disability  Pensions  (sec.  505 
of  the  Act  and  sees.  104  and  105  of  the  Code) 

a.  Sick  Pay 

Prior  I^w 

Under  prior  law,  gross  income  did  not  include  amounts  received 
under  wage  continuation  plans  when  an  employee  was  ''absent  from 
work"  on  account  of  personal  injuries  or  sickness.  The  payments  that 
were  received  when  an  employee  was  absent  from  work  were  generally 
referred  to  as  "sick  pay"  (under  sec.  105  (d) ) . 

The  proportion  of  salary  covered  by  the  wage  continuation  pay- 
ments and  any  hospitalization  of  the  taxpayer  determined  whether  or 
not  there  was  a  waiting  period  before  the  exclusion  applied.  If  the  sick 
pay  was  more  than  75  percent  of  the  regular  weekly  rate,  the  waiting 
period  before  the  exclusion  became  available  was  30  days  whether  or 
not  the  taxpayer  was  hospitalized  during  the  period.  If  the  rate  of  sick 
pay  was  75  percent  or  loss  of  the  regidar  weekly  rate  and  the  taxpayer 
was  not  hospitalized  during  the  period,  the  waiting  period  was  7  days. 
If  the  sick  pay  was  75  percent  or  less  of  the  regular  weekly  rate  and 
the  taxpayer  was  hospitalized  for  at  least  1  day  during  the  period,  there 
was  no  waiting  period  and  the  sick  pay  exclusion  applied  immediately. 
In  no  case  could  the  amount  of  "sick  pay"  exclusion  exceed  $75  a  week 
for  the  first  30  days  and  $100  a  week  after  the  first  30  days. 

During  the  period  that  a  retired  employee  was  entitled  to  the  sick 
pay  exclusion,  lie  could  not  recover  any  of  his  contributions  toward  any 
annuity  under  section  72.^ 

iReg.  sec.  1.72-15  (b)  and  (c)(2)  and  1.72-4(b)  (2)  (iv). 


128 

jReasons  for  change 

Section  105  (d) ,  which  provided  the  exclusion  for  "sick  pay,"  was  ex- 
tremely complex.  The  provision's  complexity  required  a  separate  28- 
line  tax  form  which  was  so  difficult  that  many  taxpayers  had  to 
obtain  professional  assistance  in  order  to  complete  it  and  avail  them- 
selves of  the  exclusion.  The  Congress  believed  that  elimination  of 
the  complexity  in  this  area  was  imperative. 

In  addition,  the  sick  pay  provision  caused  some  inequities  in  the 
tax  treatment  of  sick  employees  compared  to  working  ones  and  the 
treatment  of  lower-income  taxpayers  compared  to  those  with  higher  in- 
comes. Excluding  "sick  pay"  payments  (received  in  lieu  of  wages) 
from  income  when  an  employee  was  absent  from  work,  while  taxing  the 
same  payments  if  made  as  wages  while  he  was  at  work,  was  not  justi- 
fied. A  working  employee  generally  incurs  some  costs  of  earning  in- 
come not  incurred  by  a  sick  employee  who  stays  at  home.  The  latter 
may  incur  additional  medical  expenses  on  account  of  his  sickness,  but 
he  may  deduct  such  medical  expenses  if  they  exceed  the  percentage  of 
income  limitations. 

Under  prior  law,  low-  and  middle-income  taxpayers  received  on  a 
percentage  basis  less  benefit  from  the  sick  pay  exclusion  than  did  tax- 
payers in  higher  marginal  tax  brackets  because  of  the  progressivity  of 
tax  rates.  Taxpayers  who  received  no  sick  pay,  of  course,  received  no 
benefit  at  all.  The  Congress  believed  that  the  exclusion  allowed  under 
section  105  should  not  have  a  regressive  effect  and  that  the  provision 
should  direct  a  fairer  share  of  its  tax  benefits  to  low-  and  middle- 
income  taxpayers. 

Explanation  of  provision 

The  Act  repeals  the  prior  sick  pay  exclusion  and  continues  the 
maximum  exclusion  of  $100  a  week  ($5,200  a  year)  only  for  taxpayers 
under  age  65  vi/ho  have  retired  on  disability  and  are  permanently  and 
totally  disabled.  For  this  purpose  permanently  and  totally  disabled 
means  unable  to  engage  in  any  substantial  gainful  activity  by  reason  of 
any  medically  determinable  physical  or  mental  impairment  which  can 
be  expected  to  result  in  death  or  which  has  lasted  or  can  be  expected  to 
last  for  a  continuous  period  of  not  less  than  12  months.  A  taxpayer  is 
considered  to  be  "retired"  even  if  not  fonnaJly  placed  on  retirement 
but  receiving  some  other  form  of  income  in  lieu  of  wages,  such  as  ac- 
cumulated leave,  provided  he  is  not  expected  to  return  to  work.  The 
Congress  expects  that  proof  of  disability  must  be  substantiated  by  the 
taxpayer's  employer,  who  is  to  certify  this  status  under  procedures  ap- 
proved in  advance  by  the  Tntornal  Revenue  Service.  The  Service  may 
also  issue  regulations  requiring  the  taxpayer  to  provide  proof  from 
time  to  time  that  he  is  disabled.  If,  at  the  time  an  individual  retires 
on  disability,  a  qualified  physician  is  not  certain  that  the  retiree's 
disability  will  in  fact  be  permanent,  the  Service  may  accept  subsequent 
evidence  that  his  disability  was  permanent  and  qualified  him  as  of 
the  time  of  his  retirement  for  ^his  provision.  (At  age  65,  taxpayers 
become  ineligible  for  this  exclusion  but  are  entitled  to  claim  the 
revised  elderly  credit.) 

The  maximum  amount  excludable  is  to  be  reduced  on  a  dollar-for- 
dollar  basis  by  the  taxpayer's  adjusted  gross  income  (including  dis- 
ability income)   in  excess  of  $15,000.  Thus,  if  a  taxpayer  receives 


129 

$5,200  in  disability  income  and  $15,000  (or  more)  in  other  income 
which  together  equal  $20,200  (or  more),  he  would  not  be  entitled  to 
any  exclusion  of  his  disability  payments. 

In  order  to  claim  this  exclusion,  a  taxpayer  who  is  married  at  the 
close  of  a  taxable  year  must  file  a  joint  return  with  his  or  her  spouse, 
unless  they  have  lived  apart  at  all  times  during  that  year.  Each  spouse 
is  entitled  to  a  separate,  maximum  $5,200  exclusion,  but  the  phaseout 
for  adjusted  gross  income  in  excess  of  $15,000  applies  on  a  per-retum 
basis. 

The  Act  also  provides  a  transitional  rule  allowing  persons  who, 
before  January  1,  1976,  retired  on  disability  or  who  were  entitled  to 
retire  on  disability,  and  on  January  1,  1976,  were  permanently  and 
totally  disabled  (though  they  may  not  have  been  permanently  and 
totally  disabled  on  their  retirement  date)  to  claim  a  disability  income 
exclusion  if  they  otherwise  qualify.  Another  transitional  rule  allows 
taxpayers  who  retired  on  disability  before  January  1,  1976,  and  who 
were  entitled  to  a  sick  pay  exclusion  on  December  31,  1975,  also  to 
benefit  from  the  section  72  amiuity  exclusion  before  age  65,  if  they 
make  an  irrevocable  election  not  to  claim  the  disability  exclusion. 

The  Act  provides  that  when  a  taxpayer  reaches  age  65,  he  can  begin 
to  recover  his  investment  in  an  annuity  contract  (if  any)  under  section 
72.  A  special  rule  enables  certain  permanently  and  totally  disabled  tax- 
payers who  determine  that  they  will  not  be  able  to  claim  any  (or  little) 
sick  pay  exclusion  to  benefit  from  the  section  72  exclusion  before  age 
65.  Under  this  rule,  the  taxpayer  may  make  an  irrevocable  election  not 
to  seek  the  benefits  of  the  disability  income  exclusion  for  that  year  or 
subsequent  years.  ^ 

The  new  rules  apply  both  to  civilians  and  to  military  personnel. 
However,  Veterans'  Administration  payments  remain  completely  ex- 
empt from  tax. 

Effective  date 
This  provision  applies  to  taxable  years  beginning  after  December  31, 
1975. 

6.  Disability  Pensions  of  the  Military,  etc. 

Prior  law 
Prior  law  excluded  from  gross  income  amounts  received  as  a  pen- 
sion, annuity,  or  similar  allowance  for  pei-sonal  injuries  or  sickness 
resulting  from  active  service  in  the  armed  forces  of  any  country,  as 
well  as  similar  amounts  received  by  disabled  members  of  the  National 
Oceanic  and  Atmospheric  Administration  (NOAA,  formerly  called 
the  Coast  and  Geodetic  Survey),  the  Public  Health  Service,  or  the 
Foreign  Service  (sec.  104(a)  (4)).^ 

2  At  age  65  the  taxpayer  then  becomes  eligible  for  the  elderly  credit  rather  than  having 
to  wait  until  mandatory  retirement  age  as  was  the  case  under  prior  law.  Public  retirees  who 
retired  on  disability  and  malte  this  election  must  wait  until  minimum  retirement  age  to  use 
the  retirement  Income  credit  (rather  than  the  mandatory  age  of  prior  law).  Otherwise, 
public  retirees  who  retired  on  disability  would  be  eligible  for  the  retirement  income  credit 
at  a  substantially  earlier  time  than  under  prior  law.  Congress  did  not  intend  this  sub- 
stantial liberalization  of  the  retirement  income  credit  for  public  retirees. 

"Under  Treasury  regulations  (Reg.  sec.  1.105— 4(a)  (3)  (i)  (a) ),  the  portion  of  a  dis- 
ability pension  received  by  a  retired  member  of  the  Armed  Forces  which  was  In  excess 
of  the  amount  excludable  under  this  provision  was  excluded  as  sick  pay  under  a  wage 
continuation  plan  subject  to  the  limits  of  section  105(d)  if  such  pay  was  received  before  the 
member  reached  retirement  age.  This  Act  repeals  the  .sick  ipay  provision  and  substitutes 
a  maximum  annual  exclusion  of  $5,200  for  persons  who  are  permanently  and  totally 
disabled.   (See  Explanation  of  provisions  under  a.  Sick  Pay  above.) 


130 

Reasons  for  change 

The  Congress  was  concerned  with  two  somewhat  conflicting  aspects 
of  the  exclusion  of  disability  payments  from  gross  income :  on  the  one 
hand,  the  abuse  of  the  exclusion  in  certain  instances,  particularly  by 
retiring  members  of  the  armed  forces,  and  on  the  other  hand,  the  ex- 
pectation and  reliance  cf  present  members  of  the  affected  government 
services,  especially  the  armed  forces,  on  the  government  benefits  avail- 
able to  them  when  they  entered  government  employment  or  enlisted  in 
or  were  draft/cd  into  the  milit/ary. 

Criticism  of  the  exclusion  of  armed  forces  disability  pensions  from 
income  focused  on  a  number  of  cases  involving  the  disability  retire- 
ment of  military  personnel.  In  many  cases,  armed  forces  personnel 
have  been  classified  as  disabled  for  military  service  shortly  before  they 
would  have  become  eligible  for  retirement  principally  to  obtain  the 
benefits  of  the  special  tax  exclusion  on  the  disability  portion  of  their 
retirement  pay.  In  most  of  these  cases  the  individuals,  having  retired 
from  the  military,  earn  income  from  other  employment  while  receiving 
tax-free  "disability"  payments  from  the  military.  The  Congress  ques- 
tioned the  equity  of  allowing  retired  military  personnel  to  exclude  the 
payments  which  they  receive  as  tax-exempt  disability  income  when 
they  are  aible  to  earn  substantial  amounts  of  income  from  civilian  work, 
despite  disabilities  such  as  high  blood  pressure,  arthritis,  etc. 

However,  in  order  to  pro/ide  benefits  to  any  present  personnel  who 
may  have  joined  or  continued  in  the  government  or  armed  services  in 
reliance  on  possible  tax  benefits  from  this  program,  the  Congress  be- 
lieved any  changes  in  the  tax  treatment  of  military  disability  payments 
should  affect  only  future  members  of  the  armed  forces,  NOAA,  Public 
Health  Service  and  Foreign  Service.  The  Congress  also  believed  that 
the  risks  borne  by  some  civilian  employees  of  the  United  States  Gov- 
ernment are  similar  to  those  faced  in  combat  by  the  military.  It  thus 
decided  to  extend  tax  exclusion  benefits  to  civilian  government  em- 
ployees who  receive  disability  pay  for  injuries  resulting  from  acts  of 
terrorism. 

Explanation  of  provisions 

The  Act  eliminates  the  exclusion  of  disability  payments  from  income 
for  those  covered  under  section  104(a)(4),  that  is,  members  of  the 
armed  forces  of  any  country,  NOAA,  the  Public  Health  Service  and 
the  Foreign  Service.  This  change  applies  only  prospectively  to  per- 
sons who  join  these  government  services  after  September  24,  1975. 
Specific  exceptions  continue  the  exclusion  in  certain  cases  for  future 
disability  payments  for  injuries  and  sickness  resulting  from  active 
service  in  the  armed  forces  of  the  United  States. 

At  all  times,  Veterans'  Administration  disability  payments  will  con- 
tinue to  be  excluded  from  gross  income.  In  addition,  even  if  a  future 
serviceman  who  retires  does  not  receive  his  disability  benefits  from  the 
Veterans'  Administration,  he  will  be  allowed  to  exclude  from  his  gross 
income  an  amount  equal  to  the  benefits  he  could  receive  from  the  Vet- 
erans' Administration.  Otherwise,  future  members  of  the  armed  forces 
will  be  allowed  to  exclude  military  disability  retirement  payments 
from  their  gross  income  only  if  the  payments^  are  directly  related  to 
"combat  injuries."  A  combat-related  injury  is  defined  as  an  injury  or 


131 

sickness  which  is  incurred  as  a  result  of  any  one  of  the  following  activi- 
ties: (1)  as  a  direct  result  of  armed  conflict;  (2)  while  engaged  in 
extra-hazardous  service,  even  if  not  directly  engaged  in  combat;  (3) 
under  conditions  simulating  war  including  maneuvers  or  training ;  or 
which  is  (4^  caused  by  an  instrumentality  of  war,  such  as  weapons. 
This  definition  of  com  bat -related  injuries  is  meant  to  cover  an  injury 
or  sickness  attributable  to  the  special  dangers  associated  with  armed 
conflict  or  preparation  or  training  for  armed  conflict. 

In  addition,  the  Act  provides  an  exclusion  for  disability  payments 
to  civilian  employees  of  the  United  States  Government  for  injuries 
which  result  from  acts  of  terrorism  and  which  are  incurred  while  the 
employees  are  performing  official  duties  outside  the  United  States. 

All  persons  who  were  members  of  the  armed  forces  of  any  country 
(or  a  military  reserve  unit),  the  National  Oceanic  and  Atmospheric 
Administration,  the  Public  Health  Service  and  the  Foreign  Service 
as  of  September  24,  1975,  or  Avho  as  of  that  date  were  subject  to  a 
written  binding  commitment  to  enter  these  Government  services  or 
were  retirees  from  these  sei-vices  receiving  disability  retirement  pay- 
ments which  were  excluded  from  their  gross  income  under  prior  law, 
will  continue  to  exclude  such  payments  from  gross  income  under  the 
Act.  In  addition,  all  disability  benefits  paid  by  the  Veterans'  Ad- 
ministration will  continue  to  be  exempt  from  tax,  as  under  prior  law. 

Effective  date 
This  provision  relating  to  members  of  the  armed  forces  of  any 
country,  the  National  Oceanic  and  Atmospheric  Administration,  the 
Public  Health  Service  and  the  Foreign  Service  applies  to  persons 
who  joined  these  services  after  September  24,  1975.  The  exclusion  for 
disability  payments  for  injuries  resulting  from  acts  of  terrorism  ap- 
plies to  taxable  years  beginning  after  December  31,  1976. 

Reveiiue  effect 
The  change  in  the  sick  pay  provision  will  increase  tax  receipts  by 
$380  million  in  fiscal  year  1977,  $357  million  in  fiscal  year  1978,  and 
$450  million  in  1981.  The  changes  in  the  disability  exclusion  will  have 
no  revenue  impact  until  substantial  numbers  of  persons  entering  gov- 
ernment service  after  September  24,  1975,  retire.  The  new  exclusion 
for  disability  payments  for  injur-ies  resulting  from  acts  of  terrorism 
will  cause  a  negligible  revenue  loss. 

6,  Moving  Expenses  (sec.  506  of  the  Act  and  sees.  217  and  82  of  the 
Code) 

Prior  law 

An  employee  or  self-employed  individual  may  claim  a  deduction 
from  gross  income  for  certain  expenses  of  moving  to  a  new  residence 
in  coimection  with  beginning  work  at  a  new  location  (sec.  217).  Any 
amount  received  directly  or  indirectly  as  a  reimbursement  of  moving 
expenses  must  be  included  in  a  taxpayer's  gross  income  as  compensa- 
tion for  services  (sec.  82),  but  he  may  offset  this  income  by  deducting 
expenses  which  would  otherwise  qualify  as  deductible  items. 

Deductible  moving  expenses  are  the  expenses  of  transporting  the 
taxpayer  and  members  of  his  household,  as  well  as  his  household  goods 
and  personal  effects,  from  the  old  to  the  new  residence;  the  cost  of 


132 

meals  and  lodging  enroute;  the  expenses  for  premove  househunting 
trips;  temporary  living  expenses  for  up  to  30  days  at  the  new  job 
location;  and  eei'tain  expenses  related  to  the  sale  or  settlement  of  a 
lease  on  the  old  residence  and  the  purchase  of  a  new  one  at  the  new  job 
location. 

Tlie  moving  expense  deduction  was  subject  to  a  number  of  limitations 
under  prior  law.  A  maximum  of  $1,000  could  be  deducted  for  premove 
househunting  and  temporary  living  expenses  at  the  new  job  location.  A 
maximum  of  $2,500  (reduced  by  any  deduction  claimed  for  househunt- 
ing or  temporary  living  expenses)  could  be  deducted  for  certain  quali- 
fied expenses  for  the  sale  and  purchase  of  a  residence  or  settlement  of  a 
lease.  If  both  a  husband  and  w  ife  began  new  jobs  in  the  same  general 
location,  the  move  was  treated  as  a  single  commencement  of  work.  If  a 
husband  and  wife  filed  separate  returns,  the  maximum  deductible 
amounts  were  halved. 

Also,  under  prior  law  in  order  for  a  taxpayer  to  claim  a  moving 
expense  deduction,  his  new  principal  place  of  w^ork  had  to  be  at  least 
50  miles  farther  from  his  former  residence  than  was  his  former  prin- 
cipal place  of  work  (or  his  former  residence,  if  he  had  no  former  place 
of  work).  During  the  12-month  period  following  his  move,  the  tax- 
payer had  to  be  a  full-time  employee  in  the  new  general  location  for 
at  least  three- fourths  of  the  following  year,  that  is,  39  weeks  during 
the  next  12-month  period.  A  self-employed  pei-son  was  required,  dur- 
ing the  24-month  period  follow  ing  his  arrival  at  his  new  work  location, 
to  perform  services  on  a  full-time  basis  for  at  least  78  weeks,  with  at 
least  39  weeks  of  full-time  work  falling  within  the  first  12  months. 
Even  if  the  39-  or  78-week  requirement  had  not  been  fulfilled  at  the  end 
of  a  taxable  year  (but  could  still  be  fulfilled),  the  taxpayer  could  elect 
to  deduct  any  qualified  moving  expenses  which  he  had  paid  or  incurred 
provided  he  met  all  the  other  requirements.  If  he  failed  to  meet  the 
full-time  employment  period  requirement  in  a  subsequent  taxable 
year,  he  had  to  include  the  amounts  previously  deducted  in  his  gross 
income  for  the  subsequent  year.^ 

Pursuant  to  statutory  autorization,^  the  Secretary  of  the  Treasury 
had  entered  into  agreements  with  the  Secretary  of  Defense  for  mem- 
bei-s  of  the  Army,  Navy,  and  Air  Force,  and  with  the  Secretary  of 
Transportaion  for  members  of  the  Coast  Guard  to  allow  special  treat- 
ment tor  servicemen's  moving  expenses  for  taxable  years  ending  before 
January  1,  1976. 

As  a  result,  the  Secretaries  of  Defense  and  Transportation  were  not 
required  to  report  or  withhold  tax  on  moving  expense  reimbursements 
made  to  members  of  the  armed  forces,  nor  were  membei-s  of  the  armed 
forces  required  to  include  in  income  the  value  of  in-kind  moving  serv- 
ices provided  by  the  military.  However,  members  of  the  armed  forces 
could  deduct  moving  expenses  to  the  extent  they  exceeded  military  re- 
imbursements, and  would  otherwise  qualify  as  deductible  expenditures 
under  section  217,  without  counting  any  military  in-kind  reimburse- 
ments against  the  dollar  limitations.  This  special  legislative  morato- 
rium on  the  application  of  the  moving  expense  provision  to  mem- 
bers of  the  military  lapsed  as  of  January  1, 1976. 

1  The  39-  and  78-week  tests  were  waived  if  the  employee  was  unable  to  satisfy  them  as 
a  result  of  death,  disability,  or  Involuntary  separation  (other  than  for  willful  miscon- 
duct), 

3  Public  Law  93-490,  sec.  2,  88  Stat.  1466.  93d  Cong.,  2d  sess.,  October  26,  1974. 


133 

Reasons  for  change 

The  prior  provisions  for  moving  expenses  reflected  significant  revi- 
sions made  by  the  Tax  Reform  Act  of  1969.  Generally,  the  Congress 
believes  that  the  basic  rationale  and  requirements  of  these  provisions 
remain  sound. 

The  mobility  of  labor  continues  to  be  important  to  the  economy  of 
the  United  States.  Frequently,  employers  must  transfer  employees 
from  one  location  to  another  and  workers  must  change  their  residence 
in  order  to  obtain  better  employment  opportunities.  The  substantial 
moving  expenses  incurred  by  many  taxpayers  in  connection  with  em- 
ployment-related moves  may  be  viewed  as  a  cost  of  earning  income. 
Allowing  a  tax  deduction  for  certain  moving  expenses  helps  achieve 
a  more  accurate  account  of  a  taxpayer's  net  income. 

Despite  inflation  between  1969  and  1975,  there  had  been  no  adjust- 
ment of  the  $1,000  and  $2,500  ceilings  on  moving  expense  deductions. 
The  Congress  believed  that  these  ceilings  should  be  set  at  higher 
dollar  levels.  However,  the  Congress  did  not  believe  that  the  two 
ceilings  had  to  be  increased  proportionately. 

The  50-mile  test  restricted  the  deduction  of  expenses  to  a  move  to  a 
new  job  location  which  was  at  least  50  miles  farther  from  the  tax- 
payer's former  residence  than  was  his  former  principal  place  of  work. 
For  example,  if  a  taxpayer's  former  residence  was  30  miles  from  his 
former  job,  his  new  job  location  had  to  be  at  least  50  miles  farther 
from  his  former  residence;  that  is,  it  had  to  be  a  total  of  at  least  80 
miles,  if  his  moving  expenses  were  to  be  deductible.  Recognizing  the 
increasing  cost  of  commuting,  the  growing  concern  for  gasoline  con- 
servation, and  the  continuing  inadequacy  of  mass  transportation  in 
most  areas  of  the  country,  the  Congress  decided  that  some  reduction 
of  the  50-mile  test  was  appropriate. 

Certain  changes  made  in  the  1969  Act  created  unforeseen  adminis- 
trative difficulties  for  the  military.  The  Department  of  Defense  and 
the  Department  of  Transportation  (with  respect  to  the  peacetime 
Coast  Guard)  apparently  have  no  economically  feasible  procedure 
for  identifying  or  valuing  the  in-kind  reimbui-sements  provided  for 
each  serviceman  where  the  military  pays  a  mover  for  the  moving  ex- 
penses, or  does  the  moving  itself.  The  Department  of  Defense,  acting 
on  behalf  of  all  the  military  services,  indicated  in  discussions  with 
the  Internal  Revenue  Service  that  establishing  such  a  system  for 
identifying  reimbursed  moving  expenses  and  in-bound  services  would 
involve  substantial  administrative  burdens  for  the  Department,  as  well 
as  increasing  its  expenses,  at  no  revenue  gain  to  the  Treasury.  As  a 
result  of  these  administrative  problems,  the  Internal  Revenue  Service 
in  1971  agreed  to  a  moratorium  for  the  reporting  and  reimbursement 
rules  (except  for  cash  reimbursements)  in  the  case  of  the  military.  The 
Service  extended  this  administrative  moratorium  through  1972  and 
1973.  As  indicated  above,  in  1974  the  armed  forces  were  exempted  from 
these  requirements  by  legislation  effective  through  December  31,  1975. 

The  Congress  agreed  that  requiring  the  military  to  report  and  with- 
hold tax  on  reimbursed  in-kind  moving  expenses  and  requiring  service- 
men to  include  reimbursements  or  allowances  for  moving  expenses  in 
income  would  entail  needless,  costly  administration  by  the  military 
services. 


234-120  O  -  77  -  10 


134 

In  addition,  the  military  had  found  the  mileage  limitation  (the  50- 
mile  limit)  and  the  39- week  rule  a  hardship  for  military  personnel 
because  many  mandatory  personnel  moves  are  for  less  than  39  weeks 
and  for  less  than  50  miles.  The  Congress  believed  that  servicemen 
who  are  required  to  change  their  residence  incident  to  a  permanent 
change  of  station  should  not  be  required  to  include  in  income  the 
in-kind  moving  assistance,  allowances,  or  reimbursements  provided 
by  the  military  and  should  not  be  denied  a  deduction  for  otherwise 
deductible  expenses  involved  in  a  mandatory  move  only  because  they 
fail  the  time  and  mileage  tests.  Therefore,  the  Congress  exempted 
members  of  the  armed  forces  from  the  time  and  mileage  limitations  for 
moves  incident  to  a  permanent  change  of  station  when  the  military 
authorizes  in-kind  moving  assistance.  The  Congress  also  believed  it 
appropriate  to  exclude  from  income  the  in-kind  moving  services  and 
assistance  provided  to  move  servicemen's  spouses  and  dependents  in 
connection  with  moves  required  by  the  military. 

Explanation  of  provision 

The  Act  modifies  the  prior  treatment  of  job-related  moving  ex- 
penses in  a  number  of  respects.  It  increases  the  maximum  deduction 
for  premove  househunting  and  temporary  living  expenses  at  the  new 
job  location  from  $1000  to  $1500  and  increases  from  $2500  to  $3000  the 
maximum  deduction  for  qualified  expenses  for  the  sale,  purchase  or 
lease  of  a  residence  (reduced  by  any  deduction  claimed  for  premove 
househunting  or  temporary  living  expenses).  As  with  the  existing 
limitations,  the  new  amounts  are  halved  if  a  husband  and  wife  file 
separate  returns.  The  Act  also  reduces  the  50-mile  rule  to  35  miles. 

With  regard  to  military  moves,  the  Act  also  exempts  military  moves 
from  the  time  and  mileage  requirements  and  excludes  from  income 
cash  reimbursements  or  allowances  to  the  extent  of  expenses  actually 
paid  or  incurred,  as  well  as  all  in-kind  services  provided  by  the  mili- 
tary. The  Armed  Services  are  exempted  from  the  reporting  require- 
ments under  section  82  with  regard  to  in-kind  moving  services  (includ- 
ing storage),  reimbursements  and  allowances  provided  to  members 
on  active  duty  for  moves  pursuant  to  military  orders  and  incident 
to  a  permanent  change  of  station.  In  addition,  the  Act  provides  that 
when  a  military  member  is  required  to  relocpte  and  the  member's 
spouse  and  dependents  move  to  a  different  location,  all  in-kind  moving 
and  storage  expenses,  and  reimbursements  and  allowances  (to  the  ex- 
tent of  moving  expenses  actually  paid  or  incurred)  provided  by  the 
military  to  move  the  member  and  the  spouse  and  dependents  to 
and  from  their  separate  locations  are  excluded  from  income.  In  cases 
where  the  military  moves  the  member  and  the  member's  spouse  and 
dependents  to  or  from  separate  locations  and  they  incur  unreimbursed 
expenses,  their  moves  are  treated  as  a  single  move  to  a  new  principal 
place  of  work  for  purposes  of  section  217. 

Ejfective  date 
This  provision  is  to  apply  generally  to  taxable  years  beginning  after 
December  31,  1976,  except  that  the  military  provisions  are  to  apply 
for  years  beginning  after  1975. 


135 

Revenue  effect 
This  provision  will  reduce  budget  receipts  by  $7  million  in  fiscal 
year  1977,  $47  million  in  fiscal  year  1978,  and  $62  million  in  fiscal  year 
1981. 

7.  Tax  Simplification  Study  by  Joint  Committee  (sec.  507  of  the 
Act) 

Prior  law 
Prior  law  contained  no  provision  requiring  a  specific  report  on  tax 
simplification  by  the  Joint  Committee.  However,  the  law  (sec.  8022 
of  the  Code)  provides  that  the  Joint  Committee  on  Taxation  is  to 
investigate  the  operation  and  effects  of  the  Federal  system  of  internal 
revenue  taxes,  including  studies  for  the  simplification  of  the  income 
tax.  The  Joint  Committee  is  to  publish  its  proposals  and  report  the 
results  and  any  recommendations  to  the  Senate  Finance  and  House 
Ways  and  Means  Committees. 

Reasons  for  change 
The  Congress  believes  that  simplification  of  the  Code  is  urgent  and 
that  the  Joint  Committee  should  make  a  specific  study  involving  ways 
of  simplifying  and  indexing  the  tax  laws. 

Explanation  of  provision 
The  Act  requires  the  Joint  Committee  to  conduct  a  study  on  "sim- 
plifying and  indexing  the  tax  laws"  (including  whether  tax  rates  can 
be  reduced  by  repealing  any  or  all  tax  deductions,  exemptions  or 
credits).  A  report  of  its  study  and  investigation  together  with  its  rec- 
ommendations, including  recommendations  for  legislation,  is  to  be 
submitted  to  the  Senate  Finance  and  House  Ways  and  Means  Com- 
mittee by  June  30, 1977. 

Revenue  effect 
T  his  provision  will  not  have  any  revenue  effect. 


E.  BUSINESS-RELATED  INDIVIDUAL  INCOME  TAX  REVI- 
SIONS 

1.  Deductions  for  Expenses  Attributable   to   Business  Use   of 
Home  (sec.  601  of  the  Act  and  new  sec.  280A  of  the  Code) 

Prior  law 

Under  the  code,  no  deductions  are  allowed  for  personal,  living,  and 
family  expenses  except  as  expressly  allowed  under  the  code  (sec.  262). 
Generally,  under  this  provision,  expenses  and  losses  attributable  to  a 
dwelling  which  is  occupied  by  a  taxpayer  as  his  personal  residence  are 
not  deductible.  However,  deductions  for  interest,  certain  taxes,  and 
casualty  losses  attributable  to  a  personal  residence  are  expressly 
allowed  under  other  provisions  of  the  tax  laws  (sees.  163, 164  and  165). 
Under  prior  law,  if  a  portion  of  the  residence  was  used  in  the  tax- 
payer's trade  or  business  or  for  the  production  of  income,  a  deduction 
would  be  allowed  for  an  allocable  portion  of  the  expenses  incurred  in 
maintaining  such  personal  residence. 

In  any  case  involving  the  business  use  of  a  personal  residence,  it 
must  first  be  established  that  the  expenses  were  incurred  in  carrying  on 
a  trade  or  business  (sec.  162)  or  for  the  production  of  income  (sec. 
212).  Thus,  there  must  be  some  relatively  clear  connection  between  the 
activities  conducted  in  the  home  and  a  trade  or  business  or  the  pro- 
duction of  income.  Under  the  regulations  (Reg.  §  1.262-1  (b)  (3) ) ,  the 
expenses  of  maintaining  a  household  are  treated  as  nondeductible  per- 
sonal expenses  if  the  taxpayer  only  incidentally  conducts  business  in 
his  home.  However,  under  prior  law,  if  a  part  of  the  housa  is  used  as 
the  taxpayer's  place  of  business,  the  allocable  portion  of  the  expenses 
attributable  to  the  use  of  the  home  as  a  place  of  business  was  allowed 
as  a  deduction. 

For  this  purpose  the  expenses  attributable  to  the  office  or  business 
use  of  the  home  were  deductible  if  they  were  "ordinary  and  necessary" 
expenses  paid  or  incurred  in  carrying  on  a  trade  or  business  or  for  the 
production  of  income.  These  expenses  were  claimed  as  deductions  by 
self-employed  individuals  who  used  portions  of  their  residences  for 
trade  or  business  purposes,  employees  who  maintained  offices  in  con- 
nection with  the  performance  of  their  duties  as  employees,  or  investors 
who  maintained  offices  in  connection  with  investment  activities.  Typi- 
cally, the  expenses  for  which  a  deduction  was  claimed  included  an  allo- 
cable portion  of  the  depreciation  or  rent,  maintenance,  utility,  and  in- 
surance expenses  incurred  in  connection  with  the  residence. 

With  respect  to  the  maintenance  of  an  office  in  an  employee's  home, 
the  position  of  the  Internal  Revenue  Service  iwas  that  the  office  must  be 
required  by  the  employer  as  a  condition  of  employment  and  regularly 
used  for  the  performance  of  the  employee's  duties.  (Revenue  Ruling 
62-180, 1962-2  C.B.  52,  set  forth  these  standards  as  they  applied  to  the 
deductibility  of  expenses  attributable  to  an  office  maintained  in  an  em- 

(136) 


137 

ployee's  home.)  Certain  courts  had  decided  that  a  more  liberal  stand- 
ard than  that  urged  by  the  Internal  Revenue  Service  was  appropriate. 
Under  these  decisions,  the  expenses  attributable  to  an  office  maintained 
in  an  employee's  residence  were  deductible  if  the  maintenance  of  the 
office  was  "appropriate  and  helpful"  to  the  employee's  business: 
George  H.  Neioi,  T.C.  Memo.  1969-131,  aff'd  432  F.  2d  998  (2d  Cir. 
1970)  ;  Jay  R.  Gill,  T.C.  Memo.  1975-3;  Hall  v.  U7iited  States,  387  F. 
Supp.  612  (D.C.  N.H.,  1975). 

In  Stephen  A.  Bodzin,  60  T.C.  820  (1973) ,  the  Tax  Court,  in  a  deci- 
sion allowing  a  deduction  for  an  office  in  an  employee's  residence, 
held  that  "the  applicable  test  for  judging  the  deductibility  of  home 
office  expenses  is  whether,  like  any  other  business  expense,  the  main- 
tenance of  an  office  in  the  home  is  appropriate  and  helpful  under  all 
the  circumstances."  However,  the  court  cautioned  that  no  deduction 
would  be  allowable  if  personal  convenience  were  the  primary  reason 
for  maintaining  the  office  notwithstanding  any  conclusion  as  to  the 
"appropriateness"  and  "helpfulness"  of  the  office.  On  appeal,  the 
Fourth  Circuit  reversed  the  decision  of  the  Tax  Court  (509  F.2d  679). 
The  Appellate  Court  held  that,  as  a  factual  matter,  the  expenses  attrib- 
utable to  the  taxpayer's  residence  were  nondeductible  personal  ex- 
penses and  that  it  was  therefore  unnecessary  to  decide  if  the  mainte- 
nance of  the  office  was  appropriate  and  helpful  in  carrying  on  his 
business.  Thus,  it  was  not  clear  which  standard  would  be  applied 
in  the  Fourth  Circuit  in  a  case  in  which  the  court  found  both  personal 
and  business  use  of  a  residence.  However,  the  court  suggested  that 
to  obtain  a  deduction,  an  employee  would  have  to  show  that  the  office 
provided  by  the  employer  is  not  available  at  the  times  the  employee 
uses  the  office  in  his  residence  or  that  the  employer's  office  is  not  suit- 
able for  the  purposes  for  which  the  taxpayer  is  using  the  office  in  his 
residence.^ 

The  Tax  Court  had  also  applied  the  "appropriate  and  helpful"  st-^nd- 
ard  to  determine  the  deductibility  of  expenses  attributable  to  the  main- 
tenance of  an  office  in  the  home  of  an  investor.  {Lena  M.  Anderson, 
TC  Memo  1974-49.)  In  that  case,  the  taxpayer  was  allowed  a  portion 
of  the  expenses  attributable  to  a  family  room  which  was  partially  used 
to  conduct  investment  activities  which  consisted  of  keeping  records 
with  respect  to  rental  properties,  preparing  the  taxpayer's  income 
tax  returns,  and  writing  lettei-s  to  brokers  and  taxing  authorities. 

With  respect  to  an  apartment  or  residence  used  by  a  taxpayer  while 
in  a  travel  status,  the  expenses  attributable  to  the  maintenance  of  the 
apartment  or  residence  are  treated  as  lodging  expenses  subject  to 
certain  other  rules  relating  to  deductibility  (sec.  162).  As  such,  the 
expenses  are  deductible  only  if  they  are  reasonable  and  necessary  in 
the  conduct  of  the  taxpayer's  business  and  directly  attributable  to  it. 
"Lavish  or  extravagant"  expenses  are  not  allowable  deductions.  The 
expenses  attributable  to  the  apartment  or  house  are  deductible  as 
lodging  expenses  if  properly  allocable  to  the  taxpayer's  trade  or  busi- 
ness even  though  the  transportation  expenses  are  not  deductible  be- 
cause the  trip  was  undertaken  primarily  for  personal  purposes. 

Additional  requirements  also  apply  with  respect  to  a  residence  where 
the  business  use  consists  of  entertainment  of  clients,  customers,  or 


1  The   Supreme   Court   denied   certiorari    in    the   Bodzin   case   on    October   6,    1975    (44 
U.S.L.W.  3201). 


138 

business  associates.  In  such  cases,  the  residence  is  treated  as  an  enter- 
tainment facility,  and  no  deduction  is  allowed  for  any  expenditure 
unless  the  taxpayer  establishes  that  the  facility  was  used  primarily 
for  the  furtherance  of  the  taxpayer's  trade  or  business  and  that  the 
items  of  expense  were  directly  related  to  the  active  conduct  of  such 
trade  or  business  (sec.  274). 

In  determining  whether  or  not  an  entertainment  facility  was  used 
prim.arily  for  the  furtherance  of  the  taxpayer's  trade  or  busine^ss,  the 
taxpayer  must  establish  that  the  primary  use  of  the  facility  was  for 
ordinary  and  necessary  business  use  based  upon  the  facts  and  circum- 
stances considered  on  a  case-by-case  basis.  Generally,  the  actual  use  of 
the  facility  is  controlling,  and  not  its  availability  for  use.  The  factors 
to  be  considered  include  the  nature  of  each  use,  the  frequency  and 
duration  of  business  use  and  the  amount  of  expenditures  incurred  for 
business  purposes. 

The  regulations  provide  that  with  respect  to  an  entertainment  facil- 
ity, a  taxpayer  shall  be  deemed  to  have  established  that  an  entertain- 
ment facility  was  used  primarily  for  the  fuitherance  of  his  trade  or 
business  if  more  than  50  percent  of  the  total  calendar  days  of  use  of 
the  facility  during  any  taxable  year  were  business  use  days. 

An  expenditure  is  considered  directly  related  to  the  active  conduct 
of  the  taxpayer's  trade  or  business  if  four  requirements  are  met:  (1) 
the  taxpayer  had  more  than  a  general  expectation  of  deriving  income 
or  benefit  (other  than  goodwill)  at  some  indefinite  future  time;  (2)  the 
taxpayer  actually  engaged  in,  or  reasonably  expected  to  engage  in, 
business  meetings,  negotiations,  etc.,  for  the  purpose  of  obtaining  in- 
come or  other  benefits;  (3)  in  light  of  all  the  facts  and  circumstances, 
(111'  ])rincipal  function  of  the  combined  business  meeting,  etc.,  and  en- 
tertainment was  the  active  conduct  of  the  taxpayer's  trade  or  business, 
and  (4)  the  expenditure  was  allocable  to  the  taxpayer  and  person  or 
persons  with  whom  the  taxpayer  engaged  in  the  active  conduct  of 
trade  or  business  during  the  entertainment. 

In  determining  the  deductible  amount  attributable  to  the  business 
use  of  the  home,  the  general  rule  is  that  any  reasonable  method  of  allo- 
cation may  be  used.  In  all  cases  involving  the  dual  use  of  a  home,  the 
allocation  of  expenses  attributable  to  the  portion  of  the  residence  used 
for  business  purposes  will  take  into  account  the  space  used  for  those 
purposes,  e.g.,  a  percentage  of  the  expenses  based  on  the  square  feet  of 
that  portion  compared  to  the  total  square  feet  of  the  residence.  In  addi- 
tion, a  further  allocation  based  on  time  of  use  is  required  when  the 
portion  of  the  residence  is  not  exclusively  used  for  business  purposes. 
In  Rev.  Rul.  62-180,  1962-2  C.B.  52,  54,  the  Internal  Revenue  Service 
held  that,  after  allocating  expenses  attributable  to  a  den  used  for  busi- 
ness and  personal  purposes  on  the  basis  of  space,  a  further  allocation 
must  be  made  on  the  basis  of  time  of  use  to  reflect  the  dual  use.  For 
purposes  of  the  latter  allocation,  the  Service  ruled  that  the  allocation 
should  be  made  on  the  basis  of  availability  for  use  rather  than  actual 
use,  i.e.,  the  ratio  of  time  actually  used  for  business  purposes  to  the 
total  time  it  is  available  for  all  uses.  Plowever,  in  Goerge  W.  Gino^ 
60  T.C.  304,  314  (1973)  (followed  in  Lena  M.  Anderson,  T.C.  Memo, 
1974r-i9),  the  Tax  Court  held  that  such  expenses  should  be  allocated 
on  the  basis  of  actual  business  use  as  compared  with  actual  total  use. 


139 

In  another  case  where  the  allocation  could  not  clearly  be  determined, 
the  Cohan  rule  was  applied  to  estimate  the  approximate  space  of  an 
apartment  which  was  used  for  business  purposes.  George  H.  Newi^ 
T.C.  Memo.  1969-131,  aff'd.,  432  F.2d  998  (2d  Cir.  1970).  The  Cohan 
rule  provides,  generally,  that  where  there  is  evidence  that  the  tax- 
payer incurred  certain  deductible  expenses  but  the  exact  amount  can- 
not be  determined,  a  close  approximation  would  be  acceptable  and, 
therefore,  the  deduction  would  not  be  entirely  disallowed.  Under  pres- 
ent law,  however,  because  of  certain  substantiation  requirements,  no 
deduction  is  allowed  for  certain  expenditures  relating  generally  to 
travel  or  entertainment  on  the  basis  of  a  Cohan  approximation  or  on 
the  basis  of  unsupported  testimony  of  the  taxpayer. 

Reasons  for  change 

The  Congress  believed  that  there  was  a  great  need  for  definitive 
rules  to  resolve  the  conflict  that  existed  between  several  court  decisions 
and  the  position  of  the  Internal  Revenue  Service  as  to  the  correct 
standard  governing  the  deductibility  of  expenses  attributable  to  the 
maintenance  of  an  office  in  the  taxpayer's  personal  residence. 

With  respect  to  the  "appropriate  and  helpful"  standard  employed 
in  the  court  decisions,  the  determination  of  the  allowance  of  a  deduc- 
tion for  these  expenses  was  necessarily  a  subjective  determination.  In 
the  absence  of  definitive  controlling  standards,  the  "appropriate  and 
helpful"  test  increased  the  inherent  administrative  problems  because 
both  business  and  personal  uses  of  the  residence  were  involved  and  sub- 
stantiation of  the  time  that  the  space  was  used  for  each  of  these  activi- 
ties was  clearly  a  subjective  determination.  In  many  cases  the  applica- 
tion of  the  appropriate  and  helpful  test  appeared  to  result  in  treating 
personal  living;  and  family  expenses  which  are  directly  attributable 
to  the  home  (and  therefore  not  deductible)  as  ordinary  and  necessary 
business  expenses,  even  though  those  expenses  did  not  result  in  addi- 
tional or  incremental  costs  incurred  as  a  result  of  the  business  use  of 
the  home.  Thus,  expenses  otherwise  considered  nondeductible  personal, 
living,  and  family  expenses  might  be  converted  into  deductible  busi- 
ness expenses  simply  because,  under  the  facts  of  the  particular  case, 
it  was  appropriate  and  helpful  to  perform  some  portion  of  the  tax- 
payer's business  in  his  personal  residence.  For  example,  if  a  university 
professor,  who  was  provided  an  office  by  his  employer,  used  a  den  or 
some  other  room  in  his  residence  for  the  purpose  of  grading  papers, 
preparing  examinations  or  preparing  classroom  notes,  an  allocable 
portion  of  certain  expenses  might  have  been  claimed  as  a  deduction 
even  though  only  minor  incremental  expenses  were  incurred  in  order 
to  perform  these  activities. 

Explanation  of  'provision 

The  Act  adds  a  new  section  to  the  Code  (sec.  280A)  which  provides, 
in  part,  that  no  deductions  shall  be  allowed  with  respect  to  a  dwelling 
unit  which  is  used  by  the  taxpayer  as  a  residence,  unless  specifically 
excepted  from  this  new  section  and  otherwise  allowable.  The  provi- 
sions of  this  section  apply  to  individuals,  trusts,  estates,  partnerships, 
and  electing  small  business  corporations.  This  provision  does  not  apply 
to  a  corporation  (other  than  an  electing  small  business  corporation). 

The  general  disallowance  provision,  however,  does  not  apply  with 


140 

respect  to  certain  expenses  which  are  otherwise  allowable  as  deduc- 
tions; for  example,  the  deductions  allowable  for  interest  (sec.  163), 
certain  taxes  (sec.  164)  and  casualty  losses  (sec.  165)  may  still  be 
claimed  as  deductions  without  regard  to  their  connection  with  the 
taxpayer's  trade  or  business  or  income  producing  activities. 

In  the  case  of  a  taxpayer  (other  than  an  employee)  who  exclusively 
uses  a  portion  of  a  dwelling  unit  on  a  regular  basis  as  his  principal 
place  of  business,  as  a  place  of  business  which  is  used  by  patients, 
clients,  or  customers  in  meeting  or  dealing  with  the  taxpayer  in  the 
normal  course  of  his  trade  or  business,  or  in  the  case  of  a  separate 
structure  which  is  not  attached  to  the  dwelling,  in  connection  with  the 
taxpayer's  trade  or  business,  an  allocable  portion  of  ordinary  and 
necessary  trade  or  business  expenses  paid  or  incurred  in  connection 
with  such  trade  or  business  use  will  be  allowed  as  a  deduction.  How- 
ever, the  amount  of  the  deduction  is  subject  to  a  limitation  discussed 
below. 

Exclusive  use  of  a  portion  of  a  taxpayer's  dwelling  unit  means  that 
the  taxpayer  must  use  a  specific  part  of  a  dwelling  unit  solely  for  the 
purpose  of  carrying  on  liis  trade  or  business.  The  use  of  a  portion  of  a 
dwelling  unit  for  both  personal  purposes  and  for  the  carrying  on  of  a 
trade  or  business  does  not  meet  the  exclusive  use  test.  Thus,  for 
example,  a  taxpayer  who  uses  a  den  in  his  dwelling  unit  to  write  legal 
briefs,  prepare  tax  returns,  or  engage  in  similar  activities,  as  well  for 
personal  purposes,  will  be  denied  a  deduction  for  the  expenses  paid  or 
incurred  in  connection  with  the  use  of  the  residence  which  are  allocable 
to  these  activities. 

Under  the  Act,  an  exception  to  the  exclusive  use  test  is  provided  in 
the  case  of  a  taxpayer  whose  trade  or  business  is  selling  products  at 
retail  or  wholesale  and  whose  dwelling  unit  is  the  sole  fixed  location 
of  such  trade  or  business.  Under  this  exception,  the  ordinary  and 
necessary  expenses  allocable  to  space  (within  a  dwelling  unit)  which 
is  used  as  a  storage  unit  for  inventory  will  not  be  disallowed.  How- 
ever, the  space  must  be  used  on  a  regular  basis  and  must  be  a  separately 
identifiable  space  suitable  for  storage. 

In  addition  to  the  exclusive  use  test,  the  Act  requires  that  the  por- 
tion of  the  residence  used  for  trade  or  business  purposes  must  be  used 
by  the  taxpayer  on  a  regular  basis  in  order  for  the  allocable  portion 
of  the  expenses  to  be  deductible.  Expenses  attributable  to  incidental 
or  occasional  trade  or  business  use  of  an  exclusive  portion  of  a  dwelling 
unit  would  not  be  deductible. 

The  provision  does  not  permit  a  deduction  for  any  portion  of  ex- 
penses paid  or  incurred  with  respect  to  the  use  of  a  dwelling  unit 
which  is  used  by  the  taxpayer  both  as  a  residence  and  in  connection 
with  income  producing  activities  (sec.  212).  For  example,  no  deduction 
will  be  allowed  if  a  taxpayer  who  is  not  in  the  trade  or  business  of 
making  investments  uses  a  portion  of  his  residence  (exclusively  and 
on  a  regular  basis)  to  read  financial  periodicals  and  reports,  clip  bond 
coupons  and  perform  similar  activities  because  the  activity  is  not  a 
trade  or  business. 

In  the  case  of  an  employee,  a  deduction  for  the  portion  of  the 
ordinary  and  necessary  business  expenses  attributable  to  the  use  of  a 
residence  which  are  paid  or  incurred  in  connection  with  the  per- 


141 

formance  of  services  as  an  employee  will  be  allowable  only  if,  in  addi- 
tion to  satisfying  the  exclusive  and  regular  use  tests,  the  use  is 
for  the  convenience  of  his  employer.  If  the  use  is  merely  appropriate 
and  helpful,  no  deduction  attributable  to  such  use  will  be  allowable. 
The  Act  also  provides  an  overall  limitation  on  the  amount  of  deduc- 
tions that  a  taxpayer  may  take  for  the  business  use  of  the  home.  The 
allowable  deductions  attributable  to  the  use  of  a  residence  for  trade 
or  business  purposes  may  not  exceed  the  amount  of  the  gross  income 
derived  from  the  use  of  the  residence  for  that  trade  or  business  reduced 
by  the  deductions  which  are  allowed  without  regard  to  their  connection 
with  the  taxpayer's  trade  or  business  (e.g.,  interest  and  taxes).  In  the 
case  where  gross  income  is  derived  both  from  the  use  of  the  residence 
and  from  the  use  of  facilities  other  than  the  residence,  a  reasonable 
allocation  (based  on  the  facts  and  circumstances  of  each  case)  is  to 
be  made  to  determine  that  portion  of  the  gross  income  derived  from 
the  use  of  the  residence.  With  respect  to  the  deductions  which  are 
allocable  to  the  trade  or  business  use  of  the  residence,  deductions 
allowable  without  regard  to  whether  the  activity  is  a  trade  or  business 
are  to  be  deducted  first.  Any  remaining  gross  income  may  then  be 
reduced  (but  not  below  zero)  by  the  remaining  allowable  deductions 
which  are  allocable  to  such  use. 

Effective  date 
This  provision  applies  to  taxable  years  beginning  after  Decem- 
ber 31,  1975. 

Revenue  effect 
The  revenue  effect  of  this  provision  is  combined  with  that  of  the 
following  vacation  home  provisions. 

2.  Deduction  for  Expenses  Attributable  to  Rental  of  Vacation 
Homes  (sec.  601  of  the  Act  and  sec.  280A  of  the  Code) 

Prior  law 

A  taxpayer  is  allowed  a  deduction  for  the  ordinary  and  necessary 
expenses  paid  or  incurred  during  the  taxable  year  in  carrying  on  a 
trade  or  business  (sec.  162),  or  for  the  management,  conservation,  or 
maintenance  of  property  held  for  the  production  of  income  (sec.  212). 
In  order  to  be  entitled  to  a  deduction  under  these  provisions,  it  is 
necessary  that  the  activity  be  engaged  in  by  the  taxpayer  for  profit 
(i.e.,  for  the  purpose  of  or  with  the  intention  of  making  a  profit.)^ 
The  determination  of  whether  an  activity  is  engaged  in  for  profit  is  to 
be  made  on  the  basis  of  objective  standards,  taking  into  account  all 
facts  and  circumstances  of  each  case.  Although  a  reasonable  expecta- 
tion of  profit  is  not  required,  the  facts  and  circumstances  (without 
regard  to  the  taxpayer's  subjective  intent)  must  indicate  that  the  tax- 
payer entered  into  or  continued  the  activity  with  the  objective  of  mak- 
ing a  profit.  No  deduction  is  allowed  under  section  162  or  212  if  the 
activity  is  carried  on  primarily  as  a  sport,  hobby,  or  for  recreation. 

Even  though  an  activity  is  not  engaged  in  for  profit  (and  therefore 
no  deduction  is  allowed  under  section  162  or  212),  certain  deductions 


iSee  Morton  v.  Commissioner,  174  F.  2d  302.  304  (2d  Clr.),  cert,  denied,  338  U.S.  828 
(1949)  ;  Schley  v.  Commissioner,  375  F.  2d  747  (2d  Cir.  1967)  ;  and  George  W.  Mitchell, 
47T.C.  120  (1966). 


142 

are  allowed  under  other  provisions  of  the  tax  law.  Subject  to  specific 
limitations  discussed  below,  a  deduction  is  allowed  under  section  183 
for  expenditures  which  are  of  the  type  that  may  be  deducted  without 
regard  to  whether  they  are  incurred  in  connection  with  a  trade  or 
business  or  for  the  production  of  income.  These  items  include  the  de- 
ductions which  are  allowed  for  interest  (sec.  163),  certain  State  and 
local  property  taxes  (sec.  164),  and  casualty  losses  (sec.  165). 

Section  183  further  provides  that,  in  the  case  of  an  activity  not 
engaged  in  for  profit,  a  deduction  is  allowed  for  expenses  which  could 
be  deducted  if  the  activity  were  engaged  in  for  profit,  but  only  to  the 
extent  these  expenses  do  not  exceed  the  amount  of  gross  income  de- 
rived from  the  activity  reduced  by  the  deductions  which  are  allowed 
in  any  event  (e.g.,  interest  and  certain  State  and  local  taxes).  In  other 
words,  as  to  expenses  such  as  depreciation,  insurance,  and  maintenance, 
a  taxpayer  is  allowed  a  deduction  but  only  to  the  extent  of  income 
derived  from  the  activity.  The  taxpayer  is  not  allowed  to  use  these 
deductions  to  create  losses  which  can  be  used  to  offset  other  income. 

A  taxpayer  is  presumed  to  be  engaged  in  an  activity  for  profit  for 
a  taxable  year  if,  in  two  or  more  years  of  the  period  of  five  consecutive 
taxable  years  (seven  consecutive  taxable  yeai-s  in  the  case  of  an  activ- 
ity which  consists  in  major  part  of  the  breeding,  training,  showing, 
or  raising  of  horses)  ending  with  such  taxable  year,  the  activity  was 
in  fact  carried  on  at  a  profit.  For  purposes  of  this  presumption,  the 
activity  is  treated  as  being  carried  on  for  a  profit  in  a  given  taxable 
year  if  the  gross  income  fi*om  the  activity  exceeds  the  deductions  at- 
tributable to  the  activity  which  would  be  allowable  if  it  were  engaged 
in  for  profit. 

The  rules  for  determining  whether  an  activity  is  a  trade  or  business 
or  engaged  in  for  the  production  of  income  are  the  same  as  those  used 
for  determining  whether  an  activity  is  engaged  in  for  profit.  As  a 
result,  except  for  the  presumption  discussed  above,  if  deductions  with 
respect  to  the  activity  are  not  allowable  as  a  trade  or  business  expense 
(sec.  162)  or  as  expenses  incurred  for  the  production  of  income,  etc. 
(sec.  212) ,  then  the  activity  will  be  treated  as  an  activity  not  engaged 
in  for  profit  under  section  183. 

The  Regulations  provide  a  list  of  relevant  factors  which  should 
normally  be  taken  into  account  in  determining  whether  the  activity  is 
engaged  in  for  profit.  Among  other  factors,  the  presence  of  personal 
motives  must  be  considered,  especially  where  there  are  recreational  or 
personal  elements  involved.-  By  way  of  illustration,  the  regulations 
provide  tliat  a  taxpayer  will  be  treated  as  holding  a  beach  house  pri- 
marily for  personal  purposes  if,  during  a  three-month  season,  the 
beach  house  is  personally  used  by  the  taxpayer  for  one  month  and 
used  for  the  production  of  rents  for  the  remaining  two  months  (Regs. 
§  1.183-1  (d)  (3) ).  However,  except  for  this  example,  there  are  no 

2Treas.  Reg.  §  1.183-2(b).  These  factors  Include:  (1)  The  manner  in  which  the  tax- 
payer carries  on  the  activity,  (2)  the  expertise  of  the  taxpayer  or  his  advisers,  (3)  the 
time  and  effort  expended  hy  the  taxpayer  in  carrying  on  the  activity,  (4)  the  expectation 
that  assets  used  in  the  activity  may  appreciate  in  value,  (5)  the  success  of  the  taxpayer 
in  carrying  on  other  similar  or  dissimilar  activities,  (6)  the  taxpayer's  history  of  income 
or  losses  with  respect  to  the  activity,  (7)  the  amount  of  occasional  profits,  if  any,  which 
are  earned,  (8)  the  financial  status  of  the  taxpayer,  and  (9)  the  elements  of  personal 
pleasure  or  recreation. 


143 

definitive  rules  relating  to  how  much  personal  use  of  vacation  prop- 
erty will  result  in  a  finding  that  the  rental  of  the  vacation  property 
is  an  activity  not  engaged  in  for  profit. 

Generally,  no  deduction  is  allowed  for  personal,  living,  and  family 
expenses  except  as  otherwise  expressly  provided  under  the  tax  laws 
(sec.  262).  Deductions  that  are  expressly  allowable,  even  though  they 
are  attributable  to  personal  use,  include  items  of  interest,  certain  taxes, 
and  casualty  losses.  However,  no  deduction  is  allowed  for  such  items 
as  depreciation,  maintenance,  insurance,  and  utilities  to  the  extent 
these  items  are  attributable  to  personal  use.  As  a  result,  under  prior 
law,  where  property  was  used  for  both  personal  and  business  use,  the 
total  amount  of  maintenance,  insurance,  and  utilities  expenses  and 
depreciation  incurred  during  a  taxable  year  had  to  be  allocated  on  a 
reasonable  and  consistently  applied  basis. 

Reasons  for  change 

Where  expenses  attributable  to  a  residence  are  treated  as  deductible 
business  expenses,  an  opportunity  exists  to  convert  nondeductible  per- 
sonal, living  and  family  expenses  into  deductible  expenses.  In  the  case 
of  so-called  "vacation  homes"  that  are  used  both  for  personal  purposes 
and  for  rental  purposes,  it  would  appear  that  frequently  personal 
motives  predominate  and  the  rental  activities  are  undertaken  to  inini- 
mize  the  expenses  of  ownership  of  the  property  rather  than  to  make 
an  economic  profit. 

In  marketing  vacation  homes,  it  has  become  common  practice  to  em- 
phasize that  certain  tax  benefits  can  be  obtained  by  renting  the  prop- 
erty during  part  of  the  year,  while  reserving  the  remaining  portion 
for  personal  use.  In  addition,  certain  an-angements  have  been  devised 
whereby  an  individual  owner  of  a  condominium  unit  is  entitled  to 
exchange  the  time  set  aside  for  the  personal  use  of  his  own  unit  (typi- 
cally three  to  six  weeks)  for  the  use  of  a  different  unit  under  the  same 
general  management  at  another  location. 

Under  many  of  these  arrangements,  it  is  extremely  difficult  under 
existing  law  to  determine  when  an  activity  is  engaged  in  for  profit. 
The  present  regulations  provide  that  in  making  this  determination 
a  number  of  factors  shall  be  taken  into  acxjount.  These  factors  include 
the  presence  of  "personal  motives",  especially  where  there  are  recrea- 
tional or  personal  elements  involved.  However,  except  for  the  example 
mentioned  above,  no  objective  standards  are  set  forth  in  the  regula- 
tions. The  Congress  concluded  that  definitive  rules  should  be  provided 
to  specify  the  extent  to  which  personal  use  would  result  in  the  disal- 
lowance of  certain  deductions  in  excess  of  gross  income.  In  a  case 
where  personal  use  is  the  controlling  faxitor  to  be  considered,  this  ap- 
proach would  obviate  the  need  for  subjective  determinations  to 
be  made  concerning  the  taxpayer's  motive  and  the  primary  purpose 
for  which  the  vacation  home  is  held. 

In  addition,  if  there  is  any  personal  use  of  a  vacation  home,  the 
portion  of  expenses  allocable  to  rental  activities  should  be  limited 
to  an  amount  determined  on  the  basis  of  the  ratio  of  time  that  the 
home  is  actually  rented  for  a  fair  rental  to  the  total  time  that  the 
vacation  home  is  used  during  the  taxable  year  for  all  purposes  (i.e., 
rental,  business,  and  personal  activities). 


144 

Explanatio7t  of  provision 

The  Act  adds  a  new  provision  (sec.  280A)  which,  in  general,  pro- 
vides a  limitation  on  the  amount  allowable  to  a  taxpayer  for  the  deduc- 
tions attributable  to  the  rental  of  a  dwelling  unit  if  the  taxpayer  per- 
sonally uses  the  unit  in  excess  of  specified  periods  of  time  during  a 
taxable  year.  This  new  limitation  only  applies  if  the  taxpayer's  use  of 
the  dwelling  unit  for  personal  purposes  during  his  taxable  year  exceeds 
the  greater  of  fourteen  days  or  ten  percent  of  the  number  of  the  days 
during  the  year  for  which  the  vacation  home  is  rented.  (Rules  for  deter- 
mining personal  use  and  rental  days  are  discussed  below.)  The  Act  also 
provides  that  in  the  case  where  the  taxpayer  rents  a  dwelling  unit 
used  as  a  residence  for  less  than  15  days,  neither  operating  gain  nor  loss 
would  be  recognized  for  tax  purposes. 

The  provisions  of  this  section  apply  to  an  individual,  a  trust,  estate, 
partnership,  and  an  electing  small  business  corporation.  The  provisions 
do  not  apply  to  corporate  taxpayers  (other  than  shareholders  of  sub- 
chapter S  corporations).  However,  no  inference  should  be  drawn 
from  this  section  in  the  case  of  a  corporation,  as  to  whether  or  not 
expenses  incurred  for  the  maintenance  of  a  residence  are  connected 
with  its  trade  or  business  for  purposes  of  the  tax  laws. 

If  a  taxpayer  exceeds  the  pereonal  use  limitations  for  the  dwelling 
unit  for  a  taxable  year,  the  deductions  attributable  to  the  rental  activity 
are  limited  to  the  amount  by  which  the  gross  income  derived  from 
the  rental  activity  exceeds  the  deductions  otherwise  allowable  without 
regard  to  such  rental  activities  (e.g.,  interest  and  certain  taxes).  For 
this  purpose,  deductions  attributable  to  the  rental  activities  are  those 
items  which  are  of  a  type  allowable  only  as  expenses  incurred  in  con- 
nection with  a  trade  or  business  or  the  production  of  income  (e.g., 
sec.  162  or  212). 

If  the  personal  use  limitation  applies,  the  allowable  deductions 
would  be  determined  after  first  determining  the  expenses  of  the  dwell- 
ing unit  which  are  allocable  to  the  rental  activities  (in  accordance 
with  the  new  allocation  rules).  Grenerally,  the  amounts  allowable  as 
deductions  would  be  determined  in  the  same  manner  as  provided  in 
the  regulations  prescribed  under  section  183  of  the  Code. 

The  applicability  of  this  new  limitation  on  allowable  deductions 
would  be  determined  solely  by  reference  to  the  taxpayer's  personal  use 
of  the  dwelling  unit  during  his  taxable  year  rather  than,  as  under  sec- 
tion 183,  by  reference  to  the  profits  or  losses  during  any  consecutive 
period  of  taxable  years  or  on  the  basis  of  a  facts  and  circumstances 
determination  of  the  taxpayer's  objectives.  Generally,  application  of 
section  183  of  the  code  would  not  be  affected  by  these  new  provisions. 
Thus,  if  the  rental  of  a  dwelling  unit  is  treated  as  an  activity  not 
engaged  in  for  profit  after  consideration  of  the  relevant  objective 
standards  prescribed  by  the  regulations  under  section  183,  deductions 
attributable  to  the  rental  activity  would  be  limited  under  that  provi- 
sion (sec.  183)  even  though  the  new  provisions  did  not  apply  because 
there  was  little  or  no  personal  use  of  the  dwelling  unit,  i.e.,  the  unit 
was  not  used  for  personal  purposes  for  more  than  14  days. 

As  indicated  above,  where  the  dwelling  unit  is  rented  for  less  than 
15  days  during  the  taxable  year,  neither  operating  gain  nor  operat- 
ing loss  would  be  recognized  for  Federal  income  tax  purposes.  Thus, 


145 

where  a  dwelling  unit  is  rented  for  less  than  15  days,  neither  the 
new  limitation  under  this  new  section  nor  the  provisions  of  section  183 
(pertaining  to  activities  not  engaged  in  for  profit)  are  applicable.  In 
tlhis  case,  expenses  which  would  be  allowable  if  the  taxpayer  were  in  a 
trade  or  business  or  subject  to  the  provisions  of  section  183  (e.g.,  main- 
tenance, utilities,  insurance  and  depreciation)  will  not  be  allowed  as  a 
deduction  and  any  revenue  received  from  the  rental  of  a  dwelling  unit 
for  less  than  15  days  will  not  be  includible  for  tax  purposes.  How- 
ever, a  deduction  for  expenses  otherwise  allowable  (e.g.,  interest,  cer- 
tain taxes  and  casualty  losses)  will  be  allowed  as  a  deduction. 

This  new  limitation,  as  indicated  above,  will  not  apply  unless  the 
taxpayer  uses  the  dwelling  unit  for  personal  purposes  during  his 
taxable  year  for  more  than  fourteen  days  or  ten  percent  of  the  number 
of  the  days  during  such  year  for  which  the  dwelling  unit  is  rented, 
whichever  is  greater.  For  this  purpose,  a  dwelling  unit  would  not 
be  treated  as  rented  (at  a  fair  rental)  for  any  day  for  which  it  is 
treated  as  used  for  personal  purposes.  In  the  case  of  a  dwelling  unit 
owned  by  a  partnership,  trust,  estate,  or  subchapter  S  corporation,  ^he 
number  of  days  of  personal  use  by  a  taxpayer  shall  be  determined  by 
reference  to  the  total  number  of  days  of  personal  use  by  the  partners, 
beneficiaries,  or  stockholders,  as  the  case  may  be.  However,  if  two  or 
more  partners,  beneficiaries,  or  stockholders  personally  use  the  dwell- 
ing unit  during  the  same  day,  that  day  would  constitute  only  one 
day  of  personal  use.  If  a  taxpayer  owns  a  dwelling  unit  during  only 
a  portion  of  the  taxable  year,  no  reduction  of  the  personal  use  specified 
under  the  provision  would  be  required  by  reason  that  the  dwelling 
unit  was  owned  for  less  than  a  full  year. 

The  taxpayer  generally  would  be  deemed  to  have  used  a  dwelling 
unit  for  personal  purposes  for  a  day  if,  for  any  part  of  the  day,  the 
unit  is  used  for  personal  purposes  by  (1)  the  taxpayer  or  any  other 
person  who  owns  an  interest  in  the  home;  (2)  their  bix)thers  and  sis- 
ters, spouses,  ancestors,  or  lineal  descendants;  (3)  any  individual  who 
uses  the  unit  under  a  reciprocal  arrangement  (whether  or  not  a  fair 
rental  is  charged)  ;  or  (4)  any  other  individual  who  uses  the  dwelling 
unit  during  a  day  unless  for  that  day  the  unit  is  rented  for  a  fair 
rental.  With  respect  to  use  by  a  person  other  than  the  taxpayer  who 
also  owns  an  interest  in  the  dwelling  unit,  the  taxpayer  would  be 
deemed  to  have  used  the  dwelling  unit  for  personal  purposes  for  a 
day  if,  for  any  part  of  the  day  the  unit  is  used  by  a  co-owner  or  a 
holder  of  any  interest  in  the  unit  (other  than  a  security  interest  or  an 
interest  under  a  lease  for  a  fair  rental)  for  personal  purposes.  For  this 
purpose,  any  other  ownership  interest  existing  at  the  time  the  tax- 
payer has  an  interest  in  the  unit  shall  be  taken  into  account  even  if 
there  are  no  immediate  rights  to  possession  and  enjoyment  under  such 
other  interest. 

A  taxpayer  would  not  be  considered  to  have  personally  used  a 
dwelling  unit  with  respect  to  a  use  by  his  employee,  even  if  it  is 
I'ented  for  less  than  a  fair  rental,  if  the  value  of  such  use  is  excludable 
from  income  by  the  employee  under  section  119  of  the  code  (relating 
to  meals  and  lodging  furnished  for  the  convenience  of  an  employer). 
Further,  if  the  taxpayer  spends  a  normal  work  day  cleaning,  painting, 
repairing  or  otherwise  maintaining  the  dwelling  unit,  such  use  shall 
not  be  treated  as  personal  use. 


146 

For  purposes  of  this  new  provision,  the  term  "dwelling  unit"  in- 
cludes a  house,  apartment,  condominium,  house  trailer,  boat,  or  similar 
property.  The  term  would  include  any  environs  and  outbuildings, 
such  as  a  garage,  which  relate  to  the  use  of  the  dwelling  unit  for 
living  accommodations.  However,  the  term  would  not  include  that 
portion  of  a  dwelling  unit  that  is  used  exclusively  as  a  hotel,  motel, 
inn,  or  similar  establishment. 

In  any  case  where  there  is  any  personal  use  of  a  dwelling  unit  dur- 
ing the  taxpayer's  taxable  year  (whether  or  not  that  pei'sonal  use 
constitutes  use  as  a  residence),  the  expenses  allocable  to  the  rental  of 
the  vacation  home  will  be  limited  to  an  amount  which  bears  the  same 
ratio  to  such  expenses  as  the  number  of  days  the  unit  is  actually 
rented  out  for  the  year  bears  to  the  total  number  of  days  the  unit  is 
actually  used  for  all  purposes  during  the  year.  However,  the  limita- 
tion upon  allocable  expenses  would  not  apply  to  expenses  such  as 
interest  or  taxes  which  are  allowable  even  if  not  attributable  to  the 
rental  activity. 

For  purposes  of  this  limitation,  the  personal  use  of  a  dwelling  unit 
would  be  determined  in  accordance  with  the  rules  described  above. 
However,  for  purposes  of  determining  the  relationship  of  rental  days 
to  total  days  of  use,  the  number  of  rental  days  would  include  any  day 
for  which  the  dwelling  unit  is  rented  for  a  fair  rental  even  if  the 
taxpayer  is  deemed  to  have  personally  used  the  unit  for  that  day.  The 
period  during  which  the  unit  is  merely  held  out  for  rent  would  not 
be  considered  in  determining  the  number  of  rental  days  for  a  taxable 
year. 

Effective  date 

This  provision  applies  to  taxable  years  beginning  after  December  31, 
1975. 

Reveniie  effect 

This  provision  and  the  provision  relating  to  business  use  of  the 
home  will  increase  revenues  by  $207  million  in  fiscal  year  1977,  $206 
million  in  fiscal  year  1978,  and  $305  million  in  fiscal  year  1981. 

3.  Deductions  for  Attending  Foreign  Conventions  (sec.  602  of  the 
Act  and  sec.  274(h)  of  the  Code) 

Prior  law 

Generally,  the  deductibility  of  traveling  expenses  paid  or  incurred 
to  attend  a  foreign  convention,  seminar,  or  similar  meeting  while 
away  from  home  is  governed  by  the  ordinary  and  necessary  standard 
under  sections  162  and  212  of  tlie  code  and,  in  certain  cases,  the  special 
disallowance  rules  provided  under  section  274(c). 

Generally,  to  be  deductible,  traveling  expenses  must  be  reasonable 
and  necessary  in  the  conduct  of  the  taxpayer's  business  and  directly 
attributable  ito  the  trade  or  business.  If  a  trip  is  primarily  related  to 
the  taxpayer's  business  and  the.  sjjecial  foreign  travel  allocation  rules 
do  not  apply,  the  entire  traveling  expenses  (including  food  and  lodg- 
ing) to  and  from  a  destination  are  deductible.  If  a  trip  is  primarily 
personal  in  nature,  the  traveling  expenses  to  and  from  the  destination 
are  not  deductible  even  if  the  taxpayer  engages  in  business  activities 


147 

while  at  the  destination.^  However,  expenses  incurred  while  at  the  des- 
tination which  are  allocable  to  the  taxpayer's  trade  or  business  are 
deductible  even  if  the  transportation  expenses  are  not  deductible. 

With  respect  to  expenses  incurred  in  attending  a  convention  or 
other  meeting,  the  test  under  section  162  is  whether  there  is  a  suffi- 
cient relationship  between  the  taxpayer's  trade  or  business  and  his  at- 
tendance so  that  he  is  benefiting  or  advancing  the  interests  of  his  trade 
or  business.  Generally,  deductibility  depends  upon  the  facts  and  cir- 
cumstances of  each  particular  case.  (Reg.  §  1.162-5(e)  (1) ).  If  the 
convention  is  for  political,  social,  or  other  purposes  unrelated  to  the 
taxpayer's  business,  the  travel  expenses  are  not  deductible.  The  Inter- 
nal Revenue  Service  has  ruled  that  the  test  for  allowance  of  deduc- 
tions for  convention  expenses  is  met  if  the  agenda  of  the  convention 
or  other  meeting  is  so  related  to  the  taxpayer's  position  as  to  show  that 
attendance  was  for  business  purposes.  (Rev.  Rul.  63-266,  1963-2 
C.B.88). 

If  an  individual  travels  away  from  home  primarily  to  obtain  edu- 
cation for  which  the  expenses  are  deductible  as  trade  or  business  ex- 
penses, the  expenses  for  travel,  meals,  and  lodging  incurred  while 
away  from  home  are  deductible.  However,  the  portion  of  the  travel 
expenses  attributable  to  personal  activities,  such  as  sightseeing,  is 
treated  as  a  nondeductible  personal  or  living  expense.  If  the  travel 
away  from  home  is  primarily  personal,  only  the  meals  and  lodging 
incurred  during  the  time  spent  in  participating  in  educational  pur- 
suits are  deductible.  Further,  in  the  case  of  foreign  travel  to  obtain 
education,  deductions  are  subject  to  special  allocation  rules. 

Under  section  274(c)  of  the  code,  expenses  of  travel  outside  the 
United  States  are  deductible  only  to  the  extent  allocable  to  the  tax- 
payer's trade  or  business  or  income-producing  activities  if  such  travel 
is  for  more  than  one  week  or  the  time  of  travel  outside  the  United 
States  which  is  not  attributable  to  the  pursuit  of  the  taxpayer's  trade 
or  business  is  25  percent  or  more  of  the  total  time  on  such  travel.  In 
the  case  of  foreign  travel  to  which  section  274(c)  applies,  this  alloca- 
tion requirement  overrides  the  general  rule  that  the  entire  expenses 
of  travel  are  deductible  if  the  primary  purpose  of  the  trip  was  related 
to  a  trade  or  business. 

General  reasons  for  change 
Serious  administrative  problems  have  arisen  because  of  the  recent 
proliferation  of  conventions,  educational  seminars,  and  cruises  which 
were  ostensibly  held  for  business  or  educational  purposes,  but  which 
were  held  at  locations  outside  the  United  States  primarily  because  of 
the  recreational  and  sightseeing  opportunities.  In  Technical  Informa- 
tion Release  1275  (February  14,  1974),  the  Internal  Revenue  Service 
announced  that  it  intended  to  scrutinize  deductions  for  business  trips, 
conventions,  and  cruises  which  appear  to  be  vacations  in  disguise.  The 
Service  noted  that  a  number  of  professional,  business  and  trade  orga- 
nizations have  been  sponsoring  cruises,  trips  and  conventions  during 
which  only  a  small  portion  of  time  is  devoted  to  business  activity  and 
that  the  practice  seemed  to  be  growing.  In  cases  where  there  were  indi- 

iSee  Patterson  v.  Thomas.  289  F.  2d  108  (5th  CIr.,  1961)  ;  Espandiar  Kadivar,  T.C. 
Memo  1973-95  ;  Rev.  Rul.  74-292,  1974-1  C.B.  43. 


148 

cations  of  abuse,  the  Service  intended  to  request  lists  of  the  names 
and  addresses  of  the  participants  on  cruises  and  other  trips.  However, 
under  prior  law,  allowance  of  deductions  claimed  by  participants  con- 
tinued to  depend  upon  the  facts  and  circumstances,  including  the  re- 
lationship of  the  meeting  to  a  particular  taxpayer's  trade  or  business. 

As  indicated  above,  the  basic  test  that  has  been  applied  by  the  Inter- 
nal Revenue  Service  was  whether  the  convention  or  other  meeting  was 
primarily  related  to  the  taxpayer's  business  or  whether  it  was  pri- 
marily personal  in  nature.  Thus,  in  administering  this  test,  the  Inter- 
nal Revenue  Service  was  required  to  make  a  subjective  determination 
as  to  the  motives  and  intentions  of  the  taxpayer  after  taking  into 
account  all  the  facts  and  circumstances  in  a  particular  case.  One  of  the 
important  factors  considered  by  the  Service  in  making  this  subjective 
detennination  was  the  amount  of  time  spent  on  business  activities  as 
compared  to  the  amount  of  time  spent  on  personal  activities.  There 
were  no  specific  guidelines  or  formulae  in  the  statute  or  regulations 
that  specified  when  this  factor  would  weigh  in  the  favor  of  or  against 
the  taxpayer.  The  taxpayer  was  not  required  to  keep  detailed  records 
relating  to  the  amount  of  time  spent  on  each  of  these  activiites.  Upon 
audit,  the  taxpayer  frequently  attempted  to  substantiate  the  business 
nature  of  his  trip  by  providing  the  Service  with  the  agenda  from  the 
meeting  or  a  certificate  of  attendance  which  was  furnished  by  the 
organization  sponsoring  the  meeting.^ 

The  administrative  problems  created  by  the  lack  of  specific  guide- 
lines were  substantial.  The  pix)cess  of  trying  to  ascertain  all  the  facts 
and  circumstances  was  extremely  time  consuming  both  for  the  taxpayer 
and  the  Service.  Further,  additional  importance  was  placed  on  the  sub- 
jective judgment  of  the  IRS  because  of  the  basically  "all  or  nothing" 
approach  under  prior  law.  If  the  primary  purpose  was  determined  to 
be  pleasure,  no  amount  of  the  travel  expense  could  be  deducted.  Since 
reasonable  and  competent  auditors  differed  in  evaluating  all  the  facts 
and  circumstances,  the  deduction  of  one  taxpayer  could  be  totally  dis- 
allowed while  another  taxpayer  (perhaps  with  slightly  different  facts) 
could  obtain  a  complete  deduction  for  travel  expenses.  This  disparity 
of  treatment  resulted  in  complaints  that  the  Service  did  not  treat 
taxpayers  equally. 

The  Congress  was  concerned  that  the  lack  of  specific  detailed 
requirements  has  resulted  in  a  proliferation  of  foreign  conventions, 
seminars,  cruises,  etc.  which,  in  effect,  amounted  to  Government-sub- 
sidized vacations  and  served  little,  if  any,  business  purpose.  It  was 
indicated  that  the  promotional  material  often  highlight  the  deduct- 
ibility of  the  expenses  incurred  in  attending  a  foreign  convention  or 
seminar  and,  in  some  cases,  describe  the  meeting  in  such  terms  as  a 
"tax-paid  vacation"  in  a  "glorious"  location.  In  addition,  it  was 
pointed  out  that  there  were  organizations  that  advertised  that  they 
could  find  a  convention  for  the  taxpayer  to  attend  in  any  part  of  the 
world  at  any  given  time  of  the  year.  This  type  of  promotion  had  an 
adverse  impact  on  public  confidence  in  the  fairness  of  the  tax  laws. 

Explanation  of  provision 
The  act  limits  the  deductions  allowable  for  the  expenses  of  indi- 

2  A  few  organizations  maintained  attendance  records  and  required  participants  to  "sign 
in"  at  each  session  of  the  convention  or  seminar. 


149 

viduals  attendin<j  foreign  conventions.  The  term  "foreign  convention" 
means  an}^  convention,  seminar  or  similar  meeting  held  outside  the 
United  States,  its  })ossessions,  and  the  Trust  Territory  of  the  Pacific. 

Generally,  under  the  act,  no  deduction  will  be  allowed  for  expenses 
paid  or  incurred  by  an  individual  in  attending  more  than  two  foreign 
conventions  in  any  taxable  year.  In  addition,  with  respect  to  the  two 
conventions  for  which  a  deduction  is  allowable,  the  act  limits  the 
amount  of  expenses  that  can  be  deducted  for  transportation  and  sub- 
sistence. If  an  individual  attends  more  than  two  foreign  conventions 
in  a  year,  he  must  select  which  two  of  the  foreign  conventions  are  to 
be  taken  into  account  for  purposes  of  determining  the  allowable 
deductions. 

The  provisions  apply  to  any  person,  whether  or  not  such  person  is 
the  individual  attending  the  foreign  convention.  For  example,  if  an 
employee  is  reimbursed  for  attending  a  foreign  convention  on  behalf 
of  his  employer  corporation  (or  if  the  corporation  directly  pays 
the  expenses),  the  corporation  will  be  allowed  a  deduction  for  the  ex- 
penses of  attending  the  foreign  convention  only  to  the  extent  that  the 
employee  is  (or  would  be)  allowed  a  deduction.  Thus,  the  corporation 
would  be  allowed  a  deduction  for  the  reimbursement  (subject  to  the 
transportation  and  subsistence  limitations)  only  if  the  employee  se- 
lects the  convention  as  one  of  the  two  conventions  to  be  taken  into 
account  for  the  taxable  year.  In  applying  these  provisions  to  a  cor- 
poration, it  is  intended  that  the  two  convention  rule  be  applied  on  an 
employee-by-employee  basis. 

With  respect  to  subsistence  expenses  incurred  to  attend  a  foreign 
convention,  no  deduction  will  be  allowed  unless:  (1)  a  full  day  or 
half-day  of  business  activities  are  scheduled  on  each  day  during  the 
convention  and  (2)  the  individual  attending  the  convention  attends 
at  least  two-thirds  of  the  hours  of  the  daily  scheduled  business  activ- 
ities or,  in  the  aggregate,  attends  at  least  two-thirds  of  the  total  hours 
of  scheduled  business  activities  at  the  convention.  A  full  day  of  sched- 
uled business  activities  means  a  day  during  which  at  least  6  hours  of 
business  activities  are  scheduled  and  a  half -day  means  a  day  during 
which  at  least  3  hours  of  business  activities  are  scheduled.  Thus,  if  6 
hours  of  business  activities  are  scheduled  for  a  day,  the  individual 
must  attend  at  least  4  hours  for  it  to  be  counted  as  a  full  day.  However, 
if  the  individual  attends  only  2  of  the  6  hours  scheduled,  the  day  will 
not  count  either  as  a  full  day  related  to  business  activities  or  as  a  half- 
day  related  to  business  activities.  If  a  convention  has  scheduled  more 
than  6  hours  of  business  activities  (or  more  than  3  hours  and  less  than 
6  hours  in  the  case  of  half-days)  on  a  day,  then  the  actual  hours  of 
scheduled  business  activities  will  be  taken  into  account  in  computing 
whether  or  not  the  individual  has  attended  at  least  two-thirds  of  the 
hours  of  the  daily  scheduled  business  activities.  Similarly,  in  deter- 
mining whether  the  two-thirds  aggregate  test  is  met,  all  scheduled 
hours  of  business  activities  will  be  taken  into  account. 

In  no  event  will  time  spent  at  parties,  receptions,  or  similar  social 
functions  be  taken  into  account  for  purposes  of  determining  whether 
the  required  3  or  6  hours  of  business  activities  were  scheduled.  Further, 
where  there  is  a  banquet  at  which  there  is  a  speaker  or  lecturer,  only 
the  time  attributable  to  the  speech  or  lecture  (if  business  related)  will 
be  taken  into  account. 


234-120  O  -  77  -  U 


150 

In  the  case  where  subsistence  expenses  are  allowed  under  the  Act, 
the  amount  allowable  as  a  deduction  while  at  the  convention  or  travel- 
ing to  or  from  the  convention  is  not  to  exceed  the  dollar  per  diem  rate 
for  the  site  of  the  convention  which  has  been  established  for  United 
States  civil  servants  under  section  5702(a)  of  title  5  of  the  United 
States  Code  and  which  is  in  effect  for  the  calendar  montli  in  which 
the  convention  begins.  For  purposes  of  this  provision,  "subsistence 
expenses"  means  lodging,  meals,  and  other  necessary  expenses  for  the 
personal  sustenance  and  comfort  of  the  traveler,  including  tips  and 
taxi  and  similar  transportation  expenses. 

With  respect  to  transportation  expenses  outside  the  United  States, 
the  amount  allowable  as  a  deduction  may  not  exceed  the  lowest  coach 
or  economy  rate  charged  by  any  commercial  airline  for  such  trans- 
portation during  the  caleiidar  month  the  convention  is  held.  However, 
where  the  taxpayer  travels  coach  or  economy  class  on  a  regularly 
scheduled  flight  of  a  common  carrier,  the  cost  of  that  economy  or 
coach  fare  is  to  be  allowed  as  a  deduction  (subject  to  the  special 
foreign  travel  allocation  rules  if  applicable).  If  there  is  no  coach  or 
economy  rate,  the  deduction  allowable  would  be  limited  to  the  lowest 
first  class  rate  charged  by  any  commercial  airline  for  such  transpor- 
tation. Transportation  expenses  for  travel  within  the  LTnited  States 
are  deductible  to  the  extent  the  cost  is  reasonable. 

A  deduction  for  the  full  expenses  of  transportation  (subject  to  the 
coach  or  economy  rate  limitation)  to  and  from  the  site  of  a  foreign 
convention  will  be  allowable  only  if  one-half  or  niore  of  the  total  days 
of  the  trip  are  devoted  to  business-related  activities.  In  determining 
whether  a  day  is  devoted  to  business-related  activities,  the  same  rules 
for  counting  full  days  and  half-days  for  purposes  of  su]>sistence  ex- 
penses are  to  be  applied. 

If  less  than  one  half  of  the  total  days  of  the  trip  are  devoted  to  busi- 
ness-related activities,  then  only  a  proportionate  amount  of  the  trans- 
portation expenses  will  be  allowable  as  a  deduction.  The  amount  allow- 
able is  to  be  determined  by  multiplying  the  transportation  expenses 
paid  or  incurred  (after  the  application  of  the  coach  or  economy  rate 
rule)  by  a  fraction,  the  numerator  of  which  is  the  total  days  of  the 
trip  devoted  to  business-related  activities  and  the  denominator  of 
which  is  total  days  of  the  trip.  For  purposes  of  this  provision,  the 
travel  days  to  and  from  the  site  of  the  convention  shall  not  be  taken 
into  account  in  determining  the  total  days  of  the  trip  or  of  business 
related  activities. 

In  any  case  where  the  transportation  and  subsistence  expenses  are 
either  not  separately  stated  or  under  the  facts  and  circumstances  there 
is  reason  to  believe  that  the  allocation  of  expenses  between  transporta- 
tion and  subsistence  expenses  is  not  properly  reflected,  all  amounts  paid 
for  such  expenses  shall  be  treated  as  having  been  paid  solely  for  sub- 
sistence expenses  subject  to  the  subsistence  expense  per  diem  limita- 
tion. 

The  Act  provides  that  no  deduction  is  to  be  allowed  unless  the  tax- 
payer complies  with  certain  reporting  requirements  in  addition  to  the 
substantiation  requirements  of  present  law.  Under  these  reporting  re- 
quirements, the  taxpayer  must  furnish  information  indicating  the  total 
days  of  the  trip  (exclusive  of  the  transportation  days  to  and  from 


151 

the  convention),  the  number  of  hours  of  eacli  day  that  he  devoted 
to  business  activities  (and  a  brochure  describing  the  convention,  if 
available),  and  furnish  any  other  information  required  by  regula- 
tions. In  addition,  the  taxpayer  must  attach  a  statement  signed  by 
an  appropriate  officer  of  the  sponsoring  organization  to  his  income 
tax  return  which  must  include  a  schedule  of  the  business  activities  of 
each  convention  day,  the  nvnnber  of  hours  of  business-related  activities 
that  the  taxpayer  attended  each  day  and  any  other  information  re- 
quired by  regulations. 

Effective  date 
This  provision  shall  apply  to  conventions  beginning  after  Decem- 
ber 31,  1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in  fiscal 
year  receipts  of  less  than  $5  million  annually. 

4.  Qualified  Stock  Options  (sec.  603  of  the  Act  and  sees.  422  and 
424  of  the  Code) 

Prior  law 

An  employee  stock  option  is  a  right,  which  is  limited  in  time,  granted 
by  a  corporate  employer  to  one  or  more  employees  to  purchase  a  stated 
amount  of  stock  in  the  corporation  at  a  stated  price.  An  option  is  a 
relatively  low  risk  means  of  acquiring  an  equity  interest  in  a  corpora- 
tion, since  the  option  need  not  be  exercised  unless  the  value  of  the  stock 
increases  during  the  option  period.  If  the  value  of  the  stock  drops 
below  the  price  at  which  the  stock  may  be  purchased  (i.e.,  below  the 
option  price),  .the  employee  can  allow  the  option  to  lapse  (although 
ordinarily  the  employee  would  lose  the  amount  which  he  may  have 
originally  paid  for  the  option,  if  any) . 

Under  prior  law,  employee  stock  options  fell  broadly  into  two  cate- 
gories: "qualified"  and  nonqualified  options.  The  former  category  was 
governed  by  statutory  rules  which  set  forth  conditions  which  the 
option  must  meet  in  order  to  receive  the  fa\^orable  tax  treatment  ac- 
corded "qualified"  stock  options  under  prior  law.  Employee  options 
which  do  not  satisfy  these  requirements  (often  called  "non-qualified" 
or  "nonstatutory"  options)  are  gov^emed  by  rules  set  forth  in  the  in- 
come tax  regulations  (Regs.  §  1.421-6)  and  by  certain  statutory  rules 
which  apply  generally  to  property  transferred  to  employees  in  connec- 
tion with  their  performance  of  services  (sec.  83) . 

Under  prior  law,  no  income  was  recognized  on  the  grant  to  a  cor- 
porate employee,  or  on  his  exercise  of,  a  "qualified"  option  to  receive 
stock  in  the  employer  corporation  (sec.  421).  The  stock  acquired  by 
the  exercise  of  the  option  is  a  capital  asset  in  the  hands  of  the  employee 
and  the  income  realized  from  the  eventual  sale  of  the  stock  is  ireiierallv 
treated  as  long-term  capital  gain  or  loss.^ 

No  deduction  was  available  to  the  employer,  as  a  business  expense 
(under  sec.  162)  with  respect  to  either  the  granting  of  a  qualified  stock 
Option  or  the  transfer  of  stock  to  the  employee  when  he  exercised  a 
qualified  option. 


1  Generally  similar  tax  treatment  was  also  avaUable  in  the  case  of  "restricted"  stock 
options,  which  were  the  predecesscs  to  qualified  options,  but  restricted  stock  options  are 
no  longer  being  granted,  and  most  restricted  options  which  were  granted  in  the  past  have 
now  been  exercised  or  have  lapsed. 


152 

A  qualified  option  (meeting  the  requirements  in  sec.  422)  must  be 
granted  pursuant  to  a  plan  approved  by  the  shareholders  of  the  corpo- 
ration. The  option  must,  by  its  terms,  be  exercised  within  5  years  from 
the  date  it  is  granted  and  the  purchase  price  of  the  shares  (option 
price)  may  not  be  less  than  the  fair  market  value  of  the  company's 
stock  on  the  date  when  the  option  is  granted  to  the  employee.  In  addi- 
tion, any  stock  acquired  under  a  qualified  option  may  not  be  disposed 
of  within  3  years  after  it  is  transferred  to  the  employee.  The  option 
must  also  be  exercised  while  the  option  holder  is  an  employee  of  the 
corporation,  or  within  three  months  after  the  termination  of  his 
employment. 

By  contrast,  nonqualified  stock  options  were  (and  remain)  generally 
subject  ot  the  rules  of  section  83.  Generally,  under  section  83,  the  value 
of  a  nonqualified  stock  option  constitutes  ordinary  income  to  the  em- 
ployee if  the  option  itself  had  a  readily  ascertainable  fair  market  value 
at  the  time  it  was  granted  to  the  employee.  If  the  option  did  not  have 
a  readily  ascertainable  value  when  granted,  it  would  not  constitute 
ordinary  income  at  the  time  it  was  granted;  when  the  option  is  exer- 
cised, however,  the  spread  between  the  option  price  and  the  value  of 
the  stock  at  that  time  constitutes  ordinary  income  to  the  employee. 

As  can  be  seen  from  the  above  description,  qualified  options  had 
the  advantage  that  an  executive  was  not  required  to  pay  any  ordinary 
income  tax  on  the  value  of  the  option  as  such  when  the  company  grants 
it  to  him,  or  on  any  "bargain  element"  which  may  exist  if  '^nd  when 
he  decided  to  exercise  the  option  and  purchase  stock  in  the  company. 
(The  bargain  element  is  the  excess  of  the  fair  market  value  of  a  share 
of  stock  over  its  purchase  price.)  The  employee  was  only  required  to 
pay  tax  when  he  sold  the  shares  purchased  under  the  option.  Further, 
if  he  held  the  shares  for  at  least  3  years  (as  required  for  the  option 
to  remain  qualified)  he  was  entitled  to  pay  tax  at  capital  gain  rates  on 
the  full  amount  of  his  gain  (if  any)  over  the  price  which  he  originally 
paid  to  buy  the  shares. 

Although  an  employee  did  not  have  to  pay  tax  under  the  qualified 
stock  option  rules  at  the  time  he  exercised  the  option  and  received 
stock  worth  more  than  he  paid  for  it,  the  bargain  element  was  treated 
as  an  item  of  tax  preference.  (This  rule  remains  in  effect  for  qualified 
options  granted  and  exercised  under  certain  transition  rules  described 
below.)  This  means  that  the  excess  of  the  fair  market  value  of  the 
share  at  the  time  of  exercise  over  the  purchase  price  paid  by  the  em- 
ployee was  subject  to  the  minimum  tax. 

ReasoTis  for  change 
The  principal  reason  for  the  prior  tax  treatment  of  qualified  stock 
options  was  said  to  be  that  such  treatment  allowed  corporate  employers 
to  provide  "incentives"  to  key  emploj'ees  by  enabling  these  employees 
to  obtain  an  equity  interest  in  the  corporatioii.  However,  it  seems 
doubtful  whether  a  qualified  stock  option  gives  key  employees  more 
incentive  than  does  any  other  form  of  compensation,  especially  since 
the  value  of  compensation  in  the  form  of  a  qualified  option  is  subject 
to  the  uncertainties  of  the  stock  market.  Moreover,  even  to  the  extent 
a  qualified  option  is  an  incentive,  it  still  represents  compensation  and 
the  Congress  believes  that  as  such  it  should  be  subject  to  tax  in  much 
the  same  manner  as  other  compensation.  Moreover,  to  the  extent  that 


153 

there  was  an  incentive  effect  resulting  from  stock  options,  it  could  be 
argued  that  prior  law  discriminated  in  favor  of  corporations  (which 
were  the  only  kind  of  employers  who  could  grant  qualified  options)  as 
opposed  to  all  other  forms  of  business  organization. 

Explanation  of  provisions 

Under  the  Act,  prior  law  will  not  apply  to  qualified  stock  options 
granted  after  May  20,  1976,  except  in  the  case  of  an  option  granted 
under  a  written  plan  adopted  and  approved  on  or  before  that  date,  or 
under  a  plan  adopted  by  a  board  of  directors  on  or  before  May  20, 
1976  (even  if  the  plan  is  approved  by  the  shareholders  after  that  date) . 

Thus,  generally,  stock  options  granted  after  May  20,  1976,  whether 
or  not  otherwise  qualified  (under  the  requirements  of  section  422)  will 
be  subject  to  the  rules  which  apply  in  the  case  of  most  nonqualified 
options  granted  after  June  30,  1969  (sec.  83  of  the  code).  Under  these 
rules,  if  an  employee  receives  an  option  which  has  a  readily  ascer- 
tainable fair  market  value  at  the  time  it  is  granted,  this  value  (less 
the  price  paid  for  the  option,  if  any)  constitutes  ordinary  income  to 
the  employee  at  that  time.- 

On  the  other  hand,  if  the  option  does  not  have  a  readily  ascertain- 
able fair  market  value  at  the  time  it  is  granted,  the  value  of  the  option 
does  not  constitute  income  to  the  employee  at  that  time,  but  would  be 
taxable  to  the  employee  when  the  option  is  exercised.  The  ordinary 
income  recognized  at  that  time  is  the  spread  between  the  option  price 
and  the  value  of  the  stock  (unless  the  stock  is  nontransferable  and 
si'bject  to  a  substantial  risk  of  forfeiture) . 

Any  option  which  is  subject  to  the  provisions  outlined  above  (sec. 
83)  is  not  treated  as  a  tax  preference  for  purposes  of  the  minimum  tax. 

To  illustrate  these  rules,  consider  the  case  of  a  qualified  option 
granted  to  a  corporate  executive  to  buy  100  shares  at  $10  per  share. 
The  employee  exercises  the  option  in  full  when  the  shares  are  selling 
at  $15  per  sliarc  in  the  open  market.  ITuder  the  act,  this  transaction 
would  be  treated  (under  sec.  83)  as  follows: 

(a)  At  the  time  that  the  company  grants  the  option  to  the  execu- 
tive, if  the  option  as  such  has  a  readily  ascertainable  fair  market  value, 
the  value  of  the  option  (less  any  amount  which  he  may  have  been  paid 
for  it)  is  taxable  to  the  executive  as  ordinary  income. 

(b)  If  the  option  itself  does  not  have  a  readily  ascertainable  market 
value,  the  executive  will  be  subject  to  tax  when  he  exercises  the  option 
and  acquires  the  shares  under  option  to  him.  In  this  example,  the 
employee  will  be  taxable  on  the  $5  per  share  bargain  element  (or  a 
total  of  $500)  at  the  time  he  exercises  his  option.  This  income  will  be 
treated  as  comjiensation  taxable  at  oi-dinary  income  rates.'' 


2  Howpvpr.  if  thp  option  is  nontransferable  and  Is  also  subject  to  a  substantial  risk  of 
forfeiture,  recognition  of  income  would  be  postponed  until  one  or  both  of  these  en- 
cumbrances is  removed. 

^As  indicated  above,  recognition  of  income  could  be  postponed  if  the  stoclc  is  not  trans- 
ferable and  if  it  is  subject  to  a  substantial  risk  of  forfeiture.  In  this  case,  the  tax  is 
im|)osed  (at  ordinary  income  rates)  at  the  time  when  either  of  these  two  restrictions  is 
removed  and  the  tax  base  is  the  exces.?  of  the  fair  marlcet  value  of  the  shares  at  the  time 
when  eltlier  of  these  two  restrictions  is  removed  over  the  amount  which  the  employee 
originally  paid  for  the  property.  However,  under  section  83,  an  employee  who  receives 
stock  (or  other  property)  in  liis  employer  corporation  burdened  by  restrictions  which 
would  free  him  from  paying  a  tax  at  that  time  may,  nevertheless,  elect  to  pay  tax  on  the 
bargain  element  existing  at  that  time.  If  the  employee  makes  this  election  and  pays  tax 
when  he  exercises  the  option,  any  later  increase  in  value  of  the  shares  will  generally  be 
taxable  to  him  as  capital  gain  (rather  than  compensation  income)  when  he  disposes  of 
the  shares. 


154 

Income  recognized  by  the  employee  under  these  rules  would  gen- 
erally constitute  earned  income  for  purposes  of  the  maximum  tax  on 
earned  income  (sec.  1348). 

(c)  Aft«r  the  executive  pays  tax  at  ordinary  income  rates  on  the 
compensation  portion  of  the  transaction,  he  would  be  entitled  to  add 
the  amount  of  ordinary  income  recognized  to  his  basis  in  the  shares. 
Any  further  gain  (realized  when  the  employee  sells  the  shares)  would 
generally  be  taxable  as  a  capital  gain. 

(d)  The  employer  corporation  is  entitled  to  a  deduction  (under 
sec.  83)  in  an  amount  equal  to  the  ordinary  income  realized  by  an 
employee  under  the  above  rules.  The  employer's  deduction  accrues  at 
the  time  that  the  employee  is  considered  to  have  realized  compensa- 
tion income. 

The  Congress  intends  that  in  applying  these  rules  for  the  future, 
the  Service  will  make  every  reasonable  effort  to  determine  a  fair  mar- 
ket value  for  an  option  (i.e.,  in  cases  where  similar  property  would  be 
valued  for  estate  tax  purposes)  where  the  employee  irrevocably  elects 
(by  reporting  the  option  as  income  on  his  tax  return  or  in  some  other 
manner  to  be  specified  in  regulations)  to  have  the  option  valued  at  the 
time  it  is  granted  ( particularly  in  the  case  of  an  option  granted  for  a 
new  business  venture) .  The  Congress  intends  that  the  Service  will  pro- 
mulgate regulations  and  rulings  setting  forth  as  specifically  as  pos- 
sible the  criteria  which  will  be  weighed  in  valuing  an  option  which  the 
employee  elects  to  value  at  the  time  it  is  granted. 

Of  course,  merely  because  the  option  is  difficult  to  value  does  not 
mean  that  the  option  has  no  value.  The  Congiess  intends  that  under 
these  rules,  the  value  of  an  option  would  be  determined  under  all  the 
facts  and  circumstances  of  a  particular  case.  Among  other  factoi-s  that 
would  be  taken  into  account  would  be  the  value  of  the  stock  underlying 
the  option  (to  the  extent  that  this  could  be  ascerained),  the  length  of 
the  option  period  (the  longer  the  period,  the  greater  the  chance  the 
imderlying  stock  might  increase  in  value) ,  the  earnings  potential  of  the 
corporation,  and  the  success  (or  lack  of  success)  of  similar  ventures. 
Corporate  assets,  including  patents,  trade  secrets  and  knowhow  would 
also  have  to  be  taken  into  account. 

The  Congress  anticipates  that  under  the  Service's  rules,  certain 
options,  such  as  those  traded  publicly,  would  be  treated  as  having  a 
readily  ascertainable  fair  market  value,  regardless  of  whether  the 
employee  makes  an  election.  However,  the  regulations  could  provide 
that  in  certain  other  cases  the  option  would  ordinarily  not  be  valued 
at  the  time  it  is  granted  unless  the  employee  so  elects. 

The  rules  outlined  above  are  not  to  apply  to  employee  "stock  pur- 
chase plans'*  (described  in  sec.  423  of  the  Code)  under  which  the 
rank  and  file  employees  of  a  corporation  (as  well  as  the  executives) 
are  afforded  an  opportunity  to  purchase  corporate  stock  on  a  non- 
discriminatory basis.  The  prior  Federal  tax  treatment  of  this  type  of 
plan  is  not  affected  by  this  provision  of  the  Act. 

The  Act  also  provides  certain  transition  rules  so  as  not  to  disturb 
arrangements  which  were  entered  into  in  reliance  on  prior  law.  Under 
the  transition  rules,  prior  law  will  continue  to  govern  qualified  stock 
options  granted  pursuant  to  a  written  qualified  stock  option  plan  which 
was  adopted  by  the  board  of  directors  of  the  corporation  before  May  21, 


155 

1976.  For  purposes  of  this  rule,  it  is  immaterial  whether  the  share- 
holders approve  the  plan  before,  on,  or  after  the  date,  although  in  order 
to  be  a  qualified  plan  the  shareholders  must  approve  the  plan  within 
12  months  before  or  after  its  adoption  b}'  the  board  (sec.  •122(b)  (1) ). 
In  order  to  retain  its  qualification  the  option  must  be  exercised  by  the 
employee  before  May  21,  1981  (i.e.,  within  five  years  of  the  May  20, 
1976  cutoff  date).  However,  this  requirement  does  not  have  to  be 
spelled  out  inider  the  terms  of  the  option ;  it  is  sufficient  if  the  option 
is  actuall}^  exercised  on  or  before  May  20, 1981. 

In  general,  a  plan  is  to  be  treated  as  having  been  "adopted"  by  the 
board  of  directors  of  the  corporation  by  May  20, 1976,  only  if  all  of  the 
action  required  for  adoption  has  been  completed  by  that  date.  For 
example,  if  the  plan  had  been  adopted  by  the  directors  of  a  corpora- 
tion under  procedures  which  were  valid  under  State  law,  the  plan 
would  generally  be  treated  as  having  been  "adopted"  within  the  mean- 
ing of  the  statute.  For  purposes  of  these  iiiles,  any  amendment  of  an 
existing  plan  to  increase  the  number  of  shares  which  ma}'  be  granted 
under  the  plan  is  to  be  treated  as  a  new  plan.  Thus  options  granted  as 
a  result  of  a  plan  amendment  adopted  after  May  20,  1976,  would  not 
be  qualified  options.  It  is  not  necessary,  however,  in  the  case  of  a  plan 
adopted  by  May  20,  1976,  for  options  to  have  been  granted  under  the 
plan  by  that  date  or  for  the  directors  or  shareholders  to  have  author- 
ized the  specific  grant  of  options  under  the  plan  to  specific  individuals. 

If  qualified  options  are  granted  under  the  transition  rule,  but  the 
options  are  not  exercised  until  after  May  20,  1981,  the  Congress  intends 
that  the  option  is  to  be  treated  as  an  option  which  did  not  have  a  read- 
ily ascertainable  fair  market  value  at  the  time  it  was  granted  (w'ithin 
the  meaning  of  sec.  83  (e)  (3) ) .  Thus,  the  value  of  the  option  in  this  case 
would  not  constitute  income  to  the  employee  when  granted  (or  at  a 
time  the  transition  rule  expires),  but  if  the  option  subsequently  is 
exercised,  and  if  the  fair  market  value  of  the  stock  exceeds  the  option 
price,  this  excess  will  constitute  ordinary  income  to  the  employee  at 
the  time  of  exercise. 

The  Act  also  requires  that  all  outstanding  restricted  stock  options 
(sec.  424)  must  be  exercised  on  or  before  May  20,  1981,  in  order  to 
receive  the  Federal  tax  treatment  previously  accorded  these  options. 

As  under  prior  law,  in  the  event  of  a  corporate  merger,  consolida- 
tion or  other  reorganization,  the  employer  corporation  may  substitute 
a  new  option  for  an  old  option,  as  long  as  the  new  option  and  the  old 
option  are  substantiall}'  equivalent  (sec.  425).  Thus  the  surviving 
corporations  in  a  corporate  merger  could  substitute  options  on  its  stock 
for  options  on  the  stock  of  the  nonsurviving  corporation,  so  long  as  the 
options  were  of  equivalent  value  and  the  new  option  did  not  provide 
for  any  additional  benefits  for  the  employee  which  he  did  not  have 
under  the  old  option.  These  substitutions  can  occur  after  May  20,  1976. 
on  the  same  basis  as  before  that  date.  (Of  coui*se,  "old  options"  could 
not  be  granted  after  May  20,  1976,  by  the  acquired  corporation,  except 
as  provided  under  the  transition  rules.  Hovrever,  if  a  corporation 
adopted  an  option  plan  in  1974  and  is  reorganized  in  1977  into  a  hold- 
ing compan}'^  with  one  or  more  operating  subsidiaries,  the  holding 
company  may  adopt  the  1974  option  plan  and  continue  to  grant 


156 

qualified  stock  options  to  the  extent  permissible  had  the  reorganiza- 
tion not  occurred.) 

Ejfective  date 
The  amendments  with  respect  to  qualified  stock  options  apply  to 
taxable  years  ending  after  May  20, 1976. 

Reverme  effect 
This  program  will  increase  budget  receipts  by  $7  million  in  fiscal 
year  1977,  $20  million  in  fiscal  year  1978,  and  $5  million  in  fiscal  year 
1981. 

5.  Treatment  of  Losses  From  Certain  Nonbusiness  Guaranties 
(sec.  605  of  the  Act  and  sec.  166  of  the  Code) 

Prior  Jaws 

Under  prior  law  (which  remains  in  effect),  in  the  case  of  a 
noncorporate  taxpayer,  "business"  bad  debts  are  deductible  as  ordi- 
nary losses  for  the  year  in  which  the  debt  becomes  worthless  or  par- 
tially worthless.  On  the  other  hand,  "nonbusiness"  bad  debts  are 
treated  as  short-term  capital  losses,  which  means  that  the  losses  ai-e 
offset  first  against  the  taxpayer's  capital  gains  (if  any) ,  and  may  then 
be  deducted  against  ordinary  income  to  the  extent  of  $1,000  per  year. 

On  the  other  hand,  where  the  noncorporate  taxpayer's  loss  results 
from  a  situation  where  he  guaranteed  the  debt  of  a  noncorporate 
person,  and  was  required  to  make  good  on  that  guaranty  because  the 
borrower  defaulted,  section  166(f)  of  the  code  provided  that  the 
guarantor  could  treat  the  payment  under  the  guaranty  as  a  business 
bad  debt  (even  though  the  guaranty  did  not  arise  in  connection  with 
the  gviaran tor's  trade  or  business)  if  the  proceeds  of  the  loan  were 
used  by  the  borrower  in  his  trade  or  business,  and  the  debt  was  worth- 
less when  payment  was  made  by  the  guarantor  (i.e.,  the  borrower  was 
insolvent).  The  deduction  is  allowed  for  the  year  in  which  the  pay- 
ment is  made. 

However,  the  guarantor  of  a  corporate  obligation  which  becomes 
worthless  must  treat  the  guaranty  payment  as  a  nonbusiness  bad  debt 
(Reg.  §  1.166-8  (b) ).  Also,  if  the  loan  was  not  used  in  the  borrower's 
trade  or  business,  the  provisions  of  section  166(f)  did  not  apply.  How- 
ever, the  guarantor's  payment  was  still  deductible  as  a  nonbusiness 
bad  debt  (short-term  capital  loss)  if  the  debt  was  worthless  when  paid 
and  the  guarantor  had  a  right  of  reimbursement  (subrogation) 
against  the  borrower.^ 

Where  the  guarantor  had  no  right  of  subrogation,  there  was  some 
uncertainty  as  to  whether,  and  under  what  circumstances,  the  guar- 
antor was  entitled  to  deduct  his  guaranty  payment.  For  some  time  it 
was  believed  that  the  payment  could  not  be  deducted  as  a  bad  debt  on 
the  theory  that  unless  there  is  a  right  of  recovery  against  the  borrower, 
there  is  no  "debt"  which  might  become  worthless  in  (lie  hands  of  the 
guarantor.  However,  if  the  guaranty  transaction  was  entered  into  in 
connection  with  the  taxpayer's  trade  or  business,  or  the  agreement  was 
part  of  a  transaction  entered  into  for  profit  on  the  part  of  the  tax- 
payer, then  the  payment  was  claimed  to  be  deductible  as  a  loss  under 

1  If  the  debt  is  not  worthless,  no  deduction  Is  j^nerally  allowed  (on  the  theory  that  pay- 
ment by  the  guarantor  was  voluntary). 


157 

section  165.^  More  recently,  courts  have  held  that  there  was  a  bad 
debt  on  the  grounds  that  there  was  an  implied  promise  on  the  part  of 
the  borrower  to  reimburse  the  guarantor  for  his  payments.^ 

General  reasons  for  cliange 

As  discussed  above,  where  a  taxpayer  makes  a  loan  which  is  not 
connected  with  his  trade  or  business,  and  the  debt  becomes  worthless, 
he  is  generally  required  to  treat  the  loss  as  a  short-term  capital  loss. 
On  the  other  hand,  where  a  third  party  made  the  loan,  which  was 
guaranteed  by  the  taxpayer,  and  the  proceeds  of  the  loan  were  used  by 
the  borrower  in  his  trade  or  business,  any  loss  which  results  could 
generally  be  deducted  by  the  taxpayer  against  ordinary  income.  The 
Congress  concluded  that  this  distinction  made  little  sense  and  gave  a 
tax  advantage  to  guaranteeing  loans  over  making  them  directly. 

Explanation  of  provisions 

To  provide  for  more  consistent  treatment  in  the  area  of  bad  debts 
and  guaranties,  the  Act  repeals  section  166(f)  of  the  Internal  Revenue 
Code,  effective  for  taxable  years  beginning  after  December  31,  1975. 
Thereafter,  when  a  taxpayer  has  a  loss  arising  from  the  guaranty  of 
a  loan,  he  is  to  receive  the  same  treatment  as  where  he  has  a  loss  from 
a  loan  M^iich  he  makes  directly.  Thus,  if  the  guaranty  agreement  arose 
out  of  the  guarantor's  trade  or  business,  the  guarantor  would  still  be 
permitted  to  deduct  the  loss  resulting  from  the  transaction  against 
ordinary  income.  If  the  guaranty  agreement  was  a  transaction  entered 
into  for  profit  by  the  guarantor  (but  not  as  part  of  his  trade  or  busi- 
ness), he  Avould  be  able  to  deduct  the  resulting  loss  as  a  nonbusiness 
debt. 

Also,  in  the  case  of  a  guaranty  agreement  which  is  not  entered  into 
as  part  of  the  guarantor's  trade  or  business,  or  as  a  transaction  for 
profit,  no  deduction  is  to  be  available  in  the  event  of  a  payment  under 
the  guarantee. 

Generally,  in  the  case  of  a  direct  loan,  the  transaction  is  entered 
into  for  profit  by  the  lender,  who  hopes  to  realize  interest  on  the  loan. 
However,  this  may  not  be  true  in  the  case  of  loans  made  between 
friends  or  family  members,  and  in  these  cases  the  Internal  Revenue 
Service  will  generally  treat  any  loss  resulting  from  such  a  "loan"  as  a 
gift,  with  respect  to  which  no  bad  debt  deduction  is  available.  (Reg. 
§  1.166-1  (c)) 

In  the  case  of  a  guaranty  agreement,  however,  it  is  not  always  easy 
to  tell  whether  the  transaction  has  been  entered  into  for  profit  on  the 
part  of  the  guarantor.  It  is  not  uncommon  for  guaranty  agreements 
to  provide  for  no  direct  consideration  to  be  paid  to  the  guarantor. 
Often  this  may  be  because  the  guarantor  is  receiving  indirect  consid- 
eration in  the  form  of  improved  business  relationships.  On  the  other 
hand,  many  other  guaranties  are  given  without  consideration  as  a 
matter  of  accommodation  to  friends  and  relatives. 

The  Congress  believes  that  a  bad  debt  deduction  should  be  avail- 


2  The  legal  theory  led  to  attempts  on  the  part  of  some  taxpayers  to  take  themselves  out 
of  the  general  rules  relating  to  guaranties  of  debts  by  taking  steps  to  Insure  that  they 
would  have  no  right  of  subrogation  against  the  borrower  if  he  defaulted.  (This  was  par- 
ticularly true  in  the  case  of  guaranties  by  taxpayers  of  corporate  obligations  where  the 
taxpayer  was  a  shareholder  In  a  closely  held  corporation.)  The  taxpayer  would  then 
attempt  to  claim  an  ordinary  loss  deduction  under  section  165,  instead  of  receiving  non- 
business bad  debt  treatment  under  section  166. 

'See  e.g..  Bert  W.  Martin.  .52  T.C.  140  (reviewed  by  the  Court),  aflf'd  per  curiam, 
424  F.2d  1368  (9th  Cir.)  cert,  denied,  400  U.S.  902  (1970). 


158 

ablo  in  the  cnse  of  a  guaranty  related  to  the  taxpayer's  trade  or  busi- 
ness, or  a  guaranty  transaction  entered  into  for  profit.  However,  no 
deduction  should  be  available  for  a  "gift''  type  of  situation.  Thus,  the 
Congress  intends  that  for  years  beginning  in  1976  (in  the  case  of 
guaranties  made  after  1975)  and  thereafter,  the  burden  of  substanti- 
ation is  to  be  on  the  guarantor,  and  that  no  deduction  is  to  be  available 
unless  the  guaranty  is  entered  as  part  of  the  guarantor's  trade  or  busi- 
ness, or  unless  the  transaction  has  been  entered  into  for  profit,  as  evi- 
denced by  the  fact  that  the  guarantor  can  demonstrate  that  he  has  re- 
ceived reasonable  consideration  for  giving  the  guaranty.  For  this  pur- 
pose, consideration  could  include  indirect  consideiation;  thus,  where 
the  taxpayei-  can  substantiate  that  a  guaranty  was  given  in  accordance 
with  normal  business  practice,  or  for  hona-fde  business  purposes,  the 
taxpayer  would  be  entitled  to  his  deduction  even  if  he  received  no 
direct  monetary  consideration  for  giving  the  guaranty.  On  the  other 
hand,  a  father  guaranteeing  a  loan  for  his  son  would  ordinarily  not 
be  entitled  to  a  deduction  even  if  he  received  nominal  considei-ation 
for  giving  the  guaranty. 

The  Congress  also  wishes  to  make  it  clear  that  in  the  case  of  a 
guarantor  of  a  corporation  obligation,  any  payment  under  the  guar- 
anty agreement  must  be  deducted  (if  at  all)  as  a  nonbusiness  bad  debt, 
regardless  of  whether  there  is  any  right  of  subrogation,  unless  the 
guaranty  was  made  pursuant  to  the  taxpayer's  trade  or  business.  Of 
course,  if  the  payment  under  the  guaranty  by  a  corporate  shareholder 
constitutes  a  contribution  to  capital,  under  the  facts  and  circumstances 
of  the  particriar  case,  the  paym>  i*t  would  not  be  deductible  but  would 
increase  tlu-  sto.-  ^diolder's  basis  in  his  shares  in  the  corporation.  This 
rule  is  consistent  with  Congress'  understanding  of  present  law. 

The  (^ongress  further  wishes  to  resolve  for  the  future  the  appro- 
priate timing  of  the  deduction  for  a  payment  under  a  guaranty  agree- 
ment. If  the  guaranty  agreement  (including  for  this  purpose  a  guar- 
anty, indemnity  or  endorsement)  requires  payment  by  the  guarantor 
upon  default  by  the  maker  of  the  note  (i.e.,  the  borrower),  and  the 
guarantor  has  a  right  of  subrogation  oi  other  right  against  the  maker, 
no  deduction  will  be  allowed  to  the  guarantor  until  the  year  in  Avhich 
the  right  over  against  the  maker  becomes  worthless  (or  partially 
worthless,  where  the  guaranty  occurs  in  connection  with  the  guaran- 
tor's trade  or  business) .  If  the  guarantor  has  no  right  over  agaijist  the 
maker  of  the  obligation,  the  payment  under  the  guaranty  is  deductible 
as  a  bad  debt  for  the  year  in  which  the  payment  is  made.  Of  course,  if 
the  payment  is  voluntary  in  the  sense  that  there  is  no  legal  obligation 
to  make  the  payment,*  or  a  guai-anty  agreement  is  entered  after  the 
debt  has  become  worthless,  no  deduction  is  to  be  available. 
Effective  date 

The  provisions  of  this  amendment  are  to  be  effective  for  taxable 
years  beginning  after  December  81,  1975  in  connection  the  guaranties 
made  after  that  date. 
Revenue  e-ffect 

It  is  estimated  that  this  provision  will  result  in  an  increase  in  budget 
receipts  of  $1  million  in  fiscal  year  1977  and  of  5  million  annually 
thereafter. 


*  It  is  not  intpnrtpd  that  legal  action  must  have  been  brought  against  the  guarantor 
in  order  to  entitle  him  to  take  an  otherwise  available  deduction  ;  but  there  must  be  an  en- 
forceable legal  obligation  on  his  part  to  make  the  payment. 


F.  ACCUMULATION  TRUSTS 

(Sec.  701  of  the  Act  and  sees.  644  and  665-669  of  the  Code) 

Prior  law 

A  trust  is  generally  treated  as  a  separate  entity  wliich  is  taxed  in  tlK- 
same  manner  as  an  individual.  However,  there  is  one  important  dif 
fercnce:  the  trust  is  allowed  a  special  deduction  for  any  distributions 
of  income  to  beneficiaries.  The  beneficiaries  then  include  these  distri- 
butions in  their  income  for  tax  purposes.  Thus,  in  the  case  of  income 
distributed  currently,  the  trust  is  tieated  as  a  conduit  through  which 
income  passes  to  the  beneficiaries,  and  the  income  so  distributed  re- 
tains the  same  character  in  the  hands  of  the  beneficiaries  as  it  possessed 
in  the  hands  of  the  trust. 

If  a  grantor  creates  a  trust  under  which  the  trustee  is  either  re- 
quired, or  is  given  discretion,  to  accumulate  the  income  for  the  benefit 
of  designated  beneficiaries,  however,  then,  to  the  extent  the  income  is 
accumulated,  it  is  taxed  at  individual  rates  to  the  trust.  An  important 
factor  in  the  trustee's  (or  grantor's)  decision  to  accumulate  the  income 
may  be  the  fact  that  tlie  beneficiaries  are  in  highei-  tax  brackets  than 
the  trust. 

Beneficiaries  are  taxed  on  distributions  of  previously  accundated 
income  from  trusts  in  substantially  the  same  manner  as  if  the  income 
had  been  distributed  to  the  beneficiaries  currently  as  earned,  instead  of 
bein^  accumulateil  in  the  trust.  This  is  accompfislied  through  the  so- 
called  "throwback  rule,'*  under  which  distributions  of  accumulated 
income  to  beneficiaries  are  thrown  back  to  the  yoar  in  which  the  income 
would  have  be«n  taxed  to  the  beneficiary^  if  it  had  been  distributed 
currently.  The  Tax  Reform  Act  of  19(59  revised  the  prior  throwbacii 
rule  to  provide  an  unlimited  throwback  rule  with  respect  to  accumula- 
tion distributions. 

Under  prior  law,  the  tax  on  accumulation  distributions  was  com- 
puted in  either  of  two  ways.  One  method  was  the  "exact''  method,  and 
the  other  was  a  "sliortcut"  method  which  did  not  require  the  more  ex- 
tensile computations  required  by  the  exact  method.  Under  the  exact 
niethod  of  computation,  the  tax  on  an  accuuiulation  distribution  could 
not  exceed  the  aggregate  of  the  taxes  that  would  have  been  payable 
if  the  income  had  actually  been  distributed  in  the  prior  years  when 
earned.  This  method  i-equired  complete  trust  and  beneficiary  records 
for  all  past  years  so  that  the  distributable  net  income  of  the  trust  and 
the  taxes  of  the  beneficiary  could  be  determined  for  each  year.  The 
beneficiarv's  own  tax  tiien  was  recom])uted  foi-  these  years,  including 
in  his  income  the  appropriate  amount  of  trust  income  for  each  of  the 
years  (including  his  share  of  an}^  tax  paid  by  the  trust).  Against  the 
additional  tax  computed  in  this  manner,  the  beneficiary  was  allowed 
a  credit  for  his  share  of  the  taxes  paid  by  the  trust.  Any  remaining 
tax  then  was  due  and  payable  as  a  part  of  the  tax  for  the  current  year 
in  which  the  distribution  was  received. 

(159) 


160 

The  so-called  shortcut  method  in  effect  determined  the  tax  attribut- 
able to  the  acciinuilation  distribution  by  avenigin^  the  distribution 
over  a  number  of  years  (hirin<2:  which  the  income  was  earned 
by  the  trust.  This  was  accomplished  by  including,  for  purposes  of 
tentative  computations,  a  fraction  of  the  income  received  from  the 
trust  in  the  beneficiary's  income  of  each  of  the  3  immediately  prior 
years.  The  fraction  of  the  income  included  in  each  of  these  years  was 
based  upon  the  number  of  years  in  which  the  income  was  accumulated 
by  the  trust. 

Prior  law  also  provided  an  unlimited  throwback  rule  for  capital 
gains  allocated  to  the  corpus  of  an  accumulation  trust.  Tliis  provision 
normally  did  not  apply  to  '"simple  trusts"  (any  trust  which  is  required 
by  the  terms  of  its  governing  instrument  to  distribute  all  of  its  income 
currently)  or  any  other  trusts,  which  in  fact  distribute  all  their  income 
currently,  until  the  first  year  they  accumulated  income.  For  purposes 
of  this  provision,  a  capital  gains  distribution  was  deemed  to  have  been 
made  only  when  the  distribution  was  greater  than  all  of  the  accumu- 
lated ordmary  income.  If  the  trust  had  no  accoumulated  ordinary  in- 
come or  capital  gains,  or  if  the  distribution  was  greater  than  the  ordi- 
nary income  or  capital  gain  accumulations,  then  to  this  extent  it  was 
considered  a  distribution  of  corpus  and  no  additional  tax  was  imposed. 

Reasons  for  change 

The  progressive  tax  rate  structure  for  individuals  is  avoided  if  a 
grantor  creates  a  trust  to  accumulate  income  taxed  at  low  rates,  and 
the  income  in  turn  is  distributed  at  a  future  date  with  little  or  no 
additional  tax  being  paid  by  the  beneficiary,  even  when  he  is  in  a  high 
tax  bracket.  This  result  oc^iurs  because  the  trust  itself  is  taxed  on  the 
accumulated  income  rather  than  the  grantor  or  the  beneficiary. 

The  throwback  rule  (as  amended  by  the  Tax  Eeform  Act  of  1969) 
modifies  this  result  by  taxing  beneficiaries  on  distributions  they  receive 
from  accumulation  trusts  in  substantially  the  same  manner  as  if  the 
income  had  been  distributed  to  the  beneficiaries  currently  as  it  was 
earned.  The  1969  Act  made  a  number  of  significant  revisions  in  the 
treatment  of  accumulation  trusts.  In  applying  the  throwback  rule  to 
beneficiaries  with  respect  to  the  accumulation  distributions  they  re- 
ceive, the  1969  Act  provided  two  alternative  methods,  as  indicated 
above,  the  exact  method  and  the  shortcut  method.  A  number  of  admin- 
istrative problems  have  resulted  in  the  application  of  these  alternative 
methods  for  both  the  Internal  Revenue  Service  and  the  beneficiaries. 

For  example,  taxpayers  are  under  an  obligation,  as  a  practical 
matter,  to  compute  the  throwback  under  the  rule  which  results  in 
the  least  tax ;  thus,  the  shortcut  method,  which  was  intended  to  sim- 
plify  calculations  and  eliminate  recordkeeping  problems  involved  with 
the  exact  method  has  not  achieved  this  result  because  taxpayei-s  nnist 
compute  the  tax  under  both  methods.  As  a  i-esult,  the  Congress  believed 
it  was  more  desirable  to  have  one  simplified  inemod  rather  than  hav- 
ing two  alternative  methods  in  applying  the  throwback  mle.  In  the 
case  of  multiple  trusts,  however,  the  Congress  was  concerned  about 
the  potential  tax  avoidance  use  of  such  trusts.  As  a  result,  the  Act 
provides  a  special  rule  in  the  case  of  accumulation  distributions  re- 
ceived by  any  beneficiary  from  three  or  more  trusts. 

In  addition,  a  number  of  questions  were  raised  as  to  whether  the 
capital  gains  throwback  rule,  which  was  enacted  in  the  1969  Act, 


161 

presented  more  complexity  in  its  application  than  was  warranted  by 
the  concerns  raised  in  1969  with  respect  to  capital  gains.  The  Congress 
believed  it  was  appropriate  to  repeal  the  capital  gains  throwback  rule 
and  provided  instead  a  rule  to  deal  more  directly  with  the  transferring 
of  appreciated  assets  by  grantoi-s  into  trusts. 

The  Congress  also  reviewed  other  aspects  of  the  tax  treatment  of 
accumulation  trusts  and  provided  modifications  to  make  the  rules 
easier  to  apply  and  ]>e  administered.  For  example,  the  Act  provides  an 
exemption  for  the  income  accumulated  in  a  trust  during  the  minority 
of  a  beneficiarv,  as  was  provided  in  the  law  under  the  throAvback  rule 
before  1969. 

Explanation  of  provisions 

The  Act  substitutes  for  the  two  alternative  methods  used  in  com- 
puting the  throwback  rule  for  accumulation  distributions  a  single 
method,  which  is  a  revision  of  the  present  "shortcut"  method.  The  new 
shortcut  method  provided  under  the  Act  determines  (in  etfect)  the 
tax  attributable  to  the  distribution  by  averaging  the  distribution  over 
a  number  of  years  equal  to  the  number  of  years  over  which  the  income 
was  earned  by  the  trust.  This  is  accomplished  by  including,  for  pur- 
poses of  tentative  computations,  a  fraction  of  the  income  received  from 
the  trust  in  the  beneficiary's  income  for  each  of  the  5  preceding  years 
(rather  than  the  3  preceding  years  under  present  law).^  The  fraction 
of  the  income  included  in  each  of  these  years  is  based  upon  the  number 
of  years  in  which  the  income  was  accumulated  by  the  trust  (as  deter- 
mined under  prior  law).  This  average  amount  is  added  to  the  bene- 
ficiary's taxable  income  for  these  years  (rather  than  requiring  the  re- 
computation  of  his  tax  returns  as  under  prior  law).^ 

Of  these  5  preceding  years,  the  j-ear  with  the  highest  taxable  income 
and  the  year  with  the  lowest  would  not  be  considered;  m  effect,  then, 
the  computation  of  the  additional  tax  on  the  accumulation  distribution 
under  this  shortcut  method  is  based,  as  under  prior  law,  on  a  3-year 
average  basis. 

In  general,  except  as  indicated  below,  the  rules  under  the  shortcut 
method  continue  to  apply.  Thus,  if  the  accunudated  income  is  attribu- 
table to  10  different  years  (although  the  trust  may  have  been  in  exist- 
ence longer  than  10  years),  then  one-tenth  of  the  amount  distributed 
would  be  added  to  the  beneficiary's  taxable  income  in  each  of  the  3 
years.  The  additional  tax  is  then  computed  with  respect  to  these  3 
years  and  the  average  yearly  additional  tax  for  the  3-year  period  is 
determined.  This  amoinit  is  then  nndtiplied  by  the  iiumber  of  years  to 
which  the  trust  income  relates  (10  in  this  exauiple).  The  tax  so  com- 
puted may  be  offset  by  a  credit  for  any  taxes  previously  paid  by  the 
trust  v/ith  respect  to  this  income  and  any  remaining  tax  liability  is 
then  due  and  payable  in  the  same  year  as  the  tax  on  the  beneficiary's 
other  income  in  the  year  of  the  distribution.  Tender  the  Act,  unlike 


^  The  accunuilated  Income  which  is  to  be  Included  in  the  beneficiary's  Income  for  any  year 
under  the  shortcut  method  is  the  income  of  the  trust  which  v/ould  have  been  included 
in  the  beneficiary's  income  if  the  trust  had  made  the  distributions  currently  rather  than 
accumulating  the  income.  As  a  result,  the  character  of  any  tax-exempt  interest  would  be 
carried  with  the  accumulated  income  and,  thus,  would  not  be  subject  to  tax  to  the 
beneficiary. 

"  For  purposes  of  adding  the  accumulated  income  to  the  taxable  income  of  a  beneiciary 
for  a  year,  the  beneficiary's  taxable  income  may  not  be  less  than  zero.  Thus,  if  in  any 
year  to  which  the  shortcut  method  applies  a  beneficiary  has  a  net  operating  loss,  the 
beneficiary's  taxable  income  for  that  particular  year  will  be  treated  as  being  zero. 


162 

under  prior  law,  no  refunds  or  credits  are  to  be  made  to  any  bene- 
ficiary or  a  trust  as  a  result  of  any  accumulation  distributions. 

The  Act  provides  a  special  rule  to  deal  with  multiple  trusts  where  a 
beneficiary  receives  an  accumulation  distribution  from  more  than  two 
trusts  with  res2:>ect  to  the  same  year.  Under  this  rule,  in  tlie  case  of  a 
distribution  from  the  third  trust  (and  any  additional  trusts) ,  the  bene- 
ficiary is  to  recompute  his  tax  under  the  revised  shortcut  method  in  the 
same  manner  as  indicated  above  except  that  no  credit  is  to  be  given 
for  any  taxes  previously  paid  by  the  trust  with  respect  to  this  income. 
The  xVct  provides  a  de  Tninlmw  rule  under  which  this  special  nmltiple 
trust  rule  is  not  to  apply.  Under  this  de  minimis  rule,  the  special  mul- 
tiple tinist  rule  is  not  to  apply  where  an  accumulation  distribution  from 
a  trust  (including  all  prior  accumulation  distributions  from  the  trust 
to  the  beneficiary  for  that  same  year)  is  less  than  $1,000. 

The  Act  provides  that  the  throwback  rule  is  not  to  apply  to  any 
distributions  of  income  accumulated  for  a  beneficiary  while  he  was 
a  minor ;  that  is,  before  the  birth  of  such  beneficiary  or  before  the  bene- 
ficiary is  21  years  of  age.  This  exception  for  minors,  however,  is  not 
to  apply  in  the  case  of  distributions  covered  mider  the  multiple  trust 
rule. 

The  Act  also  modifies  the  rules  for  determining  when  an  accumula- 
tion distribution  is  made.  Under  prior  law,  if  a  trust  had  deductions 
taken  into  account  in  determining  distributable  net  income,  for  ex- 
ample, fees  which  are  chargeable  to  corpus,  the  trust  accounting  in- 
come (as  defined  under  section  643(b) )  exceeded  the  distributable  net 
income  of  the  trust.  In  this  case,  a  distribution  of  the  current  ^^ear's 
trust  income  to  a  beneficiary,  which  otherwise  is  technically  the  ac- 
counting income  of  the  trust  for  the  year,  was  treated  as  constituting 
an  accmnulation  distribution  of  the  trust.  To  deal  with  this  situation, 
the  Act  provides  a  rule  that  a  distribution  made  or  required  to  be  made 
by  a  trust  to  a  beneficiary  in  a  year  which  does  not  exceed  the  income  of 
the  tnist  for  the  year  is  not  to  be  treated  as  an  accumulation  distribu- 
tion for  that  year. 

The  Act  also  repeals  the  capital  gain  throwback  rule  under  prior 
law.  The  Act,  however,  provides  a  special  nile  to  cover  the  possible 
abuse  where  the  grantor  places  in  trust  property  which  has  unrealized 
appreciation  in  order  to  shift  the  payment  of  tax  to  the  trust  at  its 
lower  progressive  rate  structure  (sec.  644).  I"rnder  this  rule,  where 
the  fair  market  value  of  property  which  is  placed  in  trust  exceeds 
the  price  paid  (if  any)  for  the  property  by  the  trust  (i.e..  where  there 
is  any  bargain  element  in  connection  with  the  transfer)  and  where 
the  ti-ust  seils  the  property  within  two  years  of  its  transfer  to  the 
trust,  the  tax  on  the  gain  (called  the  "includible  gain")  to  the  trust 
will  be  equal  to  the  amount  of  additional  tax  the  transferor  would 
have  paid  (including  any  minimum  tax  ^)  had  the  gain  been  included 
in  the  gross  income  of  the  transferor  for  his  taxable  year  in  which 
the  sale  occurred.  In  essence,  the  Act  treats  such  gains  as  if  the  trans- 
feror had  realized  the  gain  and  then  transferred  the  net  proceeds  from 
the  sale  aftertax  to  the  trust  as  corpus. 

»For  purposes  of  computing  the  minimum  income  tax  portion  of  tlie  section  644  tax, 
the  amount  of  tax  paid  by  the  transferor  shall  be  deemed  to  include  the  tax  determined 
under  section  644  other  than  the  portion  attributable  to  the  application  of  the  minimum 
Income  tax. 


163 

However,  where  the  transferor  dies  before  the  sale  within  the  two- 
year  period,  so  that  it  would  not  be  possible  to  use  the  rate  brackets  of 
the  transferor,  the  Act  makcvS  the  provision  inapplicable.  Consequently, 
in  such  a  case,  the  tax  on  the  gain  would  be  taxed  at  the  trust's  rates. 
In  addition,  in  order  to  prevent  circumvention  of  the  two-year  period 
through  a  short  sale  during  such  period,  the  Act  contains  a  rule  which 
extends  two-year  period  to  the  closing  of  tlie  short  sale. 

For  purposes  of  determining  whether  the  property  is  a  capital  asset 
subject  to  favorable  capital  gains  treatment,  the  Act  contains  a  rule 
under  wliich  the  character  of  the  property  is  to  be  determined  by 
looking  to  the  character  of  that  property  in  the  hands  of  the  trans- 
feror. Consequently,  where  section  644  applies,  the  gain  on  the  sale 
of  the  property  will  not  be  eutitled  to  capital  gains  treatment  if  the 
property  would  not  have  been  a  capital  asset  in  the  hands  of  the  trans- 
feror even  if  the  property  is  a  capital  asset  in  th.e  hands  of  the  trust.  In 
addition,  the  Act  contains  a  i-ule  which  attributes  the  activities  of  the 
trust  with  respect  to  the  property  to  the  transferor  for  this  purpose. 
In  effect,  the  provision  treats  the  trust  as  the  agent  of  the  transferor 
so  that  the  trust's  activities  are  attributed  to  the  transferor. 

The  "includible  gain"  is  the  lesser  of  the  amount  of  gain  recognized 
by  the  trust  or  the  amount  of  gain  that  the  trust  would  have  realized 
had  the  property  been  sold  immediately  after  it  was  transferred  to 
the  trust.^  Therefore,  the  transferor  cannot  use  the  trust's  lower  pro- 
gressive rate  structure  to  tax  gain  that  occurred  while  he  owned  the 
property.  Any  additional  gain  that  occurs  after  the  property  is  trans- 
ferred to  the  trust  is  subject  to  the  normal  rules  for  gains  idealized  by 
the  trust. 

In  order  to  prevent  double  taxation  of  the  "includible  gain",  the 
Act  excludes  the  includible  gain  from  the  taxable  income  of  the  trust. 
Thus,  the  tax  on  the  remaining  income  of  the  trust  (including  addi- 
tional gain  on  the  property  occurring  after  the  transfer  to  the  trust) 
will  be  computed  without  i-egard  to  that  includible  gain.  Similarly, 
since  the  includible  gain  is  excluded  from  the  trust's  taxable  income 
that  gain  is  not  included  in  the  trust's  distributable  net  income  and, 
consequently,  the  includible  gain  also  will  not  be  taxed  to  the  bene- 
ficiary if  the  gain  is  currently  distributed  to  him.  Moreover,  since  the 
includible  gain  is  not  in  the  trust's  distributable  net  income,  that  gain 
will  not  be  subject  to  tlie  accumulation  distribution  rules  (under  sub- 
part D)  where  the  gain  is  first  accumulated  and  then  distributed  m  a 
subsequent  year. 

Where  the  trustee  of  the  trust  does  not  have  sufficient  information 
about  the  transferor  to  compute  the  tax  on  the  includible  gain,  it  is 
expected  that  the  Internal  Revenue  Service  will  issue  regulations 
under  which  the  trustee  will  state  in  tlie  tax  return  that  he  does  not 
have  sufficient  information  and  that,  in  such  a  case,  the  Service  will 
computi^  (he  tax  attributable  to  that  gain.  It  is  also  expected  that  the 


*  TTnder  the  Act.  the  basis  of  the  property  for  purposes  of  determining  tlie  amount  of 
the  "incluclii)le  sain''  is  tiie  trusts  basis  immediately  after  its  transfer  to  the  trust.  Con- 
seqiiently.  this  basis  includes  any  increases  in  basis  under  section  101.5(d)  (relating  to 
Increased  basis  for  gift  tax  paid).  The  bill  also  contains  special  rules  -n-here  the  trust  sells 
the  propertj  within  the  two-year  period  and  elects  to  report  the  gain  on  the  installment 
sales  method  of  accoiinting  (sec.  453).  In  such  a  case,  the  provision  is  intended  to  treat 
each  installment  as  if  it  were  a  separate  sale  or  exchange  subject  to  the  special  two- 
year  rule. 


164 

Service  will  issue  regulations  providing  rules  where  the  transferor  has 
capital  or  net  operating  losses  and  where  the  transferor's  taxable  in- 
come or  tax  is  affected  by  subsequent  events  such  as  a  loss  cany- 
back  or  adjustment  by  the  Internal  Revenue  Service.  The  special 
rale  on  transfers  of  appreciated  property  is  not  to  apply  to  property 
placed  in  charitable  remainder  trusts  or  pooled  income  funds  or  to 
property  acquired  by  a  trust  from  a  decedent. 

There  will  be  some  cases  where,  because  the  trust  is  on  a  fiscal  year, 
it  will  not  be  ix)ssible  for  the  trustee  to  ascertain  the  tax  that  the  trans- 
feror would  have  paid  had  the  transferor  realized  the  gain  because  the 
sale  occurs  within  a  taxable  year  of  the  transferor  which  ends  after  the 
end  of  the  taxable  year  of  the  trust  in  which  the  sale  occurs.  For  ex- 
ample, assume  that  the  transferor  uses  a  calendar  year  and  the  trust 
uses  a  fiscal  year  ended  June  30,  the  transferor  transfers  appreciated 
property  to  the  trust  in  1977,  and  the  trustee  sells  the  property  during 
the  fii-st  six  months  of  calendar  year  1978.  In  such  a  case,  the  tax  re- 
turn of  the  trust  for  the  year  in  which  the  sale  occurred  (fiscal  year 
ending  June  30,  1978)  is  due  on  October  15, 1978.  However,  the  tax  re- 
turn of  the  transferor  for  the  year  in  which  the  sale  occurred  (calen- 
dar year  1978)  is  not  due  until  April  15,  1979.  In  such  a  case,  the  Act 
provides  a  rule  under  which  the  trust  will  report  the  gain  in  its  tax 
return  due  Octi)ber  15,  1979,  but  the  tax  on  the  gain  will  be  increased 
by  an  additional  amount  representing,  in  effect,  the  interest  on  the  one- 
year  delay  in  reporting  the  gain.  Where  the  trust  terminates  during 
this  one-year  period,  it  is  contemplated  that  the  Treasury  will  issue 
regulations  making  such  gain  reportable  in  the  return  of  the  trust  for 
its  last  taxable  year. 

Effective  date 
The  amendments  made  by  this  provision  to  the  acxiumulation  dis- 
tribution rules  are  to  apply  generally  to  distributions  made  in  trust 
taxable  years  beginning  after  December  31,  1975.  The  amendment 
made  with  respect  to  the  taxation  of  gain  arising  from  sales  of  prop- 
erty within  two  years  of  its  transfer  in  trust  are  to  apply  to  transfers 
made  after  May  21, 1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  not  have  a  significant  effect 
on  budget  receipts. 


G.  CAPITAL  FORMATION 

1.  Investment  Tax  Credit — Extension  of  10-Percent  Credit  and 
$100,000  Limitation  for  Used  Property  (sees.  801  and  802  of  the 
Act,  sec.  46  of  the  Code,  and  sec.  301(c)(2)  of  the  Tax  Re- 
duction Act  of  1975) 

Prior  law 

Prior  to  the  Tax  Reduction  Act  of  1975,  a  7-percent  credit  was  avail- 
able for  qualified  property  (4  percent  in  the  case  of  certain  public 
utilities).  Inv^estnient  in  qualified  used  property  eligible  for  the  credit 
was  limited  to  $50,000  per  taxable  year. 

The  Tax  Reduction  Act  of  1975  temporarily  increased  the  rate  of  the 
investment  tax  credit  for  all  taxpayers  (including  certain  public  utili- 
ties) to  10  percent  for  the  period  beginning  January  22, 1975,  and  end- 
ing December  31,  197G.  A  corporate  taxpayer  could  elect  an  11-percent 
credit  during  this  period  if  an  amount  equal  to  1  percent  of  the  quali- 
fied investment  was  contributed  to  an  employee  stock  ownership  plan. 
xA.lso,  in  the  case  of  public  utilities,  the  limitation  on  the  amount  of  tax 
liability  that  could  be  olFset  by  the  investment  tax  credit  in  a  year  was 
increased  from  50  percent  to  100  percent  during  1975  and  1976,  and 
then  reduced  gradually  (by  10  percentage  points  per  year)  back  to 
the  50-percent  level  in  5  subsequent  years.  In  addition,  the  limitation 
on  qualified  investment  in  used  property  was  temporarily  increased 
to  $100,000  until  January  1, 1977. 

Reasoi^s  for  change 
Real  investment  in  plant  and  equipment  declined  severely  in  1975, 
grew  rather  modestly  in  1976,  and  prospects  for  a  substantial  increase 
in  investment  in  1977  did  not  appear  to  be  strong.  Real  nonresidential 
fixed  investment  has  fallen  from  a  high  of  $131  billion  in  1973  to  an 
annual  rate  of  $117.7  in  the  third  quarter  of  1976.  Provision  of  the 
10-percent  investment  credit  over  a  longer  period  of  time  is  essential 
to  permit  business  to  properly  plan  their  investment  projects  without 
a  substantial  bunching  of  projects,  which  could,  in  the  short  run,  bid 
up  the  price  of  capital  goods.  Encouraging  investment  in  new  equip- 
ment and  modernization  of  existing  equipment  will  improve  the  long- 
run  ability  of  the  economy  to  achieve  economic  growth  consistent  with 
past  rates  of  gi'owth  without  inflationary  pressures.  Also,  increasing 
aggregate  demand  by  increased  investment  incentives  constitutes  an 
important  element  in  a  balanced  program  of  economic  recovery. 

Explanation  of  provinon 
The  Act  extends  the  temporary  increase  in  the  investment  credit  to 
10  percent  for  four  additional  years,  through  1980,  and  similarly  ex- 
tends the  increase  to  $100,000  in  the  litnit  on  used  property  through 
1980.  Under  the  Act,  the  credit  will  reveit  to  7  percent  (4  percent  in 


(165) 

234-120  O  -  77  -  12 


166 

the  case  of  certain  public  utilities)  and  tlie  used  property  limit  will 
drop  to  $50,000  in  1981. 

Effective  date 
These  provisions  are  effective  for  taxable  years  beginning  after 
December  31,  1975. 

Revenue  effect 
It  is  estimated  that  these  provisions  will  reduce  budget  receipts  by 
$1,300  million  in  fiscal  year  1977,  $3,306  million  in  fiscal  year  1978, 
and  $2,444  million  in  fiscal  year  1981. 

2.  First-In-First-Out  Treatment  of  Investment  Tax  Credits  (sec. 
802  of  the  bill  and  sec.  46  of  the  Code) 

Prior  law 

In  general,  the  amoimt  of  investment  credit  used  in  any  year  camiot 
exceed  $25,000  of  tax  liability  plus  50  percent  of  any  liability  in  excess 
of  $25,000,  (In  the  case  of  public  utilities,  the  Tax  Reduction  Act  of 
1975  raised  the  percentage  to  100  percent  in  1976,  90  percent  in  1977, 
and  so  forth,  dropping  back  to  50  percent  by  1980.)  A  3-year  carryback 
and  7-year  carryforward  is  then  applied  to  credits  which  are  not 
used  l>ecause  of  the  tax  liability  limitation.  (A  10-year  carryforward 
is  available  for  pre-1971  credits.)  Generally,  under  prior  law,  invest- 
ment credits  earned  in  a  particular  year  beginning  with  1971  were 
applied  first  to  the  tax  liability  for  that  year,  after  which  caiTyovers 
and  carrybacks  of  unused  credits  from  other  years  were  applied. 

In  the  case  of  carryovers  of  unused  investment  credits  earned  in 
pre-1971  tax  years,  prior  law  provided  that  these  credits  were  to  bo 
used  before  current  year  credits  were  used. 

Reasons  for  cJiange 

It  was  brought  to  the  attention  of  the  Congress  that  many  taxpay- 
ers with  substantial  amounts  of  investment  credit  carryovers  which 
arose  in  the  pavSt  would  not  l>e  able  to  use  these  credits  because  low 
levels  of  taxable  income  or  net  operating  losses  incurred  in  recent 
years  have  prevented  use  of  the  credits.  Credits  arising  in  the  future 
would  completely  absorb  the  limitation  and  thus  prevent  the  use  of 
the  carryovers.  The  Congress  was  concerned  that  the  desire  of  tax- 
payers to  use  investment  credit  carryovers  as  (juickly  as  possible 
could  significantly  dampen  the  stimulative  effect  of  the  investment 
credit  on  new  investments  because  these  taxpayers  may  be  less  likely 
to  make  new  investments  while  they  have  carryover  credits  which  the 
new  in^'estments  might  cause  them  to  lose. 

As  a  result,  the  Act  changes  the  genei-al  oi'dering  scheme  for  absorb- 
ing investment  tax  credits  to  better  facilitate  the  use  of  cariyover 
credits. 

ExflanatioTi  of  froxnsions 
The  Act  extends  the  approach  adopted  for  prc'-1971  credits  (by 
the  Revenue  Act  of  1971)  to  require  generally  that  investment  credits 
earned  first  are  to  be  utilized  first  regardless  of  whether  the  credits 
were  eaiiied  in  the  current  year  or  are  carryback  or  carryover  credits. 
In  determining  the  application  of  investment  credits  for  a  taxable 


167 

year  under  this  first-in-first-out  (P'IFO)  method,  carrj'over  credits 
from  prior  taxable  years  are  used  first,  up  to  the  amount  of  the  tax 
liability  limitation.  To  the  extent  the  limitation  exceeds  the  amount  of 
cai'ryover  credits,  current  year  and  then  carryback  credits  may  be 
applied. 

An  exception  to  this  general  rule  is  provided  to  reflect  Congress' 
concern  that  taxpayers  be  permitted  a  maximum  utilization  of  their  in- 
vestment ci-edit  carryovers  under  the  first-in-first-out  method.  It  was 
noted  that  the  converee  of  the  general  rule,  that  investment  credits 
earned  first  will  also  expire  first,  while  generally  applicable,  does  not 
result  for  tax  years  ending  in  1978,  1979,  and  1980.  This  dichotomy 
arises  because  pre-1971  credits  receive  a  10-year  carryover  while 
credits  earned  in  later  years  may  be  carried  over  for  7  years.  It  results, 
for  example,  in  the  expiration  of  1971  investment  credits  at  the  end 
of  the  1978  taxable  year  (assuming  there  are  no  short  taxable  periods) 
while  credits  earned  in  1969  could  be  carried  over  not  only  to  1978  but 
also  to  1979.  In  order  to  better  enable  the  earlier  expiring  (but  later 
earned)  inv^estment  credits  to  be  used,  the  Act  provides  that  a  carryover 
of  a  pre-19Tl  credit  will  be  postponed  to  the  extent  its  applicati(m  in  a 
carryover  year  will  cause  all  or  part  of  an  investment  credit  from  a 
}X)st-1970  year  to  expire  unused  at  the  end  of  that  carryover  year. 
In  the  above  example,  if  the  limitation  for  1978  will  not  enable  both  a 
1969  credit  carryover  and  a  1971  credit  carryover  to  be  absorbed,  the 
1971  carryover  is  to  l)e  used  first  after  which  the  1969  carryover  may 
be  used.  This  provision  does  not  in  any  way  extend  the  number  of 
carryover  years  available  for  investment  credits  earned  under  either 
the  10-year  or  7-year  rules. 

Effective  date 
These  provisions  are  effective  for  taxable  j'ears  beginning  after 
December  31,  1975. 

Revenue  effect 
It  is  estimated  that  these  provisions  will  result  in  a  decrease  in 
budget  receipts  by  less  than  $5  million  in  fiscal  year  1977  and  1978,  $5 
million  in  1979,  aiid  $20  million  in  1980. 

3.  ESOP  Investment  Credit  Provisions  (sec.  803  of  the  Act; 
sees.  46(f),  401(a),  415(c),  and  1504(a)  of  the  Code;  sees. 
301(d)  and  301(e)  of  the  Tax  Reduction  Act  of  1975;  and  sec. 
3022(a)  of  the  Employee  Retirement  Income  Security  Act  of 
1974) 

Prior  law 

Employee  compensation  paid  in  the  form  of  employer  contributions 
under  an  employee  stock  ownership  plan  (ESOP)  is  treated  as  de- 
ferred compensation  for  tax  purposes;  that  is,  the  employee  generally 
is  not  taxed  on  these  employer  contributions  until  they  are  distributed 
under  the  plan. 

ESOPs  are  generally  designed  to  be  tax-qualified  plans.  In  order 
to  qualify,  a  plan  nuist,  for  example,  satisfy  rules  prohibiting  discrim- 
ination in  favor  of  highly  paid  employees,  and  it  must  meet  standards 


168 

relatin<i:  to  employee  participation,  vesting,  benefit  and  contribution 
levels,  the  form  of  the  benefits,  and  the  security  of  the  l)enefits.  Al- 
though, in  limited  circumstances  a  contribution  to  a  plan  can  be  with- 
drawn by  the  employer  if  it  is  made  by  mistake,  the  tax  law  does  not 
permit  withdrawal  of  a  contribution  merely  because  it  is  not  deducti- 
ble. 

Under  the  tax  law,  if  a  plan  meets  these  requirements,  in  addition 
to  deferral  ot  employee  tax  on  employer  contributions  the  employer 
is  allowed  a  deduction  (within  limitations)  for  his  contributions  for 
the  year  the  contributions  are  made,  the  income  earned  on  assets  held 
imder  the  plan  is  generally  not  taxed  until  it  is  distributed,  special 
10-year  income  averaging  rules  and  nonrecognition  of  gain  rules  apply 
to  distributions  made  in  a  lump  sum,  and  estate  and  gift  tax  exclu- 
sions may  be  provided. 

An  E80P  uses  a  tax-qualified  stock  bonus  plan  ^  or  a  combination 
of  a  qualified  stock  bonus  plan  and  a  qualified  stock  money  pension 
plan.^  It  IS  a  technique  of  corporate  finance  designed  to  Iniild  beneficial 
equity  ownership  of  shares  in  the  employer  corporation  into  its  em- 
ployees substantially  in  proportion  to  their  relative  incomes,  without 
requiring  any  cash  outlay  on  their  part,  any  reduction  in  pay  or  other 
employee  benefits,  or  the  surrender  of  any  rights  on  th.e  part  of  the 
employees. 

Under  an  ESOP,  an  employee  stock  ownership  trust  generally 
acquires  stock  of  the  employer  with  the  proceeds  of  a  loan  made  to  it 
by  a  financial  institution.  Typically,  the  loan  is  guaranteed  by  the 
employer.  The  employer's  contributions  to  the  employee  trust  are 
applied  to  retire  the  loan  so  that,  as  the  loan  is  retired,  and  as  the 
value  of  the  employer  stock  increases,  the  beneficial  interest  of  the 
employees  increases.  Of  course,  if  the  employer  fails  to  make  the 
required  contributions,  or  if  the  value  of  the  employer's  stock  declines, 
the  beneficial  interest  of  the  employees  declines. 

Under  prior  law,  if  a  qualified  investment  were  made  before  January 
1,  1977,  an  extra  percentage  point  of  investment  credit  (11  percent 
rather  than  10  percent)  was  allowed  where  the  additional  credit 
amount  was  contributed  to  an  ESOP  which  satisfied  the  requirements 
of  the  Tax  Reduction  Act  of  1975.  Under  that  Act,  the  ESOP,  wliether 
or  not  tax-qualified,  must  satisfy  special  rules  as  to  vesting,'-  employee 
participation,*  allocation  of  employer  contributions,^  l)enefit  and  con- 
tribution limits,"  and  voting  of  stock  held  by  a  trust  under  the 
plan.'^  The  vesting,  allocation,  and  voting  rules  are  generally  con- 

'  A  quaUfled  stock  bonus  plan  Is  required  to  distribute  benefits  in  the  form  of  employer 
stock. 

'  A  pension  plan  which  Invests  In  employer  securities,  and  under  which  employer  con- 
tributions are  credited  to  the  separate  accounts  of  employees.  An  employee's  benefits 
under  such  a  plan  are  based  upon  the  balance  of  his  account. 

'  Each  participant's  right  to  stock  allocated  to  his  account  under  these  rules  must  be 
nonforfeitable.. 

*  The  ESOP  must  satisfy  the  same  participation   rules  applicable  to  qualified  plans. 

5  An  employee  who  participates  in  the  plan  at  any  time  during  the  year  for  which  an 
employer  contrilnition  is  made  is  entitled  to  a  share  of  the  employer  contribution,  based 
upon  the  amount  of  compensation  paid  to  him  l)y  the  employer.  Only  the  first  .$100,000 
of  employee  compensation  is  considered  for  purposes  of  the  plan. 

'The  ESOP  is  subject  to  the  same  benefit  and  contribution  limitations  applicable  to 
qualified  plans. 

■^  Employees  must  be  entitled  to  direct  the  voting  of  employer  stock  allocated  to  their 
(iccount^i  under  the  employee  trust.  The  plan  need  not  permit  employees  to  direct  the 
voting  of  unallocated  employee  stock  held  by  the  trust. 


169 

sidered  more  favorable  to  rank  and  file  employees  than  those  which 
have  been  required  for  tax  qualification. 

Reasons  jov  change 

Several  problems  arose  under  the  prior  investment  tax  credit  rules 
designed  to  encourage  the  adoption  of  ESOPs,  For  example,  because 
the  additional  investment  tax  credit  was  only  available  for  a  short 
period,  many  employers  did  not  become  aware  of  it  in  time  to  establish 
an  ESOP.  This  lag  in  recognition  of  the  new  provisions  and  uncer- 
tainty as  to  how  they  would  be  applied  probably  accounts  for  the 
modest  number  of  ESOPs  established  under  the  prior  investment 
tax  credit  rules.  Also,  because  of  the  short  period  during  which  in- 
vestments could  qualify  for  the  additional  credit,  some  employers 
found  that  the  cost  of  establishing  an  ESOP  under  the  investment 
tax  credit  rules  was  unreasonably  high  in  relation  to  the  benefits  of 
the  plan. 

Tlie  investment  tax  credit  recapture  and  redetermination  rules  were 
another  factor  which  discouraged  the  adoption  of  ESOPs.  Under 
those  rules,  if  a  portion  of  the  additional  investment  tax  credit  was 
recaptured  or  the  credit  was  redetermined  by  the  Internal  Revenue 
Service  to  be  a  smaller  amount  than  claimed,  the  employer  had  to  bear 
the  cost  of  repaying  the  excess  credit;  it  coidd  not  recover  that  cost 
directly  or  indirectly  from  an  employee  trust  under  an  ESOP. 

Special  problems  discouraged  the  adoption  of  ESOPs  by  regulated 
utilities.  Publicly  regulated  utilities  were  reluctant  to  establish  ESOPs 
under  the  investment  tax  credit  rules  because  they  were  concerned  that 
regulatory  commissions  would  require  that  the  additional  investment 
tax  credit  be  "flowed-through"  to  customers.  If  the  regulatory  com- 
missions took  that  position,  the  utilities  would  be  required,  in  effect, 
to  pay  out  the  additional  investment  tax  credit  twice — once  to  the 
ESOP  and  then  again  to  the  customers. 

Explanation  of  provislo7is 

(a)  General  Rules 

Effective  for  years  beginning  after  1976,  the  Act  extends  the  addi- 
tional one-percent  credit  program  to  qualified  investments  made  before 
January  1,  1981.  x\lso,  if  an  employer  supplements  its  contributions 
under  the  one  percent  credit  program  by  matching  employee  contiibu- 
tions  to  the  P]SOP,  beginning  in  1977  the  Act  allows  an  extra  invest- 
ment credit  (up  to  an  extra  one-half  percentage  point  of  qualified  in- 
vestments) for  the  employer's  supplementary  contributions  which  are 
matched  by  employee  contributions.  Under  the  Act,  separate  accoimt- 
ing  is  required  for  matching  employee  and  employer  contributions. 
Uontinuing  prior  law  treatment,  an  employer  contribution  for  a  tax- 
able yeai-  in  excess  of  the  amount  attributable  to  the  additional  credit 
allowed  for  tbat  year  is  deductible  for  that  year,  subject  to  the  usual 
rules  for  deduction  of  contributions  to  employee  plans. 

ITnder  the  Act,  employer  and  employee  contributions  are  subject  to 
the  overall  benefit  and  contribution  limitations  applicable  to  employee 
plans.  (The  Act  continues  prior  law  under  which  employer  contribu- 
tions to  investment  credit  ESOPs  were  subject  to  these  limitations.) 


170 

The  limitations  may  restrict  the  amount  of  the  additional  one-half 
percent  investment  credit  allowable. 

Tlie  Congress  intends  that  employee  contributions  can  be  taken  into 
account  for  the  additional  credit  it'  they  are  contributed  to  the  plan 
before  the  end  of  the  year  in  which  the  credit  is  allowed  or  if  the 
contributions  are  pledged  bj'  the  employees  to  be  paid  within  2  years 
after  the  close  of  that  year  and  the  j)ledgo  is  made  before  the  return 
for  the  year  is  filed.  If  employee  contributions  are  made  in  excess  of 
the  amount  pledged  and  are  matched  with  employer  contiibutions. 
additional  credit  can  be  claimed  by  the  emi>loyer  for  the  year  the 
(|ua]ified  investment  was  made.  Under  the  Act,  employee  contributions 
made  under  the  matching  rules  are  to  l)e  invested  in  employer  securities 
under  the  same  rules  that  apply  to  employer  contributions. 

Also,  under  the  Act,  emploj^ee  contributions  to  an  investment  credit 
ESOI^  are  subject  to  the  same  antidiscrimination  ndes  as  apply  to 
employee  contributions  imder  a  tax-qualified  pension  plan,  and  matche'l 
emploj^ee  contributions  are  subject  to  the  same  lestrictions  on  distribu- 
tion  as  employer  contributions  of  investment  credit  (generally,  no 
withdrawal  is  permitted  for  84  months). 

Under  the  Act,  em.ployee  contributions  cannot  be  compulsory ;  that 
is,  employee  contributions  may  not  be  made  a  condition  of  employment 
or  a  condition  of  participation  in  the  plan.  Of  couise,  the  level  of 
employer-derived  benefits  under  the  matching  rules  depends  u})on 
employee  contributions. 

FJoic-fhrough  of  investment  tax  credit. — Because  the  entire  addi- 
tional investment  tax  credit  is  intended  to  go  to  the  employees  partic- 
ipating in  an  ESOP,  the  Act  provides  that  the  entire  investment  ( redii 
is  not  available  to  a  company  if  a  public  service  commission  requires 
a  utility  to  flow  through  any  part  of  that  additional  credit  (claimed 
for  taxable  years  ending  after  1075)  to  the  consumer. 

Recapture  and  redetermimitimi  of  tax  credit. — Where,  an  invest- 
ment credit  is  subject  to  recapture  or  a  company's  income  or  investment 
is  redetermined  with  the  result  that  the  investment  tax  credit  is  de- 
creased, ur^der  the  Act,  the  amount  v)f  decrease  can  be  applied  to  off- 
set employer  contributions  for  other  years.  Alternatively,  the  Act 
allows  a  deduction  for  disallowed  or  recaptured  credit  which  was  con- 
tributed to  an  ESOP.  As  a  further  alternative,  the  Act  permits  an 
employer  to  recover  recaptured  credit  from  an  ESOP.  (See  ^''With- 
drawal of  contrihutions'''  below.) 

Time  of  contrihution. — Where  the  full  amount  of  investment  tax 
ciedit  is  not  allowed  for  a  year  because  the  ci'edit  is  limited  on  the 
basis  of  the  tax  for  the  year,  the  Act  provides  that  the  additional 
credit  can  be  contributed  to  the  plan  as  it  is  allowed.  Also,  the  Congress 
intended  that  if  the  investment  credit  is  carried  back  from  the  year 
of  investment  in  qualifying  property  to  a  prior  year,  the  additional 
investment  credit  wliich  is  allowed  as  a  result  of  the  carryback  is  to 
be  contributed  to  the  ESOP  for  the  year  of  the  investment  and  is  to 
be  allocated  to  plan  participants  in  the  same  manner  as  if  it  had  been 
allowed  in  the  year  of  investment. 

Administrative  expenses. — Limited  amounts  of  "start  up"  and  ad- 
ministrative expenses  for  establishing  an  ESOP  can  be  charged  against 
the  additiona,!  investment  credit  contributed  to  an  ESOP.  The  maxi- 


171 

mum  amount  of  stait  up  costs  which  may  be  charged  is  10  percent  of 
the  first  $100,000  of  the  amount  required  to  be  transferred  to  the  ESOP 
for  the  taxable  year  for  which  tlie  plan  is  established,  and  5  percent  of 
any  additional  amount  for  such  year.  In  addition,  under  the  provision, 
on'-<::oino:  costs  of  administration  (up  to  10  percent  of  the  first  $100,000 
of  the  trust's  dividend  income  plus  5  percent  of  the  remaining  dividend 
income,  but  in  no  evont  move  than  $100,000)  may  also  be  charged  to  an 
ESOP. 

Definition  of  employer  securities. — In  order  to  extend  the  benefits 
of  employee  stock  ownership  to  •'brother-sister"  corporations  and  "sec- 
ond-tiei--'  parent-subsidiary  groups,  the  provision  permits  the  stock  of 
a  member  of  a  controlled  group  of  corporations  to  be  used  as  employer 
securities  for  another  ]neml>er  of  the  group.  This  rule  also  permits  the 
stock  of  a  parent  corporation  to  be  used  as  employer  securities  with  re- 
spect to  a  subsidiary  where  the  parent  owns  80  percent  or  more  of  the 
subsidiary's  voting  stock  but  does  not  own  at  least  80  percent  of  the 
subsidiary's  non^  oting  stwk  which  is  limited  and  preferred  as  to  div- 
iilends.  In  this  situation,  the  subsidiary's  stock  could  also  be  used  as 
employer  securities. 

Consolidated  returns. — The  Act  provides  that  the  rules  for  deter- 
mining whether  there  is  a  sufficient  affiliation  between  corporations 
to  permit  the  filing  of  a  consolidated  return  are  applied  without  regard 
to  employer  securities  held  by  an  ESOP. 

C oinpensation. — Under  the  provision,  a  participant's  compensation 
is  defined  to  be  the  same  as  under  rules  of  the  Code  which  limit  con- 
tributions to  qualified  plans   (sec,  415). 

Perm/inent  plan. — The  Act  makes  clear  that  an  ESOP  which  satis- 
fies the  investment  tax  credit  rules  does  not  fail  to  be  a  permanent  pro- 
gram merely  because  employer  contributions  are  not  made  for  a  year  if 
the  additional  investment  tax  credit  is  not  available  for  the  year  (for 
reasons  other  than  the  employer's  failure  to  make  the  contribution). 

Other  provisions. — In  situations  where  the  value  of  employer  stock 
can  be  expected  to  increase  rapidly,  the  rule  of  prior  law  limiting 
the  annual  addition  to  the  account  of  a  participant  in  a  defined  con- 
tribution plan  to  $25,000  (plus  a  cost-of-living  adjustment)  may  dis- 
courage the  establishment  of  an  ESOP  designed  to  acquire  employer 
stock  from  a  present  shareholder  by  causing  the  shareholder  to  suffer 
an  unacceptable  level  of  dilution  of  his  interest  in  the  company.  In 
order  to  remove  this  barrier  to  ESOPs,  the  Act  doubles  the  dollar 
limitation  provided  by  present  law  in  the  case  of  defined  contribution 
plans  but  the  additional  amount  may  only  consist  of  employer  securi- 
ties. Also,  under  the  Act,  the  limitation  on  benefits  which  may  be  pro- 
vided under  a  defined  benefit  plan  would  be  reduced  where  the 
additional  defined  contribution  limitation  is  allowed  for  an  ESOP.  In 
order  to  assure  that  the  doubled  allowance  is  not  available  to  a  plan 
unless  rank-and-file  employees  are  the  chief  beneficiaries  of  the  plan, 
however,  under  the  Act  the  doubled  allowance  is  not  available  for  a 
plan  if  more  than  one-third  of  the  employer  contributions  to  plan  for  a 
year  are  allocated  to  employees  who  are  officers  or  shareholders,  or 
whose  compensation  for  the  year  exceeds  twice  the  amount  of  the 
dollar  limitation  ordinarily  applicable  to  the  annual  addition  to  the 
account  of  a  paiticipant  in  a  defined  contribution  plan.  (This  is  not 
intended  to  aifect  any  determination  of  which  employees  are  consid- 


172 

ered  highly  compensated  for  purposes  of  the  coverage  and  nondiscrini- 
ination  requirements  applicable  to  qualified  plans  generally.)  For 
this  purpose,  employees  who  hold  10  percent  or  less  (determined  with 
attribution  rules)  of  the  employer's  stock  (outside  of  the  ESOP)  are 
not  considered  shareholders. 

Withdrawal  of  contrihiitions. — If  the  plan  provides,  the  Act  per- 
mits funds  contributed  by  the  employer  to  be  withdrawn  from  an  in- 
vestment credit  ESOP  (1)  to  refund  employer  contributions  which 
are  not  matched  by  employee  contributions  within  the  period  specified, 
or  (2)  to  permit  the  employer  to  recover  from  the  ESOP  any  portion 
of  the  employer's  contribution  which  is  recaptured  from  the  employer 
under  the  investment  credit  rules  (for  example,  where  the  property 
for  which  the  credit  is  claimed  is  disposed  of  prematurely).  The  Act 
provides  that  the  withdrawal  of  employer  contributions  made  under 
the  one-half  percent  credit  rules  because  they  are  not  matched  by  em- 
ployee contributions,  or  a  recovery  of  employer  contributions  under 
the  recapture  rules,  will  not  cause  the  plan  to  be  considered  as  other 
than  for  the  exclusive  benefit  of  employees  and  that  employee  rights 
to  employer-derived  benefits  under  the  plan  Mill  not  be  considered 
forfeitable  merely  because  employer  contributions  of  investment 
credit  may  be  withdrawn  under  the  matching  or  recapture  rules.  The 
Act  does  not  permit  an  employer  to  recover  recaptured  investment 
credit  unless  the  employer  contributions  for  each  year  are  separately 
accounted  for  (all  contributions  made  before  enactment  of  the  Act 
can  be  aggregated  for  this  purpose) . 

Under  the  Act,  employee  funds  contributed  to  an  investment  credit 
ESOP  are  subject  to  employee  withdrawal  unless  they  are  matched  by 
employer  contributions  under  the  one-half  percent  credit  rules.  For 
example,  if  matching  employer  or  employee  contributions  cannot  be 
made  because  of  the  overall  limitations  on  benefits  and  contributions 
(sec.  415  of  the  Code),  the  unmatched  employee  contributions  would 
be  refunded  to  the  employee  (unless  he  instructs  the  plan  to  the 
contrary). 

(h)  Employee  Stock  Ownership  Plan  Regulations 

The  Act  reaffirms  Congressional  intent  with  respect  to  employee 
stock  ownership  plans  and  expresses  concern  that  administrative  niles 
and  regulations  may  frustrate  Congressional  intent.  In  this  connec- 
tion, it  has  come  to  the  attention  of  the  Congress  that  proposed  regu- 
lations issued  by  both  the  Department  of  the  Treasury  and  the  Depart- 
ment of  Labor  on  July  30,  1976,  may  make  it  virtually  impossible 
for  ESOPs,  and  especially  leveraged  ESOPs,  to  be  established  and 
function  eflfectively.  The  following  areas  are  of  specific  concern  to  the 
Congress. 

(1)  Independent  third  party. — The  proposed  rules  would  prohibit 
loans  (or  loan  guarantees)  by  fiduciaries  to  employee  stock  ownership 
plans  unless  the  loans  are  arranged  and  approved  by  an  independent 
third  party.  These  rules  would,  for  example,  prevent  a  bank  which 
serves  as  trustee  for  an  ESOP  from  making  a  loan  to  the  plan  and 
would  prevent  the  employer-fiduciary  who  established  the  plan  from 
providing  a  loan  guarantee. 

In  view  of  other  rules  presently  in  effect,  which  require  that  the 
interest  rate  for  any  such  loan  be  reasonable,  that  the  loan  be  primarily 


173 

for  the  benefit  of  participants  or  their  beneficiaries,  and  that  the  only 
collateral  the  plan  can  give  the  lender  is  the  employer's  stock  pur- 
chased with  the  loan  proceeds,  the  requirement  of  an  independent 
third  party  is  unduly  burdensome.  Consequently,  the  Congress  believes 
that  the  regulations  should  deal  directly  with  possible  abuses  which 
may  occur  in  the  administration  of  plans  rather  than  attempting  to 
require  a  plan  to  incur  the  burden  of  dealing  through  an  independent 
third  party.  Similarly,  the  Congress  believes  that  an  independent  third 
party  should  not  be  required  to  arrange  and  appi'ove  a  sale  of  stock 
between  an  employer  (or  shareholder  of  the  employer)  and  an  ESOP. 
The  Congress  has  not  considered  whether  the  principles  applicable  to 
ESOPs  in  connection  with  loans  to  the  plan  or  sales  of  employer  stock 
vshould  apply  in  the  ease  of  other  exemptions  fi'om  the  prohibited 
transaction  rules  and,  accordingly,  no  inference,  should  be  drawn 
regarding  those  other  exemptions. 

(2)  Put  option. — The  proposed  regulations  would  require  that  an 
emploj'er  provide  each  employee  who  receives  stock  from  a  leveraged 
ESOP  or  an  investment  credit  ESOP  with  a  2-year  "put  option''  if 
the  stock  is  not  listed  on  an  exchange. 

Although  the  Congress  agrees  that  a  mai-ket  should  be  provided 
for  employer  stock  distributed  by  an  ESOP  to  an  employee,  the  Con- 
gress believes  that  a  put  option  for  a  period  considerably  shorter  tiian 
two  years  will  properly  protect  emploj^ees  and  that  a  put  under  which 
the  employer  must  pay  for  tendered  stock  over  too  short  a  period  would 
effectively  deny  the  employer  the  benefits  of  capital  formation  the 
Congress  sought  to  provide  under  an  ESOP.  On  the  contrary,  the 
Congress  believes  that  the  payment  by  the  employer  could  be  made 
in  substantially  equal  installments  over  a  reasonable  periovl,  taking 
into  account  the  need  to  protect  the  interests  of  employees  and  the  need 
of  the  employer  for  capital. 

(3)  Stock  pureh/is-ed  with  loan  jn^oceeds. — Under  the  proposed  regu- 
lations, if  an  ESOP  holds  employer  stock  which  it  purchased  with 
the  proceeds  of  a  loan,  the  stock  is  to  be  placed  in  a  suspense  account 
from  which  it  is  to  be  released  under  a  formula.  The  fonnula  provided 
b}^  the  proposed  regulations,  however,  is  not  in  accordance  with  the 
common  business  practice  under  which  the  stock  is  released  from  the 
account  as  loan  principal  is  amortized. 

The  Congress  believes  that  the  regulations  should  allow  the  stock  to 
be  released  as  the  loan  principal  is  repaid  if  (a)  the  principal  is 
amortized  over  a  reasonable  period  (taking  into  account  the  facts  and 
circumstances,  including  the  interests  of  plan  participants  and  the 
employer's  need  for  capital),  and  (b)  the  employees  are  adequately 
informed  regarding  their  rights  to  employer  stock  held  by  the  plan. 

(4)  Allocation  of  stock. — Under  the  proposed  regulations,  employer 
stock  acquired  by  an  ESOP  with  loan  proceeds  must  be  allocated  to 
plan  participants  as  it  is  released  from  the  suspense  account  discussed 
in  (o)  above.  The  Congress  believes  that  the  regulations  should  permit 
the  allocation  of  stock  to  be  made  in  accordance  with  a  formula  more 
similar  to  that  provided  for  ESOPs  in  the  Trade  Act  of  1974  (19 
U.S.C.§  2373(f)  (4)). 

(5)  Voting  rights. — The  proposed  regulations  would  require  that 
employees  be  permitted  to  direct  the  voting  of  employer  stock  alio- 


174 

cated  to  their  accounts  under  a  leveraged  ESOP  even  though  other 
types  of  employee  plans  need  not  provide  employees  with  these  rights. 
(The  Tax  Reduction  Act  of  1975  requires  that  employees  be  permitted 
to  direct  the  voting  of  employer  stock  allocated  to  their  accounts  under 
an  investment  credit  ESOP  but  not  under  other  ESOPs.)  The  Con- 
gress believes  that  the  regulations  should  not  distinguish  between  lev- 
eraged ESOPs  and  other  employee  plans  in  this  regard. 

(6)  Dividend  restrictions. — Under  the  proposed  regulations,  em- 
ployer stock  held  by  an  ESOP  must  have  unrestricted  dividend  rights. 
However  dividend  restrictions  are  comuKmly  required  in  connection 
with  loans.  Consequently,  the  Congress  believes  that  such  restrictions 
should  be  permitted  if  they  are  required  in  connection  with  a  loan  \o 
the  ESOP  for  the  purchase  of  employer  securities  (but  only  if  the 
restrictions  terminate  when  the  loan  is  repaid)  or  if  they  apply  also  to 
a  significant  portion  of  the  employer  stock  not  held  by  the  ESOP. 

(7)  Right  of  first  refusal. — The  proposed  regulations  prohibit  a 
leveraged  ESOP  from  acquiring,  with  the  ]>roceeds  of  a  loan,  employer 
stock  subject  to  a  right  of  first  refusal.  Because  the  shareholders  of 
many  corporations  (especially  smaller  businesses)  believe  that  a  right 
of  first  refusal  is  necessary  to  protect  their  interests,  the  Congress  be- 
lieves that  the  prohibition  will  have  a  chilling  effect  upon  the  estab- 
lishment of  ESOPs  and  that  a  right  of  first  refusal  should  not  be 
proscribed. 

(8)  Treatment  of  sah  as  redemption. — Under  the  proposed  regula- 
tions, the  sale  of  stock  by  a  corporate  shareliolder  to  the  corporation's 
ESOP  could,  depending  upon  the  facts  and  circumstances,  be  treated 
as  a  redemption  of  the  stock  by  the  corporation.  If  the  sale  is  treated 
as  a  redemption,  the  proceeds  of  the  sale  could  be  considered  dividend 
income  rather  than  capital  gain.  The  Congress  believes  that  if  such  a 
rule  is  authorized  and  proper,  its  application  should  not  be  restricted 
to  ESOPs  and  that  it  should  be  applied  only  where  the  stock  sold  by 
the  shareholder  inures  to  his  benefit  (or  the  benefit  of  related  parties) 
under  the  plan. 

(9)  Nonvoting  common  stocky  etc. — The  proposed  regulations  im- 
pose special  rules  on  ESOPs  which  limit  the  extent  to  which  the  plan 
can  acquire  employer  securities,  other  than  voting  common  stock  with 
unrestricted  dividend  rights,  with  the  proceeds  of  a  loan.  (The  Tax 
Reduction  Act  of  1975  does  not  allow  the  additional  investment  credit 
for  nonvoting  employer  stock.)  The  Congress  believes  that  the  usual 
rules  applicable  to  employee  plans  properly  protect  the  interests  of 
plan  ]>articipants  and  that  these  s[>ecia]  lules  are  not  needed. 

(10)  Prepayment  penalty. — The  i)i-o[)ose(l  regulations  si)ecifically 
prohibit  any  loan  made  to  an  ESOP  from  containing  a  i)rovision  for 
a  prepayment  penalty.  The  ("ongress  believes  that  the  (|ue^stion  of  such 
penalties  should  be  a  matter  of  negotiation  between  the  ESOP  and  the 
lender  and  that  prepayment  penalties  should  not  be  i)ro]iibited  in  all 
cases.  (They  should  not  be  allowed  of  coui-se  if,  for  example,  payment 
of  a  penalty  would  be  imprudent.) 

(11)  No  calls  or  other  options. — The  proposed  regulations  prohibit 
stock  acquired  with  an  ESOP  loan  f lom  being  subject  to  any  calls  or 
options  (other  than  the  put  option  described  in  (2)  above).  There  is  no 
prox'ision  for  restrictions  which  may  be  requir-ed  by  State  or  Federal 


175 

law.  The  Congress  believes  that  in  the  limited  situation  where  restric- 
tions are  imposed  by  law,  stock  in  an  ESOP  should  be  permitted  to 
have  restrictions  necessary  to  comply  with  the  law. 

(12)  Comparability. — Tlie  proposed  regulations  do  not  permit  an 
ESOP  and  another  plan  to  be  considered  a  single  plan  for  purposes  of 
determining  whether  the  jjlans  meet  the  anti-discrimination  require- 
ments of  the  tax  law.  Although  the  Congress  agrees  that  an  ESOP  and 
another  type  of  plan  sliould  not  be  considered  a  single  plan  for  this 
purpose,  the  Congress  believes  that  this  rule  should  not  be  applied  to 
disqualify  a  plan  already  in  existence  and  that  two  or  more  ESOPs 
can  be  considered  as  a  single  plan  in  testing  the  coverage  and  con- 
tril?utions  or  benefits  under  the  pi  ans. 

As  stated  in  the  Report  of  the  Senate  Finance  Committee  on  the 
bill,  an  ESOP  is  designed  to  "build  equity  ownership  of  shares  in 
the  emplover  corporation  into  i+s  employees  substantially  in  propor- 
tion to  their  relative  incomes."  (S.  Kept.  No.  94-938,  p.  180.)  The 
Congress  understands  that,  under  the  proposed  regulations,  an  ESOP 
could  be  integrated  with  the  social  security  system  so  that  employer 
stock  would  not  be  allocated  to  employees  substantially  in  proportion 
to  their  compensation.  The  Congress  believes  that  social  security  inte- 
gration is  not  consistent  with  the  purposes  of  an  ESOP.  The  Con- 
gi-ess  believes,  however,  that  a  prohibition  on  integration  should  not 
apply  to  ESOPs  which  were  integrated  at  the  time  the  Act  was 
enacted. 

(13)  Inferences. — Although  the  Congress  has  commented  on  the 
merits  of  the  proposed  regulations,  these  comments  should  not  be 
taken  as  inferring  approval  or  disapproval  of  the  provisions  not  com- 
mented upon. 

(c)  Study  of  Expanded  Stock  Ownership 

The  Act  changes  the  name  of  the  existing  Joint  Pension  Task 
Force  to  the  Joint  Pension,  Profit-sharing  and  Emplo^/ee  Stock  Owner- 
ship Plan  Task  Force,  and  provides  that  the  Task  Force  is  to  study 
employee  stock  ownersliip  plans.  The  Task  Force,  which  may  con- 
sult others  who  have  information  concerning  employee  stock  owner- 
ship plans,  is  to  report  its  findings  to  the  Committee  on  Ways  and 
Means  and  the  Committee  on  Education  and  Labor  of  the  House  and 
the  Committee  on  Finance  and  the  Committee  on  Labor  and  Public 
Welfare  of  the  Senate  by  March  31, 1978. 

Effective  date 
The  additional  one-half  percent  investment  tax  credit  applies  for 
taxable  years  beginning  after  December  31,  1976.  The  investment 
credit  "flow  through"  provisions  apply  for  taxable  years  beginning 
after  December  31,  1975.  The  special  limitation  on  contributions  for 
ESOPs  applies  for  taxable  years  beginning  after  December  31,  1975. 
The  other  provisions  generally  apply  for  taxable  years  beginning 
after  December  31, 1974. 

Revenue  effect 
The  general  provisions  for  the  one  and  one-half  percent  investment 
credit  ESOPs  are  expected  to  decrease  revenue  by  $107  million  in 
fiscal  1977,  $257  million  in  fiscal  1978,  $303  million  in  fiscal  1979,  $332 


176 

million  in  fiscal  1980,  $189  million  in  fiscal  1981.  The  regulations  and 
study  provisions  have  no  effect  on  revenue. 

4.  Investment  Credit  in  the  Case  of  Movies  and  Television  Films 
(sec.  804  of  the  Act  and  sec.  48  of  the  Code) 

Prior  law 

Under  the  tax  law,  taxpayers  are  entitled  to  receive  an  investment 
credit  for  tangible  personal  property  (i.e.,  section  38  property)  which 
is  placed  in  service  by  the  taxpayer.  In  order  to  receive  the  full  credit, 
the  property  placed  in  service  by  the  taxpayer  must  have  a  useful  life 
of  at  least  7  years.  If  the  property  has  a  useful  life  of  at  least  5  years 
(but  less  than  7  years)  the  taxpayer  is  entitled  to  two-thirds  of  the 
full  credit.  If  the  property  has  a  useful  life  of  at  least  3  years  (but 
less  than  5  years)  the  taxpayer  is  entitled  to  a  one-third  credit.  In  ad- 
dition, there  cannot  be  any  predominant  foreign  use  of  the  property 
during  any  taxable  year,  or  the  property  will  cease  to  qualifj^  as  sec- 
tion 38  property. 

Prior  to  1971,  it  was  not  clear  whether  (and  if  so,  under  what  con- 
ditions) the  investment  credit  was  available  for  movie  or  television 
films.  However,  a  court  case  had  held  that  movie  films  were  tangible 
personal  propert}^  eligible  for  the  investment  credit.  During  the  legis- 
lative consideration  of  the  Kevenue  Act  of  1971,  it  was  made  clear  that 
motion  pictures  and  television  films  are  to  be  treated  as  tangible  per- 
sonal property  eligible  for  the  investment  credit  (i.e.,  section 
38  property).  However,  this  issue  was  still  being  litigated  for  years 
prior  to  1971,  and  there  were  still  a  number  of  other  unsettled  issues, 
such  as  how  to  determine  the  useful  life  of  a  film,  the  basis  on  which  the 
credit  is  to  be  computed,  and  how  to  determine  whether  tliere  has  been 
a  predominant  foreign  use  of  the  film. 

Reasons  for  change 

Due  to  the  uncertainties  of  prior  law  with  respect  to  the  questions 
of  useful  life  and  predominant  foreign  use,  it  was  often  difficult  to 
determine  whether  a  film  was  entitled  to  a  full  credit,  a  partial  one- 
third  or  two-thirds  credit,  or  possibly  no  credit.  Congress  felt  that  it 
was  desirable  to  clarify  these  issues,  in  order  to  avoid  costly  litigation 
with  respect  to  the  past,  and  to  allow  accurate  investment  planning  for 
the  movie  industry  in  future  years. 

To  achieve  the  objective  set  out  above,  the  Act,  for  past  years,  allows 
taxpayers  to  determine  their  investment  credit  on  a  film-by-film  basis 
in  accordance  with  certain  statutory  rules  prescribed  under  the  Act 
with  respect  to  useful  life  and  predominant  foreign  use,  or  to  elect  to 
take  a  40-percent  compromise  credit  for  all  their  films,  regardless  of 
the  actual  useful  life  or  foreign  use  of  any  particular  film.  The  Con- 
gress believes  that  this  40-percent  figure  represents  a  fair  compromise 
between  the  litigating  position  of  the  Internal  Kevenue  Service,  on 
the  one  hand,  and  members  of  the  industrv,  on  the  other  hand. 

In  addition,  since  the  major  purpose  of  the  investment  credit  is  to 
create  jobs  in  the  United  States,  the  Act  provides  that  for  the  future 
the  amount  of  the  investment  credit  in  the  case  of  movie  films  is  to  de- 
pend on  the  plac^  of  production  of  the  film  (i.e..  United  States  or 
foreign),  rather  than  on  the  place  where  revenues  are  received  for 
showing  the  film.  Thus,  the  foreign  use  test  will  not  apply  to  movie 


177 

films  for  the  future.  As  a  further  incentive  to  encourage  U.S.  produc- 
tion of  films,  the  Act  provides  that  where  80  percent  or  more  of  the 
direct  production  costs  of  the  film  are  U.S.  costs,  the  credit  base  for 
the  film  is  to  include  certain  indirect  costs  (such  as  general  overhead 
costs,  the  cost  of  screen  rights,  etc.) ,  but  that  otherwise  the  credit  base 
will  be  limited  to  direct  U.S.  production  costs. 

As  to  the  issue  of  useful  life,  taxpayers  may  take  a  two-thirds  credit 
on  all  their  films  (regardless  of  the  useful  life  of  particular  films),  or 
they  may  elect  to  determine  useful  life  on  a  film-by-film  basis.  Under 
this  latter  method  of  computing  the  credit,  the  useful  life  of  the  film 
will  be  treated  as  having  ended  when  90  percent  of  the  basis  of  the  film 
has  been  recovered  through  depreciation. 

Explanation  of  provisions 
As  outlined  above,  the  Act  provides  somewhat  different  rules  in  this 
area  with  respect  to  the  past  than  it  does  for  the  future,  because  the 
rules  for  the  past  are  intended  to  be  a  compromise  of  the  litigating 
positions  of  the  Internal  Eevenue  Service  and  members  of  the  film 
industry,  based  on  transactions  which  have  already  occurred.  Also,  the 
rules  are  different  for  the  future  because  the  emphasis  for  the  future  is 
to  be  on  providing  jobs  in  the  United  States. 

Films  placed  in  service  in  future  years 

General  rule. — For  the  future,  as  a  general  rule,  under  the  Act,  tax- 
payers are  to  receive  two-thirds  of  a  full  credit  for  all  their  films  re- 
gardless of  the  actual  useful  life  (or  foreign  use)  of  any  particular 
film.  This  rule  will  applv  to  all  films  placed  in  service  (i.e.,  initially 
released  for  public  exhibition  in  any  medium)  in  taxable  years  begin- 
ning after  "December  31,  1974,  regardless  of  whether  any  particular 
film  had  a  useful  life  of  7  years  or  more  (so  that  it  would  be  entitled 
to  a  full  credit  if  judged  on  an  individual  basis),  or  less  than  3  years 
(so  that  it  would  not  be  entitled  to  any  credit  if  judged  separately). 
The  credit  is  to  be  available  only  for  "qualified  films",  i.e.,  motion 
picture  films  or  television  films  or  tapes  created  primarily  for  use  as 
public  entertainment,  and  educational  films,  i.e.,  generally  films  used 
in  nrimarv  or  secondary  schools,  colleges  and  universities,  vocational 
and  post -secondary  educational  institutions,  public  libraries  and  gov- 
ernment asrencies  (thus,  for  example,  excluding  industrial  training 
films'^.  Also,  the  credit  would  be  available  for  TV  pilot  films 
and  dramatic  or  comedv  series,  such  as  "Mod  Squad"  or  "Tlie  Mary 
Tvler  Moore  ShoAv."  However,  the  credit  would  not  be  available  for 
films  which  were  topical  or  transitory  in  nature,  such  as  news  shows, 
interview  shows  such  as  "Johnnv  Carson"  or  "Firing  Line",  or  films 
or  tapes  of  sports  events,  eveii  though  some  of  these  shows  misrht  be 
shown  in  subseoaent  years.  Also,  the  credit  would  not  be  available  for 
used  films  (i.e.,  filnis  shown  previously  in  any  market) . 

Th^  90-vercent  method, — Under  the  Act,  as  an  alternative  to  the 
general  rule,  taxpayers  mav  elect  to  have  the  investment  credit  deter- 
miiied  for  all  of  their  nualified  films  placed  in  service  in  the  future  on 
a  film-by-film  basis.  Thus,  if  a  particular  film  had  a  useful  life  of 
7  years  or  more,  the  taxpayer  would  be  entitled  to  a  full  credit  for 
that  film.  On  the  other  hand,  if  a  film  had  a  useful  life  of  less  than 
3  years  the  taxpayer  would  not  be  entitled  to  anv  credit  for  that  film. 
For  purposes  of  these  rules,  the  film's  useful  life  is  to  be  treated  as 
ending  at  the  close  of  the  year  by  the  end  of  which  the  aggregate 


178 

allowable  deductions  for  depreciation  equal  at  least  90  percent  of  the 
basis  of  the  film  (adjusted  for  any  partial  dispositions,  but  determined 
without  regard  to  any  otlier  adjustments) . 

For  example,  assimie  that  a  taxpayer  who  is  on  a  calendar  year  basis 
releases  (i.e.,  places  in  service)  a  film  Avith  a  basis  of  $100  on  Febru- 
ary 1,  1975.  The  film  is  depreciated  undei*  the  income  forecast  method 
and  $50  of  depreciation  is  allowable  witli  respect  to  this  film  for  1975, 
$30  for  1976  and  $10  is  for  1977.  Thus.  $90  of  depreciation  is  allowable 
by  the  close  of  1977,  and  since  this  represents  90  percent  of  the  basis 
of  the  film  the  useful  life  of  the  film  is  to  be  treated  as  having  ended 
on  December  31, 1977,  or  less  than  three  years  after  the  film  was  placed 
in  service ;  therefore,  no  credit  would  be  available  with  respect  to  this 
film,  and  any  credit  or  partial  credit  which  had  been  claimed  would  be 
subject  to  recapture. 

On  the  other  hand,  if  less  than  $90  of  basis  had  been  recovered  by 
the  close  of  1977,  the  film  would  be  eligible  for  at  least  a  partial  credit.^ 

Of  course,  films  of  a  transitory  or  topical  nature  would  not  be  eli- 
gible for  the  investment  credit,  no  matter  when  their  basis  was  recov- 
ered through  depreciation. 

If  the  actual  useful  life  of  a  film  is  less  than  its  anticipated  useful 
life  in  the  case  of  a  taxpayer  using  the  90-percent  method,  the  credit 
is  to  be  subject  to  recapture  under  essentially  the  same  rules  which 
appl}^  in  the  case  of  any  other  section  38  property  where  the  actual 
useful  life  proves  to  be  shorter  than  the  anticipated  life.  Also,  in  the 
case  of  a  disposition  or  partial  disposition  of  rights  in  the  film  before 
the  end  of  the  anticipated  useful  life  of  the  film,  there  would  be  a  full 
or  partial  recapture.^ 

A  partial  disposition  includes  the  sale  of  commercial  exploitation 
rights  in  any  medium  (television,  for  example)  or  in  any  geographic 
area  (such  as  Great  Britain,  or  any  other  foreign  countiy).  On  the 
other  hand,  an  ordinary  commercial  license  for  less  than  the  full  rights 
of  exploitation  in  a  particular  medium  or  area  generally  does  not  con- 
stitute a  disposition  or  partial  disposition  for  purposes  of  these  rules. 

Also,  a  sale  of  exploitation  rights  to  a  member  of  an  "affiliated 
group"  does  not  constitute  a  partial  disposition.  For  example,  U.S.  film 
distributors  commonly  exploit  the  foreign  rights  to  a  U.S. -made  film 
through  use  of  a  foreign  affiliate.  For  purposes  of  these  rules,  the  term 
"affiliated  group"  is  to  have  the  same  meaning  as  it  does  for  purposes 
of  section  1504,  but  with  a  50-percent  control  test  (instead  of  80  per- 
cent), and  with  no  exclusion  of  corporations  (such  as  foreign  affiliates) 
described  in  section  1504(b).  Also  where  stock  in  a  foreign  film  dis- 
tributor is  held  by  the  trust  of  a  pension  ])lan  which  benefits  the  em- 
ployees of  that  foreign  distributor,  any  U.S.  corporation  holding  stock 
in  the  foreign  distributor  may  add  the  stock  held  by  the  nension  trust 
to  its  own  stock  holdings  for  purposes  of  determining  if  the  foreign 
film  distributor  is  an  "affiliate"  of  the  U.S.  corporation.  For  example, 
if  two  American  distributors  each  hold  49  percent  of  the  stock  in  a  for- 
eign distributor,  and  the  pension  tiaist  of  the  foreign  distributor  holds 
the  remaining  2  percent,  the  foreign  distributor  would  be  an  affiliate 


1  For  purposes  of  these  cnlnilations.  salvace  value  would  not  bo  taken  in^o  account: 
th"s.  If  ?»  f'm  has  a  hasls  of  $100,  and  a  salvage  value  of  .$10.  the  useful  life  would  not 
end  until  $90  of  depreciation  w-^s  recoverable  (i.e..  90  percent  of  the  «100  basis,  not  90 
percert  of  the  $100  basis  minus  the  $10  salvapre  value,  which  would  eoual  $811. 

=  This  ru'e  Is  not  to  apply  to  a  taxpayer  usinir  the  jrenernl  mlp  Cthe  two-thirds  method), 
however,  since  the  amount  of  the  credit  under  this  method  does  not  depend  on  the  useful 
Ufe  of  any  particular  film. 


179 

of  both  the  American  corporations  (l^ecause  each  would  add  the  2  per- 
cent interest  held  by  the  pension  trust  to  its  own  49-pereent  intere.st). 

Some  of  the  principles  above  may  be  illustrated  as  follows.  A  film 
distributor  having  a  100-percent  ownership  interest  in  a  television 
dramatic  series,  consisting  of  24  weekly  episodes,  elects  to  use  the  90- 
percent  method  of  determining  its  investment  credit  for  movie  films. 
The  distributor  estimates  the  useful  life  of  the  series  will  be  7  years 
or  more  and  claims  a  full  credit.  The  distributor  licenses  a  United 
States  television  network;  under  the  agreement  the  network  acquires 
first-run  U.S.  television  rights  for  $100,  with  the  right  to  repeat  each 
episode  over  the  network  one  time  for  an  additional  fee  of  $25, 

In  the  following  year,^  the  American  distributor  sells  the  exclusive 
rights  to  exhibit  the  series  in  Great  Britain  to  a  British  coi'poration 
which  is  not  affiliated  with  the  American  distributor.  This  constitute^ 
a  partial  disposition  of  the  series  which  triggers  a  partial  recapture  of 
the  credit. 

If,  on  the  other  hand,  the  American  distributor  entered  into  a  limited 
licensing  agreement  with  the  foreign  corporation  (similar  to  the  agree- 
ment which  it  had  entered  with  the  American  network) ,  or  sold  the 
British  rights  to  the  series  to  a  member  of  an  affiliated  group,  there 
would  be  no  partial  disposition,  and  consequently,  no  recapture. 

Films  placed  in  service  for  taxable  yeai*s  beginning  after  Decem- 
ber 31,  1974,  are  not  subject  to  the  foreign  use  rule.  This  is  because, 
in  the  case  of  a  movie  film,  jobs  are  created  where  the  film  is  produced, 
not  where  it  is  shown.  To  use  the  90-percent  method,  the  taxpayer 
would  have  to  make  an  election,  in  a  time  and  manner  to  be  prcvscribed 
in  regulations. 

Once  the  taxpayer  (or  any  related  business  entity)  has  operated 
under  the  general  rule  for  the  future,  or  has  elected  to  use  the  90-per- 
cent method,  he  cannot  change  his  method  of  operation  without  the 
consent  of  the  Internal  Revenue  Service,  The  Congress  intends  that 
permission  will  be  granted  where  the  taxpayer  undergoes  a  substantial 
transformation  in  its  operations,  but  generally  will  not  be  granted 
otherwise.  For  example,  it  might  be  appropriate  to  grant  permission 
if  a  film  studio  using  the  90-percent  method  merged  with  a  studio 
using  the  two-thirds  method ;  or  in  cases  where  a  studio  sliif l.ed  from 
the  production  of  short-lived  gi'ade  B  westerns  to  long-lived  classic 
films. 

For  purposes  of  these  rules,  related  business  entities  include  all  com- 
ponent members  of  a  controlled  group  of  corporations  (within  the 
meaning  of  section  1563(a),  without  regard  to  subsection  1563(b)  (2) ) 
but  subject  to  a  50-percent  control  test.  Also  classified  as  "related 
business  entities"  are  any  corporations,  partnerships,  trusts,  estates, 
proprietorships,  or  other  entities,  if  "related  persons",  each  of  whom 
have  at  least  a  10-percent  interest  in  each  entity,  also  have,  in  the  ag- 
gregate, at  least  50  percent  of  the  beneficial  interests  in  those  entities,* 

Thus,  for  example,  if  individuals  A,  B,  C,  and  D  each  have  a  25- 
percent  interest  in  studio  1  (which  uses  the  two-thirds  method  in  1975) , 


*  Where  a  TV  series  Is  Involved,  each  weekly  segment  Is  placed  In  service  when  It  Is 
first  shown.  Thus,  the  various  segments  of  the  series  will  not  necessarily  be  placed  In 
service  in  Che  same  year. 

*  The  term  "benefi''.al  Interest"  means  voting  stock  In  the  case  of  a  corporation,  profits 
or  capital  interest  In  the  case  of  a  partnership,  and  beneficial  Interest  in  the  case  of  a 
trust  or  estate.  "Related  persons"  are  generally  as  described  In  section  267  or  707(h), 
but  for  purposes  of  these  rules  members  of  a  family  consist  only  of  the  Individual,  his 
spouse,  and  his  minor  children. 


180 

studio  2,  formed  in  1976,  with  A  and  B  each  having  a  50-percent  prof- 
its interest,  cannot  elect  the  90-percent  method  for  1976  without  the 
permission  of  the  Internal  Ilevenue  Service.  Studio  1  and  studio  2  are 
related,  because  A  and  13  each  have  at  least  a  10-percent  interest  in  both 
studios  and  together  A  and  B  have  at  least  50  percent  of  the  beneficial 
interest  of  both  studios.  Since  studio  1  used  the  two-thirds  method 
in  1975,  studio  2  must  have  permission  to  use  a  different  method  in 
1976. 

Credit  hose. — Since  the  primary  purpose  of  the  investment  credit  is 
to  create  jobs,  the  Act  is  designed  to  encourage  the  production  of  films 
in  the  United  States.  Thus,  the  credit  base  for  motion  picture  films 
includes  the  direct  costs  which  are  allocable  to  production  of  the  film 
in  the  United  States  (including  Puerto  Rico  and  the  possessions)  and, 
in  addition,  if  at  least  80  percent  of  the  direct  production  costs  are 
allocable  to  United  States  production,  the  credit  base  also  includes 
certain  indirect  "production  costs." 

Direct  production  costs  include  compensation  payable  to  the  actors 
and  other  production  personnel.  However,  under  the  Act  certain  spe- 
cial rules  apply  in  the  case  of  participations  (described  below  in  con- 
nection with  indirect  production  costs) . 

Direct  production  costs  also  include  expenses  for  costumes,  props, 
scenery,  and  similar  items,  as  well  as  the  cost  of  the  film,  and  the  cost 
of  preparing  the  first  distribution  of  prints  (i.e.,  prints  placed  in 
service  within  12  months  after  the  film  is  first  released). 

Where  the  film  is  produced  partly  in  the  United  States  and  partly 
abroad,  the  direct  production  costs  must  be  allocated  between  the  U.S. 
and  foreign  production  of  the  film.  Under  the  Act,  compensation  for 
services  is  to  be  allocated  to  the  country  where  the  services  are  per- 
formed. However,  compensation  paid  to  United  States  citizens  is  to 
be  allocated  to  the  United  States,  even  if  the  services  are  performed 
outside  of  the  United  States.  Also,  payments  to  a  subchapter  S  cor- 
poration or  to  a  partnership  are  t-o  be  treated  as  United  States  pro- 
duction costs  if  (and  to  the  extent)  that  the  payments  are  includable 
in  gross  income  by  a  U.S.  citizen  or  any  other  United  States  person 
(which  is  not  a  partnership  or  subchapter  S  corporation).  Amounts 
paid  for  equipment  and  supplies  are  to  be  allocated  to  the  country  in 
which  the  materials  are  predominantly  used  (where  this  can  be  estab- 
lished for  particular  materials).  Subject  to  these  guidelines,  allocation 
of  direct  production  costs  is  to  be  determined  under  regulations.  The 
Congress  intends  that  generallv  (in  the  absence  of  better  evidence  as 
to  the  actual  place  of  predominant  use  of  personnel  and  materials) 
direct  production  costs  are  to  be  allocated  in  accordance  with  the  shoot- 
ing time  of  the  film. 

If  80  percent  or  more  of  the  direct  production  costs  are  allocable  to 
U.S.  production,  then  the  credit  base  for  the  film  is  to  include  all  "pro- 
duction costs"  of  the  film  (other  than  the  direct  foreign  production 
costs,  if  anv) .  These  would  include  not  only  the  direct  production  costs, 
as  outlined  above,  but  also  certain  capitalized  costs,  including  a  reason- 
able allocation  of  the  general  overhead  of  the  taxpaver,  the  cost  of 
obtaining  the  screen  ri*rhts  to  the  film,  as  well  as  the  cost  of  developing 
the  screenplay,  and  "residuals"  (whether  or  not  capitalized)  paid 
under  agreements  with  labor  organizations,  such  as  the  Actor's  Guild. 


181 

Generally,  residuals  are  amounts  paid  under  a  collective  bargaining 
agreement  to  all  members  of  tlie  union  involved  (or  in  some  cases  to  a 
guild  or  union  pension,  health,  or  welfare  fund).  The  collective  bar- 
gaining agreement  generally  covers  all  films  produced  over  a  period  of 
several  years.  Eesiduals  may  be  a  percentage  of  gross  receipts  from 
nontheatrical  uses  of  a  theatrical  film,  or  a  percentage  of  the  minimum 
salary  payable  (i.e.,  scale)  to  the  union  member. 

Under  the  Act,  particii)ations  may  be  included  in  the  credit  base 
of  an  80  percent  or  more  U.S.  produced  film  subject  to  certain  limita- 
tions. First,  participations  may  be  included  in  the  credit  base  only  to 
the  extent  that  i^articipations  paid  to  any  one  person  in  connection 
with  any  one  film  do  not  exceed  $1  million.^  Subject  to  this  rule,  par- 
ticipations are  includible  in  the  investment  credit  tax  base  to  the  extent 
of  the  lesser  of:  (1)  25  percent  of  participations  qualifying  under  the 
$1  million  limitation,  or  (2)  121^  percent  of  the  production  costs  of 
the  taxpayer's  films  for  the  year  (i.e.,  his  investment  credit  tax  base 
determined  without  regard  to  participations  or  residuals).  These  lim- 
itations are  to  be  applied  on  a  vintage  year  basis  (i.e.,  participations  in 
films  released  in  the  same  year  are  to  be  considered  in  the  aggregate 
for  purposes  of  determining  whether  the  12i/^-percent  limitattion  with 
respect  to  those  films  has  been  exceeded) . 

If  less  than  80  percent  of  the  direct  production  costs  of  a  film  are 
allocable  to  U.S.  production,  then  the  credit  base  with  respect  to  that 
film  includes  only  the  direct  U.S.  production  costs. 

Some  of  the  principles  discussed  above  may  be  illustrated  as  follows. 
Assimie  that  the  total  production  costs  of  a  film  equal  $150.  Of  this 
amount,  $50  are  indirect  production  costs,  including  $30  for  general 
overhead,  $10  for  the  screen  rights  and  $10  of  residuals.  The  direct 
production  costs  include  $75  of  salary  and  $25  for  supplies  and  ma- 
terials. Fifty  dollars  of  compensation  are  paid  to  United  States  citi- 
zens, and  S25  of  compensation  are  paid  to  non-U.S.  actors  and  pro- 
duction crew,  and  these  invdividuals  perform  services  both  in  the  U.S. 
and  abroad.  Of  the  $25  used  for  costume  and  supplies,  $10  are  paid  for 
supplies  used  only  in  the  United  States,  $5  are  paid  for  costumes  used 
only  in  a  foreign  country,  and  $10  worth  of  supplies  are  used  both  in 
domestic  and  foreign  shooting.  Sixty  percent  of  the  shooting  time  for 
the  film  occurs  in  the  U.S.,  and  40  percent  occurs  abroad.  The  calcula- 
tion is  as  follows : 


U.S.    COSTS 

Compensation  paid  to  U.S.  citizens_  $50 
60  pet.  of  compensation  paid  to  non- 
U.S.  citizens 15 

Supplies  used  onl.v  in  United  States     10 
60  i)ct.  of  the  cost  of  supplies  used 
in  the  United  States  and  abroad_       6 

Total 81 


FOREIGN    COSTS 


$00 

40  pet.  of  compensation  paid  to  non- 
U.S.  citizens 10 

Supplies  used  only  abroad 5 

40  pet.  of  the  cost  of  supplies  used 

in  the  United  States  and  abroad-  4 

Total 19 


Since  81  percent  of  the  direct  cost  of  production  is  allocable  to  United 
States  production,  the  credit  base  also  includes  the  $50  of  indirect  pro- 


■^  These  rules  affecting  participations  apply  only  for  purposes  of  the  investment  credit 
tax  base  and  no  inference  is  intended  that  similar  rules  should  be  applied  for  other 
purposes  under  the  tax  law  (i.e.,  the  taxpayer's  basis  for  depreciation).  The  Congress 
intends  that  .such  questions  be  determined  under  the  rules  of  the  tax  law  without  regard 
to  this  provision. 


182 

duction  costs.  However,  the  $10  cost  for  residuals  is  not  to  be  eligible 
for  the  credit  until  the  year  in  which  these  amounts  are  actually  paid. 

Of  course,  under  the  Act,  where  a  hhn  is  purchased  before  it  is  placed 
in  service  in  any  medium,  the  credit  base  cannot  exceed  the  purchase 
price  of  the  film  (if  this  is  less  than  the  credit  base  for  the  film  as  com- 
puted under  the  rules  outlined  above). 

Under  certain  circumstances,  it  may  be  possible  for  the  rights  to  the 
film  to  be  leased  under  section  18(d)  before  the  film  is  placed  in  service. 
However,  it  is  intended  that  the  credit  is  to  be  available  to  the  lessee 
only  where  the  lessee  acquires  full  rights  to  exploit  the  movie  or  film 
for  its  estimated  useful  life  through  a  particular  medimn  or  in  a 
particular  geographic  area ;  it  is  not  to  be  available  where  the  lessee  is 
precluded  (by  law,  regulation  or  governmental  action)  from  acquiring 
all  rights  to  exploit  the  him  or  tape  comnif  rcialiy.  Also,  in  the  case  of 
the  transfer  of  a  him  to  a  lessee  (under  section  48(d)  of  the  Code),  the 
lessee  is  generally  to  be  treated  as  having  acquired  the  hhn  for  an 
amount  equal  to  the  lessor's  credit  base  with  respect  to  that  him  (rather 
than  its  fair  market  value) . 

The  rules  outlined  above  concerning  the  credit  base  apply  regar-dless 
of  whether  the  taxpayer  uses  the  general  rule  (two-thirds  method)  or 
the  90-percent  method. 

Who  is  entitled  to  the  credit. — Under  the  Act,  a  taxpayer  is  to  be 
entitled  to  the  investment  credit  for  a  movie  film  if,  and  to  the  extent, 
that  he  has  an  "ownership  interest"  in  the  film  at  the  time  it  is  placed 
in  service.  For  purposes  of  these  rules,  a  taxpayer  will  be  treated  as 
having  an  ownership  interest  to  the  extent  that  his  capital  is  at  risk. 

Thus,  if  the  expenses  of  producing  a  movie  are  incurred  by  the  pro- 
ducer, but  are  reimbursed  by  the  distributor,  either  by  means  of  a 
nonrecourse  loan  or  otherwise,  the  distributor  would  be  entitled  to 
the  credit,  because  the  distributor's  capital  is  at  risk.  Also,  if  the  pro- 
duction costs  are  paid  from  the  proceeds  of  a  nonrecourse  loan  sup- 
plied by  a  bank  but  guaranteed  by  the  distributor,  then  the  distributor 
would  be  entitled  to  the  credit  because  its  capital  was  at  risk  in  con- 
nection with  the  film.  A  similar  result  would  follow  if  the  producer 
was  liable  to  the  bank  on  the  loan,  but  the  distributor  had  contracted 
to  pay  at  least  the  amount  of  the  loan  to  the  producer  in  connection 
with  the  film. 

The  determination  as  to  whose  capital  is  at  risk  in  connection  with 
the  film  (and,  therefore,  as  to  who  is  entitled  to  the  credit)  is  to  be 
made  as  of  the  time  the  film  is  first  placed  in  service  (i.e.,  released). 
Thereafter,  the  film  would  be  considered  used  property,  wliich  is  not  to 
be  eligible  for  the  credit  under  the  Act. 

Generally,  where  the  distributor  has  borne  the  cost  of  producing 
a  film,  and  first  releases  it  through  the  medium  of  movie  houses,  it  is 
the  distributor  who  is  entitled  to  the  credit.  In  the  case  of  a  film  or 
series  which  is  made  for  television,  the  producer-distributor  will  also 
generally  be  entitled  to  the  credit  where  the  film  is  exhibited  over  the 
network  pursuant  to  a  licensing  agreement.  On  the  other  hand,  if  the 
network  purchased  all  rights  to  the  film  or  series  before  it  was  placed 
in  service,  the  network  would  be  entitled  to  the  credit. 

It  is  possible  that  more  than  one  taxpayer  may  be  entitled  to  a  share 
of  the  credit  for  the  same  film  as,  for  example,  where  several  investors 


183 

put  up  a  portion  of  the  capital  needed  to  produce  the  film  pursuant  to 
a  joint  venture  agreement.  Generally,  where  more  than  one  party  bears 
the  risk  of  loss  with  respect  to  a  particular  film,  the  Secretary  of  the 
Treasury  or  his  delegate  may  establish  procedures  for  determining 
who  is  entitled  to  the  credit,  or  partial  credit.  (Of  course,  where  there 
are  several  parties  to  a  transaction  involving  a  movie  film,  and  one 
party  is  entitled  to  the  investment  credit  with  respect  to  that  film 
under  these  rules,  whereas  the  other  party  is  not,  the  Congress  antici- 
pates that  the  availability  of  the  investment  credit  may  often  be  taken 
into  account  by  the  parties  in  determining  their  contract  arrange- 
meiits,) 

It  is  also  possible  that  more  than  one  taxpayer  may  be  entitled  to 
the  credit  for  a  particular  film  where  the  film  is  placed  in  service  in 
more  than  one  medium  or  more  than  one  geographic  area.  For  example, 
siij^pose  that  a  producer  creates  a  U.S. -produced  film  having  a  credit 
base  of  $100.  A  distributor  acquires  exclusive  perpetual  distribution 
rights  witliin  the  United  States  in  exchange  for  a  lump-sum  payment 
of  $50  and  the  film  is  subsequently  placed  in  service.  The  distributor 
is  entitled  to  a  credit  with  respect  to  the  film  based  on  his  cost  of  $50 
in  acquiring  the  U.S.  rights.  The  producer,  who  retains  the  other 
rights  to  the  film,  would  also  be  entitled  to  a  part  of  the  credit  based 
on  his  capital  at  risk.  The  producer's  credit  base  would  be  computed 
by  subtracting  the  cost  borne  by  the  U.S.  distributor  ($50)  from  the 
credit  base  whicli  the  producer  would  otherwise  be  entitled  to  (i.e.,  the 
$100  cost  of  production).  Thus,  the  producer's  credit  base  would  equal 
$50  in  this  case. 

Filnos  Placed  in  Service  in  the  Past 

For  the  past  {i.e.^  for  taxable  years  beginning  before  January  1, 
1975),  in  general,  taxpayers  will  come  under  one  of  two  rules,  either 
the  "90-percent  method,"  as  described  above,  with  certain  modifica- 
tions to  deal  with  the  foreign-use  problem,  or  a  "40-percent  method," 
under  which  a  taxpayer  would  be  entitled  to  receive  40  percent  of  a 
full  credit  for  all  of  his  films,  regardless  of  the  useful  life  or  predomi- 
nant foreign  use  of  any  particular  film.  However,  taxpayers  may  elect 
to  come  under  the  genei-al  rule  for  the  future  (the  two-thirds  method, 
as  described  above)  for  all  section  50  propert}^  placed  in  service  after 
the  restoration  of  the  investment  credit  under  the  Revenue  Act  of  1971. 

Finally,  certain  taxpayers,  who  have  already  filed  suit  for  a  determi- 
nation as  to  their  entitlement  to  the  investment  credit  for  past  years, 
may  elect  the  application  of  the  rules  of  prior  law,  rather  than  the 
provisions  of  this  Act,  in  determining  their  entitlement  to  the  credit 
for  all  past  periods. 

General  rule  for  past. — Under  the  Act,  as  a  general  rule,  the  invest- 
ment credit  for  films  placed  in  service  in  taxable  years  beginning 
before  January  1,  1975,  is  to  be  computed  on  a  film-by-film  basis.  In 
determining  the  useful  life  of  the  film,  taxpayers  would  use  the 
90-percent  method  as  described  above.  However,  an  additional  rule 
is  necessary  for  the  past  to  determine  whether  or  not  there  was  pre- 
dominant foreign  use  of  the  film. 

Under  the  Act,  a  film  is  to  be  treated  as  having  a  predominant 
foreign  use  in  the  first  taxable  year  in  which  50  percent  or  more  of 


184 

the  gross  revenues  received  or  accrued  from  the  fihn  were  received 
or  accrued  from  showing  the  tihn  outside  the  United  States.  This  is  a 
year-by-year  test  (not  a  cumulative  test).  For  example,  assume  a  fihn 
was  released  on  P'ebruary  1,  1972,  and  revenues  of  $100  were  received 
that  year  from  showing  the  film  in  the  United  States  (with  no  foreign 
revenues),  while  in  1975  there  were  $75  of  income  from  U.S.  showings, 
and  $25  of  income  from  foreign  exhibitions,  and  in  197-1  there  were 
$40  of  U.S.  revenues,  and  $60  of  revenue  fi-om  foreign  exhibitions. 
In  this  case,  there  would  be  a  predominant  foreign  use  of  the  film  in 
1974,  and  as  a  result  the  film  would  cease  to  qualify  as  section  38 
property  in  that  year.  This  would  mean  that  the  taxpayer  would  not 
be  entitled  to  an  investment  credit  with  respect  to  the  film  because  the 
disqualifying  event  would  have  occurred  less  than  3  years  after  the 
property  had  been  placed  in  service.® 

Films  of  a  transitory  or  topical  nature  would  not  be  eligible  for  an 
investment  credit.^ 

The  JfO-percent  Tnethod. — Under  the  Act,  the  taxpayer  can  elect  to 
receive  40  percent  of  a  full  credit  for  all  of  his  films  placed  in  service 
in  taxable  years  beginning  before  January  1,  1975.^  If  the  taxpayer 
makes  this  election,  he  is  to  receive  the  40-percent  credit,  regardless 
of  the  actual  useful  life  or  predominant  foreign  use  of  any  particular 
film.  This  40-percent  method  is  offered  as  a  way  of  avoiding  costly 
litigation  with  respect  to  past  years.  It  is  believed  that  this  method 
achieves,  for  the  average  member  of  the  film  industry,  about  the  same 
size  credit  which  he  would  receive  for  all  his  films,  on  the  average, 
were  he  actually  to  litigate. 

A  taxpayer  is  not  to  receive  a  credit  for  any  films  of  a  transistory  or 
topical  nature  (because  almost  all  of  these  films  have  a  useful  life  of 
less  than  three  years).  Also,  a  taxpayer  using  the  40-percent  method 
for  the  past  is  not  entitled  to  credits  for  any  films  which  were  produced 
and  shown  exclusively  abroad. 

The  election  to  use  the  40-percent  method  is  to  be  made  by  the  tax- 
payer within  six  months  after  the  date  of  enactment  (October  4,  1976) 
in  a  manner  to  be  prescribed  in  regulations.  Any  such  election,  once 
made,  is  to  apply  to  all  the  taxpayer's  films  placed  in  service  in  the  past 
(except  those,  if  any,  covered  under  the  general  rule  for  the  future), 
and  can  be  revoked  only  with  the  consent  of  the  Internal  Revenue 
Service. 

To  prevent  a  situation  where  two  different  taxpayers  may  attempt 
to  claim  the  credit  for  the  same  film,  the  Act  provides  that  any  tax- 
payer making  the  40-percent  election  nuist  consent  to  join  in  a  judicial 
proceeding  to  determine  which  o.f  the  competing  claimants  was  entitled 
to  the  credit,  or  whether  each  of  the  parties  was  entitled  to  part  of  the 

•  For  this  limited  purpose,  gross  foreign  revenues  from  showing  films  in  future  yars 
must  also  be  taken  into  account.  In  other  words,  if  a  t.^xpayer  uses  the  90-peroent  method 
for  1974,  and  50  percent  or  more  of  the  reventies  from  showing  the  film  in  1075  are  from 
foreign  exhibitions,  this  would  constitute  a  predominant  foreign  use  of  the  film  placed  In 
service  In  1974,  and  the  taxpayer  would  not  be  entitled  to  an  Investment  credit  with 
respect  to  that  film. 

">  The  Congress  intends  that  no  Inference  should  be  drawn  from  this  report  or  this 
legislation  as  to  what  constitutes  useful  life,  predominant  foreign  use,  the  basis  on  which 
the  credit  is  to  be  computed,  or  any  other  aspect  of  the  application  of  the  investment 
credit  under  iirior  l^w. 

8  As  described  below,  the  taxpayer  can  also  use  this  method  for  films  placed  in  service 
on  or  before  August  15,  1971,  but  elect  to  use  the  general  rule  for  the  future  for  all  of  his 
section  50  films. 


185 

credit.^  The  rules  with  respect  to  entitlement  to  tlie  credit  (i.e.,  the 
capital  at  risk  rules,  etc.)  are  the  same  for  the  past  as  for  the  future. 

Credit  hase. — In  general,  under  the  Act,  the  rules  as  to  the  size  of 
the  credit  base  for  the  past  (including  those  with  respect  to  partici- 
pations) are  similar  to  the  rules  which  are  to  apply  for  the  future. 
However,  for  the  past  there  has  not  been  a  U.S.  production  test  in 
connection  with  movie  films,  and  the  Congress  does  not  believe  it 
would  be  appropriate  to  impose  such  a  test  retroactively.  (The  Act 
does  impose  a  U.S.  production  test  for  the  future,  in  order  to 
encourage  the  U.S.  production  of  movie  films.)  Thus,  for  the  past, 
taxpayers  may  include  in  the  credit  base  all  the  direct  and  indirect 
expenses  of  production,  as  described  above,  regardless  of  whether  the 
film  would  have  satisfied  the  80-percent  United  States  direct  produc- 
tion expenses  test  and  regardless  of  whether  some  of  the  expenses 
(actors'  pay,  costumes,  etc.)  included  in  the  credit  base  were  paid 
for  services  performed  abroad,  or  for  equipment  and  supplies  which 
were  used  abroad. 

The  rules  described  above  with  respect  to  the  credit  base  would 
apply  both  to  taxpayers  using  the  90-percent  method  for  the  past,  and 
to  taxpayers  using  the  40-percent  method. 

ApplHation  of  the  general  rule  for  the  future  to  certain  past  years. — 
In  connection  with  the  Eev'enue  Act  of  1971  Congress  nuide  clear  that 
it  intended  the  investment  credit  to  be  available  for  movie  films 
(whereas  this  question  has  not  been  completely  resolved  prior  to  that 
time)  even  though,  as  described  above,  certain  subsidiary  issues  were 
not  settled  in  that  Act.  For  this  reason,  the  Act  provides  that  those 
taxpayers  who  wish  to  do  so  are  to  be  allowed  to  use  the  general  rule 
for  the  future  with  respect  to  all  of  their  section  50  property  (generally 
property  placed  in  service  after.  August  15,  1971).  Thus,  the  Act  pro- 
vides that  taxpayers  may  elect  to  use  the  general  rule  for  the  future 
for  all  of  their  section  50  movie  films.  (Taxpayers  making  this  election 
could  still  use  either  the  90-percent  method  or  the  40-percent  method 
for  all  films  placed  in  ser\'ice  in  the  past  which  do  not  qualify  as 
section  50  property.) 

Taxpayers  who  make  this  election  are  to  be  covered  under  the  gen- 
eral rule  for  the  future  for  all  purposes,  including,  for  example,  the 
rules  with  respect  to  the  size  of  the  credit  base,  which  include  an 
80  percent  U.S.  production  test  and  exclude  expenses  of  foreign  pro- 
duction from  the  credit  base. 

The  election  to  use  the  general  rule  for  the  future  for  section  50 
films  would  have  to  be  made  within  one  year  after  the  date  of  enact- 
ment of  this  Act,  in  a  manner  to  be  prescribed  in  regulations.  The 
election  would  have  to  apply  to  all  of  the  taxpayer's  section  50  films, 
and  the  election,  once  made,  could  not  be  revoked  without  the  consent 
of  the  Internal  Revenue  Service.  Other  rules  with  respect  to  use  of 
this  method  for  the  past  may  also  be  prescribed  b}'  regulations. 


8  Thp  Concress  is  concerned,  however,  that  this  procedure  should  not  unnecessarily 
delay  the  allowance  of  the  credit  in  cases  where  it  is  reasonably  clear  that  there  is  only 
one  "lausible  person  who  has  a  ripht  to  claim  the  credit.  The  Congress  intends  that  the 
Service  will  develop  such  reporting  and  other  procedures  as  it  deems  necessary  to  deter- 
mine whether  there  is  a  like'ihood  that  several  persons  ma.v  claim  a  credit  with  re5;peet  to 
the  same  film,  and  that  where  there  is  no  such  likelihood,  allowance  of  the  credit  will  not 
be  unduly  delayed. 


186 

Taxpayers  who  have  already  litigated 

Some  taxpayers  have  already  litigated  the  issues  outlined  above  for 
certain  prior  years.  The  Congress  believes  that  these  taxpayers  should 
be  entitled  to  the  fruits  of  their  litigation  because  of  the  substantial 
eifoit  and  expense  which  they  have  incurred  in  connection  with  their 
suits.  Accordingly,  the  Act  provides  that  any  taxpayer  who  has  filed 
a  petition  before  any  court  before  January  1,  1976,  with  respect  to  his 
entitlement  to  the  investment  credit  for  any  prior  year,  may  elect 
(within  90  days  after  the  date  of  enactment)  to  have  his  right  to  the 
investment  credit  for  all  taxable  years  beginning  prior  to  January  1, 
1975,  determined  under  prior  law,  as  interpreted  by  the  courts,  rather 
than  under  one  of  the  methods  prsecribed  in  this  Act.  (As  an  alterna- 
tive, taxpayei-s  who  have  filed  suit  prior  to  January  1,  197G,  may  elect 
to  have  their  credit  determined  under  prior  laAV  for  yeai-s  prior  to  1971, 
and  elect  the  general  rule  for  the  future  for  all  their  section  50  prop- 
erty.) But,  of  course,  issues  which  have  not  already  been  resolved  by 
court  proceedings  (such  as  predominant  foreign  use,  the  size  of  the 
credit  base,  etc.)  must  be  settled  by  further  litigation,  and  it  is  intended 
that  no  inference  be  drawn  from  the  provisions  of  this  Act  as  to  how 
such  issues  should  be  resolved  under  prior  law. 

Generally,  under  this  procedure,  a  taxpayer  wishing  to  make  an 
election  under  these  provisions  may  do  so  by  mailing  a  letter  to  this 
effect  to  the  Commissioner  of  Internal  Revenue  within  the  90-day 
period.  Any  such  election  is  to  be  irrevocable. 

Taxpayers  relying  on  litigation  to  determine  their  credits  for  past 
yeare  still  must  use  either  the  general  rule  for  the  future  or  the  90- 
percent  method  for  all  taxable  years  beginning  after  December  31, 
1974. 

Effective  dates 
The  effective  dates  of  these  provisions  have  been  described  above. 
In  general,  the  rules  with  respect  to  the  general  rule  for  the  future  and 
the  90-percent  method  apply  to  films  placed  in  service  in  taxable  years 
beginning  after  December  31,  197-±.  In  general,  taxpayers  may  use 
either  the  90-percent  or  the  40-percent  method  for  all  prior  years,  but 
may  alternatively  elect  to  use  the  general  rule  for  the  future  for  all 
section  50  property. 

Revenue  effect 
It  is  estimated  that  the  f)rovisions  of  this  section  will  result  in  a  rev- 
enue cost  of  $37  million  for  fiscal  year  1977,  $18  minion  for  fiscal  year 
1978,  and  $3  million  for  fiscal  year  1981  and  each  year  thereafter. 

5.  Investment  Tax  Credit  in  the  Case  of  Certain  Ships  (sec.  805  of 
the  Act  and  sec.  46(g)  of  the  Code) 

Prior  law 
The  tax  on  income  deposited  into  a  capital  construction  fund  (estab- 
lished under  section  21  of  the  Merchant  Marine  Act  of  1970)  for  the 
construction  of  certain  vessels  is  deferred  until  funds  are  withdrawn 
from  the  fund  for  certain  purposes.  When  the  funds  are  withdrawn  to 
purchase,  construct,  or  reconstruct  a  qualified  vessel,  there  is  no  tax 
basis  in  the  purcliased  vessel  to  the  extent  of  the  withdrawal.  Under 


187 

prior  law,  this  reduced  the  amount  of  investment  credit  available  on 
the  purchased  vessel. 

Reasons  for  change 

The  Merchant  Marine  Act  was  amended  and  the  tax  treatment 
accorded  domestic  shipping  was  substantially  revised  when  the  in- 
vestment credit  was  not  in  effect  (1970).  As  a  result,  the  Congress 
did  not  at  that  time  address  itself  to  the  question  of  whether  the  in- 
vestment tax  credit  should  be  available  in  the  case  of  a  vessel  con- 
structed with  funds  withdrawn  from  the  tax-deferred  capital  con- 
struction fund.  In  addition,  since  the  tax  jDrovisions  relating  to  the 
capital  construction  fund  are  in  the  Merchant  Marine  Act  of  1936 
rather  than  in  the  Internal  Revenue  Code,  this  question  was  not  re- 
viewed wlien  the  investment  credit  was  subsequently  restored. 

The  Congress  believes  that  denying  the  investment  credit  in 
the  case  of  ships  built  from  monies  taken  from  tax-deferred  construc- 
tion funds  has  the  effect  of  substantially  reducing  the  inducement  to 
set  funds  aside  for  ship  construction  rather  than  using  them  for  other 
forms  of  capital  formation  for  which  the  investment  credit  is  available. 
It  is  the  understanding  of  the  Congress  that,  in  fact,  the  funds  set 
aside  for  this  purpose  since  the  restoration  of  the  investment  credit 
generally  have  been  nuich  more  limited  than  was  previously  estimated. 
The  Congress  believes  it  is  a  matter  of  national  concern  that  the  U.S. 
shipping  industry  have  a  modern  fleet  and  be  competitive  in  world 
markets.  This  is  necessary  from  the  standpoint  of  our  international 
trading  position  as  well  as  from  the  standpoint  of  having  a  fleet  in 
place  upon  which  the  United  States  can  call  in  times  of  international 
crisis.  As  a  result,  the  Congi-ess  concluded  that  it  was  undesirable  to 
limit  the  incentive  of  the  capital  construction  fund  by  denying  the 
full  investment  credit  for  monies  Avitlidrawn  from  this  fund  for  ship 
construction  while  the  investment  credit  is  available  for  many  other 
forms  of  capital  investment. 

Explanation  of  provisions 

The  Act  provides  for  an  investment  credit  of  one-half  the  regular 
credit  on  the  tax-deferred  amounts  withdrawn  from  the  capital  con- 
struction fund  which  are  used  to  purchase,  construct,  or  reconstruct 
qualified  vessels.  In  addition,  Congress  intends  that  taxpayers  are  to 
have  the  right  to  obtain  a  court  determination  as  to  whether  they  are, 
under  already  existing  law,  also  eligible  for  the  other  one-half  of  the 
regular  investment  credit.  Also,  it  is  intended  that  no  inferences  be 
drawn  either  way  on  this  issue  from  the  action  taken  in  this  Act. 

If  a  taxpaj^er  claims  the  full  investment  credit  on  its  tax  return,  it 
is  expected  that  the  Internal  Revenue  Service  will  provide,  by  regula- 
tions, procedures  which  will  require  the  taxpaj^er  to  indicate  on  its  re- 
turn that  the  full  investment  credit  is  being  claimed.  This  will  alert 
the  Internal  Revenue  Service  to  the  position  taken  by  the  taxpayer 
on  this  point.  If  the  IRS  asserts  a  deficiency  in  this  case,  the  taxpayer 
has  the  option  of  pursuing  its  claim  for  the  full  credit  in  the  Tax 
Court.  In  addition,  the  taxpayer  may  fie  a  claim  for  a  refund  which 
w^ill  allow  the  taxpayer  to  pursue  its  claim  with  the  Court  of  Claims 
or  in  the  District  Courts. 

Where  a  taxpa3'er  purchases  a  ship  with  borrowed  funds  and  uses 
the  capital  construction  fund  to  pay  off  the  indebtedness,  there  ini- 


188 

tially  will  be  allowed  a  full  investment  credit  and  then  subsequently 
there  is  to  be  a  recapture  of  no  more  than  50  percent  of  the  amount  of 
the  investment  credit  taken  on  the  purchase  price  of  tire  ship  repre- 
senting the  indebtedness  which  is  bei  g  liquidated  with  tax  deferred 
amounts  from  the  capital  construction  fund. 

Ejfective  date 
The  Act  applies  to  taxable  years  beginning  after  December  31, 1915. 
No  inference  is  to  be  drawn  from  this  provision  legarding  the  applica- 
tion of  law  with  respect  to  the  availability  of  the  credit  for  prior 
years. 

Revenue  effect 
This  provision  will  result  in  a  reduction  of  $13  million  in  budget 
receipts  in  fiscal  year  1977,  $12  million  in  fiscal  year  1978,  and  $:?3 
million  in  1981. 

6.  Net  Operating  Losses 

a.  Net  Operating  Loss  Carryover  Years  and  Carryback  Election 
(sec.  806(a)-(d)  of  the  Act  and  sees.  172,  812,  and  825  of  the 
Code) 

Prior  law 

Prior  law  provided  that  both  individual  and  corporate  tax- 
payers in  general  were  allowed  to  carry  a  business  net  operatmg 
loss  back  as  a  deduction  against  income  for  the  three  taxable  years  pre- 
ceding the  years  in  which  loss  occurred  and  to  carry  an}'  remaining  un- 
used losses  forward  to  the  five  years  following  the  loss  year  (sec.  172). 
Under  this  general  rule,  taxpayers  could  balance  out  income  and  loss 
over  a  moving  9-year  period.  Insurance  companies  were  also  allowed 
3-year  carryback  and  5-year  carryover  periods  for  their  losses,  either 
under  the  general  rule  (section  172)  or  under  separate  rules  in  sub- 
chapter L.  Exceptions  to  the  general  3-year  carryback  and  five-year 
year  carryover  rule  have  been  provided  in  the  case  of  certain  i]idus- 
tries  or  categories  of  taxpayers.  One  exception  allowed  certain  regu- 
lated transportation  corporations  to  carry  baciv  net  operating  losses 
for  the  usual  3  years  and  to  carry  over  such  losses  for  7  years.^ 

A  net  operating  loss  is  required  to  be  applied  against  income  from 
other  taxable  years,  beginning  with  the  earliest  year  to  which  the  loss 
may  be  carried.  For  example,  if  a  business  taxpayer,  subject  to  the 
general  3-year  carryback  and  5-year  carryover  rule,  had  a  net  operat- 
ing loss  for  1976,  the  loss  would  be  carried  first  to  reduce  or  eliminate 
taxable  income  (if  any)  reported  for  1973,  and  to  the  extent  any  of 
the  loss  remained  unused,  it  would  then  be  successively  applied  against 
any  income  reported  for  1974  and  1975.  Any  of  the  1976  loss  unab- 
sorbed  by  these  three  carryback  years  would,  then  be  used  as  a  deduc- 

1  Another  exception  prohibits  the  carryback  of  a  net  operating  loss  to  the  extent  the 
net  oi)erating  loss  was  attributable  to  a  foreign  expropriation  loss.  However,  a  10-year 
carryover  period  is  allowed  for  the  foreign  expropriation  loss  (15  years  in  the  case  of  a 
Cuban  expropriation  loss  under  prior  law,  now  20  years  under  section  2126  of  the  Act). 
A  third  exception,  applicable  to  financial  institutions  Tor  taxable  years  beginning  after 
December  31,  1975,  lengthens  the  carryback  period  for  net  operating  losses  to  10  years 
and  allows  the  usual  5-year  carryover  period.  Similarly,  a  bank  for  cooperatives  is  allowed 
to  carry  net  operating  losses  back  for  10  years  and  forv^ard  for  5  years.  Finally,  prior 
law  al.so  contained  a  provision  designed  for  America  Motors  Corporation  which  permitted 
a  5  year  carryback  period  and  a  carryover  perior  of  3  years  for  losses  incurred  for  taxable 
years  ending  after  December  31,  1966,  and  prior  to  January  1,   1969. 


189 

tion  on  the  taxpayer's  returns  for  the  succeeding  five  years,  begin- 
ning with  1977.  Any  loss  remaining  after  it  had  been  successively 
applied  in  these  five  years  expires,  and  the  taxpayer  loses  the  benefit 
of  this  unused  loss. 

Reasons  for  change 

Adverse  economic  conditions  in  recent  years  have  caused  many 
business  taxpayers  to  incur  sizable  net  operating  losses.  In  many 
cases  there  is  some  doubt  that,  because  of  the  severity  of  the  losses 
and  the  delay  in  the  economic  recovery,  these  taxpayers  will  generate 
sufficient  income  during  their  existing  carryover  periods  to  enable 
them  to  use  their  large  operating  loss  carryovers.  In  order  to  reduce  the 
possibility  that  a  similar  situation  will  arise  in  the  future,  Congress 
decided  to  increase  the  loss  carryover  period  by  two  additional  years 
for  taxpayers  subject  to  the  general  carryback  and  carryover  rules  and 
for  special  category  taxpayers  with  similarly  short  periods  for  absorb- 
ing operating  losses. 

In  addition,  in  some  cases  where  net  operating  losses  have  been 
carried  back  to  reduce  or  eliminate  income  reported  in  prior  years, 
the  loss  carrybacks  have  caused  investment  and  foreign  tax  credits 
carried  over  to  these  prior  years  to  expire  unused  because  of  the 
limited  carryover  periods  allowed  for  the  tax  credits. 

To  alleviate  this  problem  the  Act  provides  an  election  for  any  tax- 
payer with  a  loss  carryback  period  to  relinquish  the  carryback  period 
for  any  loss  year.  Because  of  the  interaction  of  the  net  operating  loss 
rules  and  other  provisions  of  the  Code,  a  net  operating  loss  cai'i-ybnck 
can  in  some  cases  actuall}-  increase  a  taxpayer's  aggregate  tax  liability 
over  the  9-year  carryback  and  carryover  period.  For  example,  if  a  tax- 
payer has  a  loss  to  be  carried  back  and  if  m  the  carryback  year  the  tax- 
payer had  foreign  source  income  which  resulted  in  no  U.S.  tax  liability 
because  of  foreign  tax  credits,  the  net  operating  loss  carrybacks  would 
merely  displace  the  foreign  source  income  and  accompanying  foreign 
tax  credits  without  providing  any  tax  benefit.^ 

Explanation  of  provisions 
The  Act  makes  two  changes  to  prior  law.  First,  the  loss  carryover 
period  is  increased  by  two  years  for  taxpayers  covered  by  the  general 
rule  (3-year  carryback  and  5-year  carryover)  and  similarly  situated 
taxpayers  with  relatively  short,  periods  to  which  their  losses  may  be 
applied.  Specifically,  the  two  additional  loss  carryover  years  are  avail- 
able to  taxpayers  subject  to  the  general  3-year  carryback  and  5-year 
carryover  general  rule,  and  regulated  transportation  corporations. 
In  addition,  the  Act  also  extends  the  additional  carryover  years  to 
insurance  companies  taxable  under  subchapter  L  of  the  income 
tax  provisions  (sees.  801-844),  all  of  which  had  3-year  carry- 
back and  5-year  carryover  periods,  either  under  the  general  rale  (sec- 
tion 172)  or  under  separate  provisions  in  subchapter  I.  As  a  result, 
these  taxpayers,  except  for  regulated  transportation  corporations,  will 
have  a  7-year  loss  carryover  period.  Regulated  transportation  cori:)ora- 
tions  will  have  a  9-year  loss  carryover  period.  The  two  additional 


2  Furthermore  the  foreign  tax  credits  could  be  carried  forward  only  five  years  from 
the  carryback  year  ;  under  the  Act  the  net  operating  losses  could  be  carried  forward  for 
seven  years  from  the  current  year. 


190 

carryover  yenrs  are  not  available  to  taxpayers  with  foreign  expropria- 
tion losses  or  to  real  estate  investment  trusts,  financial  institutions,  or 
banks  for  cooperatives. 

The  second  change  made  by  these  provisions  of  the  Act  concerns  the 
net  operating  loss  carr^'back  period.  An  election  is  provided  for  any 
taxpayer  with  a  loss  carryback  period  under  section  172  or  under  sub- 
chapter L  to  forego  its  entire  carryback  period  for  an  operating  Joss. 
The  election  may  not  be  made  to  forego  only  part  of  the  carryback 
period  for  an  operating  loss. 

The  election  is  available  for  any  taxable  year  for  which  there  is  an 
operating  loss  and  must  be  made  by  the  due  date  (including  extensions 
of  time)  for  filing  tlie  return  for  the  taxable  year  of  the  operating  loss. 
Once  made,  the  election  is  irrevocable  for  that  taxable  year  but  has  no 
effect  on  an  operating  loss  reported  for  any  other  taxable  year. 

Effective  date 
These  provisions  are  effective  for  losses  incurred  in  taxable  years 
ending  after  December  3il,  1975. 

Revenue,  effect 
The  provision  is  expected  to  have  a  negligible  effect  on  revenues  in 
years  before  1982. 

6.  Special  Limitations  on  Net  Operating  Loss  Carryovers  (sec. 
806(e)  of  the  Act  and  sees.  382  and  383  of  the  Code) 

Prior  law 

Prior  law  (sec.  382(a)  ^  provided  that  where  new  owners  buy  50 
percent  or  more  of  the  siock  of  a  loss  corporation  during  a  2-year  pe- 
riod, its  loss  carryovers  from  prior  years  were  allowed  in  full  if  the 
company  continued  to  conduct  its  prior  trade  or  business  or  substan- 
tially the  same  kind  of  business.  It  could  add  or  begin  a  new  business, 
however,  and  apply  loss  carryovers  incurred  by  the  former  owners 
against  profits  from  the  new  business  (unless  tax  avoidance  was  the 
principal  purpose  for  the  acquisition).  If  the  same  business  was  not 
continued,  however,  loss  carryovers  were  completely  lost.  In  the  case 
of  a  tax-free  reorganization,  loss  carryovers  were  allowed  on  a  de- 
clining scale  (sec.  382(b) ).  If  the  former  owners  of  the  loss  company 
received  20  percent  or  more  of  the  fair  market  value  of  the  stock  of 
the  acquiring  company,  the  loss  carryovers  were  allowed  in  full. 
For  each  percentage  point  less  than  20  which  the  former  owners  re- 
ceived, the  loss  carryover  was  reduced  by  5  percentage  points.  It  was  im- 
material whether  the  business  of  the  loss  company  was  continued 
after  the  reorganization  (sec.  382(b) ) . 

The  former  "purchase"  rule  of  section  382(a)  applied  where  one 
or  more  of  the  10  largest  shareholders  increased  their  stock  ownership, 
within  a  2-year  period,  by  50  percentage  points  or  more  in  a  transac- 
tion in  which  the  purchasers  took  a  cost  basis  in  their  stock  (except 
where  the  stock  was  acquired  from  "I'elated"  persons  within  the  con- 
sti-uctive  ownership  relationships  described  in  section  318  of  the 
Code.)  The  constructive  ownership  rules  of  section  318  applied,  with 
some  modifications,  in  determining  the  ownership  of  stock  for  pur- 
poses of  section  382  ( a ) . 

Section  382(a)  also  became  operative  if  a  person's  stock  ownership 
increased  by  at  least  50  percentage  points  by  reason  of  a  decrease  in 


191 

total  outstanding  stock,  such  as  occurs  in  a  redemption  of  stock  owned 
by  other  shareholders  (except  redemptions  under  sec.  303  to  pay  death 
taxes). 

Section  383  incorporates  by  reference  the  same  limitations  as  are 
contained  in  section  382  for  carryovers  of  investment  credits,  work  in- 
centive program  credits,  foreign  tax  credits,  and  capital  losses. 

The  tax  law  also  contains  a  general  i)rovision  which  authorizes  the 
Treasuiy  to  disallow  a  net  operating  loss  carrj^over  where  any 
persons  acquire  stock  control  of  a  corporation  foi'  the  principal  pur- 
pose of  evading  or  avoiding  Federal  income  tax  by  obtainiug  a  bene- 
fit which  such  persons  would  not  otherwise  have  obtained  (sec.  269 
(a)  (1)).  A  similar  rule  also  applies  to  tax  free  acquisitions  of  one 
corporation's  assets  by  an  uni-elated  corporation  where  the  acquiring 
company  takes  a  carryover  basis  in  such  assets  (sec.  26D(a)(2)). 
For  purposes  of  these  rules,  control  means  ownership  of  at  least  50 
percent  of  the  total  combined  voting  power  of  voting  stock  or  at  least 
50  percent  of  the  total  value  of  all  classes  of  stock. 

Reasons  for  change 

In  genera],  the  limitations  contained  in  sections  382,  383,  and  269 
recognize  that  any  rules  which  permit  an  operating  loss  (or  other 
tax  deductions  or  credits)  to  contiinie  despite  a  substantial 
change  in  shareholders  can  be  manipulated  for  tax  avoidance  pur- 
poses. For  example,  a  free  traffic  in  loss  carryovers  could  result  in 
large  windfalls  for  buyers  of  stock  or  assets  who  could  take  advan- 
tage of  the  weak  bargaining  position  of  the  existing  owners  of  a  loss 
business  and  acquii-e  large  carryovers  for  substantially  less  than  their 
tax  value.  Such  buyers  are  effectively  buying  a  tax  shelter  for  their  ex- 
pected future  profits,  whereas  if  the  same  persons  had  used  their 
capital  to  start  a  new  business  on  their  own,  no  such  loss  offsets  would 
be  available. 

On  the  othei  hand,  a  going  business  may  lose  money  for  a  variety 
of  reasons,  such  as  bad  economic  conditions,  competition,  location,  or 
poor  business  judgments  by  its  owners.  In  many  cases  the  loss  can  be 
fairly  well  traced  to  an  inability  or  unwillingness  by  the  existing 
owners  to  see,  or  to  make,  needed  changes.  In  situations  such  as  these, 
tlie  owners  often  seek  out  additional  co-owners  to  help  turn  the  busi- 
ness around  with  fresh  ideas  or  better  management. 

In  several  v.ays  the  former  loss  limitations  did  not  deal  adequately 
with  the  genuine  concerns  which  taxpayers  and  the  Government  have 
in  both  kinds  of  situations  described  above.  Generally,  old 
section  382(a)  covered  stock  acquisitions  and  section  382(b)  covered 
asset  acquisitions.  These  rules  were  not  coordinated,  however.  They 
also  failed  to  cover  some  transactions  where  "trafficking"  in  loss  carry- 
overs could  still  occur,  and  there  were  se\  eral  loopholes.  For  example, 
where  enough  stock  of  a  loss  corporation  was  purchased  for  cash,  car- 
ryovers were  lost  if  the  corporation  did  not  continue  to  carrj'  on  the 
same  kind  of  business  it  had  conducted  previously.  However,  losses 
could  still  be  carried  ovei'  after  a  taxfree  I'eorganization  whether  or 
not  the  same  trade  or  business  was  'continued.  Conversely,  after  a  pur- 
chase of  stock,  losses  could  be  carried  over  in  full  if  the  fonner  busi- 
ness was  continued  even  though  a  new  profitable  business  could  be 


192 

added  to  absorb  the  existing  loss  carryovers ;  but  after  a  reorganiza- 
tion, the  loss  carryover  could  be  reduced  even  if  the  old  business  were 
continued. 

The  former  purchase  rules  required  no  continuity  of  interest  by  the 
former  owners  of  a  loss  company,  since  a  100  percent  change  in  stock 
ownership  could  preserve  all  the  carryovers  if  at  least  the  same 
kind  of  business  was  continued.  By  contrast,  the  reorganization  rules 
required  at  least  20  percent  continuity  by  former  owners  if  carry- 
overs were  to  survive  in  full.  Where  the  purchase  limitations  applied, 
the  loss  carryovers  were  completely  disallowed.  Where  the  reorganiza- 
tion rules  applied,  loss  carryovers  were  merely  reduced  in  proportion 
to  the  change  in  stock  ownership. 

The  rule  that  a  loss  company  must  continue  the  same  business  when 
new  owners  buy  control  of  its  stock  presented  special  problems.  Many 
critics  of  this  test  argued  that  it  is  uneconomic  to  compel  new  owners 
of  a  failing  business  to  continue  to  operate  that  business  if  a  new 
activity  can  be  found  in  which  to  make  profits.  Besides  running  counter 
to  normal  business  practice,  this  test  was  also  difficult  to  apply  in 
specific  cases,  i.e.,  it  was  difficult  for  taxpayers  and  for  the  courts  to 
determine  at  what  point  a  change  in  merchandise,  location  or  size  of 
the  business,  or  a  change  in  the  use  of  its  assets,  should  be  treated  as 
a  change  in  the  business.  The  tax  law  has  also  general!}^  permitted  the 
continuing  owners  of  a  loss  business  to  abandon  that  business  entirely 
but  still  apply  loss  carryovers  from  the  discontinued  activity  against 
profits  from  a  new  business. 

The  reorganization  limitations  did  not  apply  to  a  "B"-tvpe  reorga- 
nization (stock  for  stock).  This  meant  that  a  profitable  company 
could  acquire  the  stock  of  a  loss  company  in  exchange  for  the  profit 
company's  stock,  liquidate  the  loss  company  after  a  reasonable  interval 
(or  transfer  profitable  assets  into  the  loss  company),  and  use  its  loss 
carryovers  without  limit  acrainst  the  future  income  from  profitable 
operations.  Where  a  profitable  company  used  a  controlled  subsidiary  to 
acquire  the  assets  of  a  loss  company  for  stock  in  the  profitable  company, 
the  reorganization  rules  could  also  be  effectively  avoided  because  the 
20  percent  continuity  of  interest  rule  for  the  loss  company's  sharehold- 
ers was  not  applied  by  reference  to  the  percentage  interest  which  these 
shareholders  received  in  the  profitable  company  (sec.  382(b)  (fi) ). 

Full  preservation  of  loss  carryovers  could  also  be  obtained  under 
the  prior  rules  by  issuing  limited  preferred  stock  (voting  or  nonvoting) 
to  the  shareholders  of  a  loss  company,  so  long  as  the  fair  market  value 
of  the  stock  was  at  least  20  percent  of  the  fair  market  value  of  all  the 
acquiring  company's  stock  immediately  after  the  reorganization. 

Congress  reviewed  the  circumstances  under  which  limitations  should 
be  imposed  on  net  operatinir  loss  carryovers,  whether  orio-inatiiiir  with 
the  same  corporation  or  inherited  fi^om  an  acquired  corporation.  Con- 
gress concluded  that  in  light  of  the  longer  caiTjv^v'er  period  permitted 
by  this  Act  (sec.  806(a)),  it  was  important  to  correct  defeats  in  the 
former  rules  of  section  382.  This  meant  closing  loopholes  and  coordinat- 
ing the  rules  for  stock  purchases  and  reorganizations  so  that  they 
operate  in  a  more  equitable  (and  economic)  manner  for  both  taxpayers 
and  the  Government.  The  basic  decision  was  to  tie  the  survival  of  loss 
carryovers  (and  section  383  items)  to  changes  in  the  stock  ownership 


193 

of  a  loss  cojnpany,  and  to  do  so  in  a  way  that  reduces  the  windfall  to 
new^  owners  who'  did  not  uiciir  the  losses  but  also  avoids  hardship  to 
the  continuing  former  owners  (which  would  occur  if  loss  carryovers 
were  eliminated  entirely). 

Explanation  of  proinsions 

The  Act  amends  sections  382  and  383  to  provide  more  nearly  paral- 
lel rules  for  acquisitions  of  stock  and  tax-free  reorganizations  involv- 
ing a  loss  company;  to  eliminate  the  test  of  business  continuity  and 
base  the  rules  solely  on  changes  in  stock  ownership;  and  to  increase 
the  amount  and  kind  of  continuity  of  ownership  required  under  these 
rules. 

The  increased  ownership  standard  applies  to  the  continuing  interest 
in  the  loss  company  held  by  its  former  owners  where  its  stock  is 
acquired  by  new  owners  or  where  the  loss  company  is  the  acquiring 
company  in  a  reorganization.  And,  as  under  prior  law,  where  the  loss 
company  is  acquired  in  a  reorganization,  the  new  standard  applies  to 
the  interest  received  by  the  former  loss  company  owners  in  the  com- 
pany which  acquires  the  loss  company.  The  Act  also  increases  the 
types  of  reorganizations  specifically  covered  by  sec.  382 ;  it  covers  in 
detail  reorganizations  in  Avhich  stock  is  transferred  for  stock  ("B" 
reorganizations)  and  triangular  reorganizations. 

For  purposes  of  new  section  382,  the  continuity  required  of  the 
former  shareholders  of  a  loss  company  is  now^  40  percent.  For  each  per- 
centage point  (or  fraction  thereof)  less  than  40  but  not  less  than  20 
which  the  loss  shareholders  retain  (or  receive) ,  the  allowable  loss  carry- 
over is  reduced  by  3i/^  percentage  points.  For  each  percentage  point 
(or  fraction  thereof)  less  than  20,  the  loss  carryovers  are  reduced  by 
11/2  percentage  points.^ 

These  rules  are,  in  general,  applied  by  reference  to  the  ownershijj 
by  the  former  owners  of  a  loss  company  of  the  lesser  percentage  owner- 
ship of  the  fair  market  value  of  the  "participating  stock"  or  of  the 
fair  market  value  of  all  the  stock  of  the  loss  company  (or,  in  the  case 
of  a  reorganization,  of  the  acquiring  company  if  that  company  is  not 
the  loss  company).*  These  tests  mean,  in  effect,  that  carryovers  can  sur- 
vive in  full  under  the  new  rules  only  if  a  loss  company's  shareholders 
retain  an  interest  in  at  least  40  percent  of  the  continuing  company's  to- 
tal current  value  and  at  least  40  percent  of  its  future  gro-svth.  This  con- 
tinuing interest  must  be  retained  directly  in  the  loss  company  or  re- 


^  This  weighted  scfle  reflects  the  fact  that  for  many  tax  purposes,  such  as  tax-free 
liquidations  under  sec.  332  and  the  filing  of  consolidated  returns,  an  acquisition  of  SO 
percent  ownership  is  virtually  equivalent  to  total  ownership,  so  that  increases  in  owner- 
ship up  to  80  percent  are  usually  more  significant  than  any  particular  ownership  level 
ahove  80  percent. 

*  For  example,  assume  that  profit  company  P  (whose  total  value  is  $600)  acquires  the 
assets  of  loss  company  L  (worth  $400)  in  a  statutory  merger.  The  combined  company 
LP's  capital  structure  consists  of  common  stock  worth  $900  and  voting  preferred  stock 
worth  $100.  Assuming  the  common  stock  qualifies  as  participating  stock,  L's  carryovers 
wi'l  be  preserved  in  full  if  L's  former  shareholders  receive  $400  worth  of  LP  common 
stock  (they  will  have  received  at  least  40  percent  of  the  value  of  participating  stock  and 
40  percent  of  the  value  of  all  stock  combined).  The  same  result  will  occur  if  these  share- 
holders receive  $360  worth  of  common  stock  and  $40  worth  of  voting  preferred  stock  (this 
will  still  constitute  40  percent  of  the  value  of  participating  stock  and  a  total  of  40  percent 
of  the  value  of  all  stock) . 

If  L's  shareholders  receive  $300  worth  of  common  stock  and  $100  worth  of  voting 
preferred  stock,  however,  they  will  have  received  40  percent  of  LP's  total  value  but  only 
3314  percent  of  its  participating  stock.  Consequently,  L's  carryovers  will  be  reduced  by 
reference  to  the  lower  of  these  two  figures,  i.e..  the  reduction  here  will  be  23.3  percent 
(6%  percentage  point  continuity  below  40  times  3%  =23.3  percentage  point  reduction). 


194 

tained  indirectly  through  stock  received  in  a  company  which  acquires 
the  loss  company. 

These  tests  are  to  be  applied,  as  under  prior  law,  by  disregarding 
unissued  or  treasury  stock,  except  where  option  attribution  under 
section  318(a)(4)  is  invoked  with  respect  to  a  warrant,  convertible 
debenture,  or  other  right  to  acquire  stock  directly  from  the  loss 
company. 

The  new  rules  for  both  taxable  and  nontaxable  acquisitions  of  a  loss 
company  apply  to  carryovers  of  operating  losses  incurred  in  the  year 
in  which  an  ownersliip  change  occurs  and  also  to  carryovers  of  earlier 
operating  losses  to  that  year  and  later  years.  The  percentage  reduction 
determined  under  the  new  rules  is  to  be  applied  separately  to  each  of 
these  two  categories.  If,  for  example,  the  percentage  reduction  figiire 
is  35  percent,  carryovers  to  the  change  of  ownership  year  are  to  be 
reduced  by  35  percent  and  the  carryover  of  a  loss  incurred  in  that  year 
is  also  to  be  reduced  by  35  percent. 

Since  section  383  incorporates  the  section  382  rules  for  capital  loss, 
investment  credit,  work  incentive  program  credit,  and  foreign  tax 
credit  carryovers,  the  Act  also  amends  section  383  to  adopt  the  same 
new  rules  for  these  items. 

Purchases^  etc.  of  stock. — The  Act  changes  section  382(a)  to  focus 
on  changes  in  stock  ownership  alone.  The  continuation  of  business  rule 
is  eliminated  along  with  the  former  all-or-nothing  eifect  of  section 
382(a).  It  will  no  longer  be  necessar^^  to  make  detailed  factual  in- 
quiries into  the  different  degrees  or  ways  that  an  existing  business  may 
have  been  changed.  As  a  result,  wlien  a  sufficient  increase  in  stock 
ownership  by  new  owners  occurs,  net  operating  loss  carryovers  will  be 
limited  even  if  the  new  owners  continue  the  same  trade  or  business.  On 
the  other  hand,  where  carryovers  are  allowable  under  the  new  rules,  the 
company  may  change,  contract  or  abandon  an  existing  business  with- 
out affecting  its  loss  carryovers. 

Section  382(a)  continues  to  measure  continuity  by  former  owners 
indirectly  by  looking  to  the  increase  in  new  owners'  percentage  owner- 
ship of  a  loss  company's  stock.  However,  the  Act  raises  the  point  at 
which  a  specified  acquisition  brings  the  limitations  into  play  from  50 
to  more  than  60  percentage  points.  If  the  increase  in  a  buyer's  stock 
ownership  is  greater  than  60  percentage  points,  the  company's  net 
operating  loss  carryovers  are  reduced  by  a  percentage  of  the  carry- 
overs equal  l:o  31/0  percentage  points  for  each  percentage  point  increase 
by  the  buyer  above  60  and  up  to  80  points.  If  the  buyer's  increase  is 
more  than  80  percentage  points,  loss  carryovers  are  also  reduced  by 
11/^  percentage  points  for  each  1  percentage  point  increase  over  80 
and  up  to  100.-^ 

The  shareholders  taken  into  account  under  the  new  section  382(a) 
test  to  determine  the  increases  in  interest  are  those  who  hold  the  15 


^  For  exaniplo,  if  a  buyer  ir.vTeases  his  stork  owuership  during  the  applicable  period 
by  80  percentage  points,  the  loss  carryover  -will  be  reduced  by  70  percent,  i.e.,  20  per- 
centage points  abo\e  the  fiO  percentaL'o  point  threshold  times  3%  =a  70  percent  reduc- 
tion in  net  operating  loss  carryovers.  This  reduction  will  be  made  whether  the  new  owners 
change  the  business  or  continue  it. 

If  the  buyer  Increases  his  ownership  Of  the  applicable  stock  of  a  loss  company  by  90 
percentage  paints,  its  loss  carryovers  will  be  reduced  by  85  percent,  i.e.,  a  70  percent  re- 
duction attributable  to  the  increase  in  stork  ownership  over  60  and  up  to  80  percentage 
points,  pins  another  1.5  percent  reduction  attributable  to  the  increase  in  percentage  points 
over  80  and  up  to  90  (10  percentage  points  times  IM;  =15). 


195 

largest  percentages  of  the  total  fair  market  value  of  all  the  stock  of 
the  company  on  the  last  day  of  its  taxable  year.  (''Participating  stock" 
is  not  used  for  this  determination.)  Once  this  group  is  ascertained,  the 
percentage  point  increase  by  the  group  is  then  determined,  as  discussed 
above,  by  reference  to  the  increase  in  percentage  point  ownership  of 
the  fair  market  value  of  participating  stock,  or  of  all  stock,  of  the 
company,  whichever  increase  is  greater. 

The  relevant  points  for  determining  the  extent  of  any  ownership 
change  as  of  the  end  of  any  taxable  year  are  the  beginning  of  the  year 
under  examination  and  the  beginning  of  the  first  and  second  preceding 
taxable  years.  If  one  or  more  of  these  three  taxable  years  is  a  short 
taxable  year,  an  additional  taxable  year  is  added  to  the  period  for 
each  such  short  j^ear. 

The  new  rules  expand  the  list  of  transactions  governed  by  section 
382(a).  In  all  cases,  the  increase  in  percentage  points  must  be  attrib- 
utable to  one  or  more  of  the  following  types  of  transactions : 

1.  A  purchase  of  stock  of  a  loss  company  from  an  existing  share- 
holder or  from  the  company  itself.  The  term  "purchase"  is  defined  as 
a  cost-basis  acquisition.^ 

2.  A  purchase  of  stock  of  a  corporation  which  owns  stock  in  a  loss 
company ;  or  a  purchase  of  an  interest  in  a  partnership  or  trust  which 
owns  such  stock. 

3.  An  acquisition  by  contribution,  merger  or  consolidation  of  an  in- 
terest in  a  partnership  which  owns  loss  company  stock,  or  an  acquisi- 
tion of  sucli  s*-ock  by  a  partnership  by  means  of  a  contribution,  merger 
or  consolidation.^ 

4.  An  exchange  to  which  section  351  applies,  i.e.,  a  transfer  of  prop- 
erty to  a  loss  company  after  which  the  transferors  own  80  percent  or 
more  of  the  company,  or  an  acquisition  by  a  corporation  of  loss 
company  stock  in  an  exchange  in  which  section  351  applies  to  the 
transferor.^ 

5.  A  contribution  to  the  capital  of  a  loss  company.^ 

6.  A  decrease  in  the  total  outstanding  stock  of  a  loss  company  (or 
in  the  stock  of  a  corporation  which  owns  such  stock) .  This  category 
thus  includes,  but  is  not  limited  to,  a  redemption  from  other  share- 
holders (except  a  section  303  redemption).  In  the  case  of  a  partner- 


8  This  category  InpUide^  n  tavabV  snle  nf  profitable  assets  to  a  loss  company  in  exchange 
for  its  stock,  since  the  seller's  basis  in  the  stock  will  be  his  cost  (fair  market  value)  for 
such   stock.   A  "failed"'  reorganization  can   thus  also  trigger  section   382(a). 

'To  illustrate  the  first  clause  it'  partnership  P-1,  in  w'nch  individuals  A  and  B  are 
equal  partners,  merges  into  unrelated  partnership  P-2,  which  owns  loss  company  stock, 
A  and  B  will  have  acquired  an  interest  in  a  partnership  (P-2)  which  owns  loss  company 
stock.  To  illustrate  the  second  clause,  if  P-2  merged  into  P-1,  A  and  B  will  have  acquired 
(through  I'-l)  a  stock  interest  in  the  loss  company. 

8  This  category  also  includes  an  increase  in  percentage  ownership  of  a  loss  company 
as  a  byproduct  of  a  contribution  to  capital  made  by  another  person.  For  example,  assume 
that  unrelated  individuals  A  and  B  own  -■•  and  ^-'s.  respectively,  of  the  sole  class  of 
outstanding  stock  of  corporation  M.  Separately,  B  also  owns  100  percent  of  the  sole  class 
of  stock  of  loss  company  L  worth  .$25,000.  A  and  B  then  make  pro  rata  contributions 
to  the  capital  of  M  :  A  contributes  .$50,000  cash  and  B  contributes  all  of  his  L  stock.  As 
a  result.  A  will  constructively  own  66%  percent  of  the  stock  of  L  (by  reason  of  his  two- 
thirds  stock  ownership  of  M).  See  sec.  318(a)(2)(C).  This  increase  in  ownership  of  L 
stock  by  a  new  owner.  A,  requires  under  section  382 (a)  a  23M!  percent  reduction  in  L's 
loss  carryovers. 

9  For  example,  loss  company  L's  total  value  is  .$200.  New  investor  N  purchases  all  of 
the  class  A  common  stock  worth  10  percent  ($20)  of  L  from  its  existing  owners,  who 
retain  all  of  the  class  B  common  stock.  N  then  contributes  $800  of  profitable  assets  to 
the  company  under  a  charter  provision  tying  dividends  to  capital  contributions  made 
by  the  shareholders.  The  capital  contribution,  in  this  example,  could  increase  N's  per- 
centage ownership  of  the  total  value  of  L  to  82  percent  ($820/$1000).  If  so,  there  would 
be  an  increase  of  72  percentage  points  attributable  to  the  capital  contribution. 


196 

ship  which  owns  loss  company  stock,  liquidation  by  a  partnership  of 
the  partnership  interest  of  one  or  more  partners,  so  as  to  increase  tlie 
ownei-ship  interest  of  other  partners  in  the  partnership,  is  also  covered. 

7.  Any  combination  of  these  transactions. 

The  above  categories  are  also  intended  to  cover  acquisitions  of  an  in- 
terest in  a  corporation,  trust  or  partnership  which  does  not  own  a 
loss  company's  stock  at  that  time  but  acquires  '■;  later  under  a  pre- 
existing plan. 

Exceptions  are  made  for  the  following  acquisitions : 

1.  Stock  acquired  from  a  person  if  the  stock  is  already  attributed 
to  the  acquirer  because  of  section  318's  constructive  ownership  rules.^° 

2.  Stock  acquired  by  inheritpnce  or  by  a  decedent's  estate  from  the 
decedent  (regardless  whether  the  basis  is  determined  under  section 
1014  or  under  tlie  carryover  basis  rules  of  section  1023) ;  by  gift.;  or 
by  a  trust  from  a  grantor. 

3.  Stock  acquired  by  a  creditor  or  security  holder  in  exchange  for 
relinquishing  or  extinguishing  a  claim  against  the  loss  company,  un- 
less the  claim  was  acquired  for  the  purpose  of  obtaining  such  stock." 

4.  Stock  acquired  by  persons  who  were  full-time  employees  of  the 
loss  company  at  all  times  during  the  36 -month  peiiod  ending  on  the 
last  day  of  the  company's  taxable  year  (or  at  at  all  times  during  its 
existence,  if  that  period  is  shorter).  This  exception  is  not  to  apply, 
however,  to  an  increase  in  the  stock  ownership  of  a  person  who  is  both 
an  employee  and  has  been  a  substantial  shareholder  of  a  loss  company. 

5.  Employer  stock  acquired  by  a  qualified  pension  or  profit-sharing 
trust  or  by  an  employee  stock  ownej-ship  plan  qualifying  under  Code 
section  4975(e)  (7)  or  under  section  301(d)  of  the  Tax  Reduction  Act 
of  1975.^2 

6.  Stock  acquired  in  a  tax-free  recapitalization  described  in  section 
368(a)  (1)(E).^^ 

The  Act  brings  under  section  382(a)  carryovers  of  operating  losses 

i"As  under  prior  law,  the  constructive  ownership  rules  of  section  318  are  incorporated 
by  i-eference  into  section  382(a),  except  that  corporation  to-shareholder  attribution,  and 
vice  versa,  operates  without  regard  to  the  50-per«?ent  threshold  rule  of  sections  318 (a) 
(2)(C)  and  318(a)(3)(C). 

This  exception  operates  only  to  the  extent  of  stock  attributed  to  the  acquiring  person 
under  section  318.  Thus,  for  example,  if  shareholder  A  owns  20  percent  of  the  stock  (by 
value)  of  corporation  M,  which  in  turn  owns  all  the  st  /ck  of  loss  companv  L,  A  wiU  be 
treated  as  owning  constructively  20  percent  (rather  than  100  percent)  of  the  stock  of  L 
pursuant  to  section  318(a)  (2)  (C>.  ' 

As  under  prior  law,  stock  acquired  for  the  purpose  of  invoking  this  exception  will  be 
disregarded  (see  regulation  sec.  1.382(a)-l(e)  (2) ). 

The  exception  for  actual  transfers  of  loss  company  stock  between  related  persons 
is  also  intended  to  apply  if  loss  company  stock  is  transferred  to  a  newly  formed  corpora- 
tion in  the  initial  transfer  of  property  to  the  new  corporation.  Such  a  tran.saction  should 
be  treated  as  if  the  transferors  had  first  become  shareholders  of  the  holding  company 
and  then  transferred  to  't  the  stock  of  the  loss  corporation. 

'1 A  court-supervised  insolvency  proceeding  is  not  required  under  this  exception.  The 
exception  is  also  intended  to  be  available  if  one  or  more  creditors  transfer  their  claims 
to  a  new  corporation  in  a  section  351  exchange  for  stock  in  the  new  corporation.  On  the 
other  hand,  this  exception  does  not  necessarily  preserve  loss  carryovers  following  a  dis- 
charge in  a  Bankruptcy  Act  proceeding  if,  under  applicable  judicial  authority,  such  a 
discharge  ipso  facto  eliminates  any  losses  to  be  carried  to  future  years. 

"This  exception  covers  only  the  a.'quisition  of  stock  of  the  emi)lover  company  (or  a 
parent  or  subsidiary  of  such  company)  by  the  employee-beneficiaries  of  the  b'-ne/it  plan. 
The  trust  must  also  benefit  such  employees  exclusively.  However,  this  exception  is  not 
intended  to  apply  to  collectively  bargained  plans  or  multi-employer  plans  within  the 
broadened  meaning  of  "exclusive  benefit"  in  sections  413(b)(3)   and    (c)(2)   of  the  Code. 

"This  exception  may  not  apply  to  a  recapitalization  and  acqiisition  which  together 
result  in  increased  owne-ship  bv  outside  investors.  Tie  Service  may  examine  such 
a  recapitalization  and,  if  appropriate  in  the  situation,  treat  it  as  'pnrt  of  a  sten 
transaction  which  is  subject  to  the  rules  of  section  382  without  regard  to  this  exception. 
This  exception  will  also  not  apply  if  an  outsider  acquires  stock  for  purposes  of  participat- 
ing in  a  recapitalization. 


197 

from  earlier  taxable  years  to  the  taxable  year  at  the  end  of  which  an 
over-60  percentage  point  increase  in  stock  ownership  has  occurred,  and 
also  carryovers  of  an  operating  loss  incurred  in  the  latter  year  itself. 
However,  the  Act  also  adopts  a  "minimum  ownership"  rule  (sec. 
382(a)(3)),  under  which  an  operating  loss  incurred  in  the  latter 
acquisition  year  can  be  carried  over  in  full  to  later  years  if  the  persons 
who  increased  their  ownership  by  over  60  percentage  points  owned 
at  least  40  percent  of  the  fair  market  value  of  the  participating  stock, 
and  of  all  the  stock,  of  the  loss  company  during  the  entire  last  half 
of  the  acquisition  year.^* 

If  the  company's  stock  ownership  changes  again  before  losses  being 
carried  over  under  the  minimum  ownership  rule  have  expired,  the 
furtlier  change  in  o^^'nership  must  be  separately  tested  under  section 
382,  As  a  result,  losses  being  carried  forward  from  a  minimum  owner- 
ship year  may  be  reduced  as  further  carryovers  by  reason  of  the  later 
transaction.  The  mininuim  ownership  rule  is  also  available  with  respect 
to  an  oj^erating  loss  incurred  in  the  first  or  second  taxable  year 
preceding  tlie  acquisition  year  (these  are  other  years  in  the  "lookback 
period"  from  the  end  of  the  taxable  year  being  tested  under  section 
382(a)).  However,  this  rule  does  not  prevent  a  reduction  in  loss 
carryovers  from  earlier  years  to  a  year  when  the  minimum  ownership 
rule  is  satisfied.^^ 

Operating  losses  of  a  corporation  incurred  in  its  first  taxable  year 
are  also  excepted  from  the  carryover  limitations  of  sec.  382(a).  This 
exception  will  permit  the  organizens  of  a  corpo^'ation  to  take  in  addi- 
tional investors  during  the  course  of  its  first  year  without  adversely 
affecting  the  carryover  of  an  operating  loss  incurred  in  that  first  year 
of  the  new  venture. 

The  Act  contains  a  successive  .application  rule  (sec.  382(a)(6)), 
providing  that  if  a  loss  carryover  has  been  once  reduced  under  section 
38L(a),  and  if  the  new  owners  do  not  increase  their  interest  further 
during  the  following  two  years,  the  same  carryover  will  not  be  reduced 
again  under  section  382(a)  at  the  end  of  either  later  year.^^ 
On   the  other  hand,   if  the  persons  whose   increase  in  ownership 


^»  Since  the  general  rule  of  section  .S82(a)(l)  is  triggered  by  sliareholders  whose  stock 
ownership  of  a  loss  company  increases,  and  the  minimum  ownership  rule  operates  as  a 
limited  exception  to  the  general  rule,  the  minimum  ownership  rule  is  itself  triggered  only 
by  those  among  the  15  largest  shareholders  whose  increase  in  ownership  would  otherwise 
bring  the  general  rule  into  effect.  For  example,  assume  that  individual  A  owns  100  percent  of 
the  sole  class  of  stock  of  a  calendar  year  loss  company  during  all  of  1980.  On  January  2, 
1981,  A  sells  09  percent  of  his  stock  to  unrelated  individual  B.  In  this  case  the  company's 
loss  carryovers  vo  1981  will  be  reduced  by  97  Vj  percent.  The  reason  is  that  B  is  the  only 
shareholder  in  the  group  of  15  whose  stock  ownership  increased  during  the  three  year  period 
ending  on  December  HI.  1981  a«d  B  did  not  have  a  40  percent  minimum  ownership  during 
the  last  half  of  1980.  The  minimum  ownership  rule  would,  however,  allow  aan  operating 
loss  suffered  in  1981  to  be  carried  over  in  full  to  later  years  since  B  did  own  at  least 
40  percent  of  the  loss  company's  stock  during  at  least  all  of  the  last  half  of  1981. 

IS  poj.  example,  assnnie  that  an  outside  investor  buys  40  percent  of  a  loss  company's 
stock  during  the  first  half  of  1980  and  then  buys  an  additional  25  percent  at  any  time  dur- 
ing 1981.  At  the  end  of  198',  loss  carryovers  to  1981  from  before  1980  will  be  scaled  down 
!)y  17  Vi  percent.  However,  the  minimum  ownership  rule  will  permit  a  loss  incurred  in  1981 
to  carry  over  in  full  to  1982  and  later  years.  The  same  rule  also  permits  an  operating  loss 
Incurred  in  1980  to  carry  over  in  full  to  1981  and  later  years  because  the  new  owner  will 
have  owned  a  minimum  40  percent  interest  during  all  of  the  last  half  of  1980. 

i^To  illustrate,  assume  that  nn  o"tside  investor  buys  65  percent  of  the  sole  class  of  a 
calendar  year  loss  company's  stock  in  March,  1980,  and  "stands  still"  for  the  n<^xt  two 
years.  At  the  end  of  19S0.  less  crrvovers  to  1980  will  be  reduced  by  17 '^  percent.  (A  loss  in 
19S0  could  carry  over  in  full,  however,  under  the  minimum  ownership  rule.)  At  the  end  of 
1981  and  1982,  however,  section  .382(a)(1)  would  literally  require  more  reductions  in  the 
unused  balance  of  the  same  carryovers  to  those  later  years  because  a  65  percentage  point 
increase  in  stock  ownership  would  have  cccurred  during  the  lookback  period  from  each  of 
those  lacer  years.  The  successive  application  rule  prevents  such  further  reductions. 


234-120  O  -  77  -  14 


198 

caused  a  reduction  in  carryovers  (or  other  persons  collaborating  with 
them  under  a  concerted  plan)  buy  additional  stock  during;  the  first 
or  second  succeeding  years,  a  further  reduction  in  the  unused  carry- 
overs should  be  made,  based  on  the  total  increase  in  ownership  by  the 
new  owners  during  the  three-year  period.  In  order  to  deal  with  this  sit- 
uation, the  Service  is  authorized  to  provide  regulations  dealing  with 
the  computation  of  the  further  reduction  in  carryovers.^" 

Mergers  and  other  tax-free  reorgaalzations. — Where  a  profit  com- 
pany acquires  the  stock  or  assets  of  a  loss  company  (or  vice  versa)  in 
a  taxfree  reorganization,  section  382(b)  measures  continuity  by  the 
loss  shareholders'  collective  percentage  ownership  of  stock  of  the 
acquiring  company  as  the  result  of  the  reorganization.  As  already  in- 
dictated,  the  new  continuity  test  for  full  survival  of  loss  carryovers  is 
40  percent,  with  a  reduction  of  31/^  percentage  points  in  the  allowable 
carryover  for  each  percentage  point  of  continuing  stock  ownership 
less  than  40  and  down  to  20,  plus  a  reduction  of  II/2  percentage  points 
for  each  percentage  point  of  continuing  stock  ownership  less  than  20. 
As  discussed  above,  these  percentage  tests  are  applied  separately  to 
the  ownership  (by  fair  market  value)  of  the  participating  stock  and 
of  all  stock,  respectively,  of  the  acquiring  company,  and  the  carryovers 
are  reduced  by  reference  to  the  lower  continuity  figure. 

As  under  prior  law,  section  382(b)  continues  to  apply  to  statutory 
mergers  or  consolidations  and  to  C,  D  and  F  reorganizations  (sec,  368 
(a)(1)(C),  (D),  (F),  except  spinoffs  under  section  355.^«  The  Act 
also  brings  under  these  rules  stock  acquisitions  solely  for  voting  stock, 
as  described  in  section  368(a)  (1)  (B).  The  rules  of  section  382'(b)  test 
the  above  reorganizations  both  where  a  loss  company  is  the  acquired 
or  the  acquiring  (or  surviving)  company.^^ 

Tl|e  new  limitations  apply  both  to  operating  loss  carryovers  from 
taxable  years  of  the  loss  company  preceding  its  taxable  year  in  which 
a  reorganization  occurs,  and  to  carrvovers  of  losses  incurred  in  the 
acquisition  year  itself.  However,  a  minimum  ownershi])  rule  allows  an 
operating  loss  incurred  in  the  acquisition  year  to  be  carried  over  in  full 
if  the  other  narty  to  the  reorganization  owned  at  least  40  percent  of 
the  fair  market  value  of  both  participating  stock  and  all  stock  of  the 
loss  company  at  all  times  during  the  last  half  of  the  acquisition  year 

^'  The  Service  is  also  authorized  to  prescribe  rules  relating  to  cases  where  a  share- 
holder whose  acquisition  of  stock  caused  a  reduction  In  carryovers  sells  his  stock  to  other 
new  investors  before  the  reduced  carryovers  are  fully  used  or  expire.  It  may  be  unfair, 
under  some  circumstances,  to  reduce  again  the  carryovers  which  have  already  been 
reduced. 

'^  The  inclusion  of  F  reorganizations  is  not  intended  to  atTect  the  question  of  whether 
an  F  reorganization  can  occur  where  two  or  more  corporations  are  combined  or,  if  so, 
whether  an  F  reorganization  can  occur  if  complete  identity  of  ownership  does  not  exist 
(see  Rev.  Rul.  75-561,  1975-2  C.B.  129). 

As  under  prior  law,  a  purchase  of  stock  followed  by  a  liquidation  under  conditions  which 
give  the  buyer  an  asset  basis  determined  under  section  334(b)(2)  does  not  allow  carry- 
overs to  the  buyer  («ec.  381(a)(1)).  A  liquidation  of  a  less  than  wholly-owned  loss  sub- 
sidiary by  a  controlling  parent  corporation,  in  the  form  of  an  "upstream"  statutory 
merger,  must  also  be  tested  under  section  382(b).  Even  though  the  parent's  tax  treatment 
wi'l  ordinarily  be  governed  by  section  332,  the  transaction  will  ordinarily  be  tested  (as 
under  nrior  law)  as  a  reorganization  as  to  the  subsidiary's  minority  shareholders.  The 
availabili+v  of  the  loss  carryovers  to  the  parent  will  then  depend  on  "the  tests  of  section 
382(b).  These  tests  will  come  into  play  because,  for  pnrnoses  of  section  3S2(b)(l).  the 
trnns-'ction  in  this  example  will  he  a  reorsranization  "described  in"  section  3fi8(a)  (1  )  ( A). 

^^  In  the  case  of  a  C  reorganization  where  the  loss  company  does  not  distribute  the 
stock  it  receives,  the  loss  company's  shareholders  are  treated  as  owning  constructively 
the  undistributed  stock  of  the  acquiring  company  in  proportion  to  the  value  of  their 
stock  interest  in  the  loss  company  (sec.  382(b)  (4)  (C)). 


199 

(sec.  382(b)  (6)  (B)).  This  rule  may  thus  appl}-  to  a  "creepmg"  ac- 
quisition where  the  other  party  to  the  reorganization  (the  acquiring 
or  acquired  company,  as  the  case  may  be)  previously  acquired  stock  in 
the  loss  company.-° 

A  separate  rule  covers  a  situation  where  a  holding  company 
(or  an  operating  company)  which  controls  a  loss  company  merges  or 
otherwise  reorganizes  with  a  profit  company  (regardless  which  com- 
pany acquires  the  o^her).  The  Act  requires,  in  effect,  that  the  stock 
which  the  holding  company's  shareholders  receive  (or  retain)  will 
determine  liow  much  of  the  actual  loss  company's  carryovers  survive 
the  reorganization  (nee.  3Si2(b)  (3)  (A)  ).=^i 

The  Act  revises  the  prior  ownership  i-ule  of  former  section  382(b) 
(5)  without,  however,  intending  any  substantive  change.  This  nile 
dealt  with  the  situation  where,  before  a  merger  or  C  reorganization, 
the  other  party  to  the  reorganization  (typically  a  profit  company) 
already  owned  stock  in  the  loss  company.  In  this  situation,  whether  the 
profit  company  acquires  the  loss  company  or  vice  versa,  the  profit  com- 
pany's stock  interest  is  converted  into  direct  ownership  of  an  equivalent 
portion  of  tlie  loss  company's  assets  and  ceases  to  be  a  stock  interest  in 
the  loss  company.  For  this  situation,  the  former  rule  deemed  the  pre- 
existing stock  interest  to  remain  outstanding  after  the  exchange  in 
order  to  give  proper  '"ci-edit"  to  the  former  owners  of  the  loss  company 
toward  satisfying  continuity  of  interest.  The  Act  reaches  the  same  re- 
sult more  simply  by  adding  to  the  stock  actually  received  by  the  former 
shareholders  of  the  loss  company  constructive  ownership  of  an  addi- 
tional amount  of  the  value  of  the  surviving  company's  stock  equal 
to  tho  value  of  the  preexisting  stock  interest  in  the  loss  company  which 
was  extinguished  in  the  reorganization  (sec.  382(b)  (4)  (B)  ).-"- 

The  prior  ownership  rule  does  not  apply  to  an  aa^uisition  of  a 
loss  company's  assets  in  a  C  reorganization  where  the  loss  company 
does  not  distribute  some  oj*  all  of  the  stock  it  receives.  (See  footnote 
17.)  The  i)rior  ownership  rule  also  does  not  apply  to  a  B  reorganiza- 
tion, for  which  special  rules  are  provided  (see  below). 

=oTlie  iiiinimum  ownprslilp  ruic  Is  not  intendefl  to  apply  where  the  actual  loss  company 
Is  a  third  entity  other  than  the  acquired  or  acquiring  company.  The  minimum  ownership 
rule  excepts  a  loss  carryover  unless  and  until  another  change  in  ownership  of  the  loss 
company  occurs.  At  any  such  later  time,  the  rules  of  section  382  may  require  a  further 
reduction  in  the  continueil  carryover  of  any  remaining  balance  of  the  carryovers. 

^  In  order  for  this  rule  to  apply,  the  company  with  an  operating  loss  carryover  must 
be  a  corporation  other  than  the  actual  acquired  or  acquiring  company.  This  rule  therefore 
does  not  apply  to  a  statutory  merger  of  a  parent  company  with  an  SO  percent  or  greater 
controlled  subsidiary  regardless  which  company  In  fact  has  loss  carryovers  and  regardless 
which  company  is  the  acquiring  company. 

The  minimum  ownership  rule  of  sec.  382(b)(6)(B)  is  intended  to  apply  only  where  the 
company  which  increases  its  ownership  of  the  loss  company  owned  the  re(|uired  miiiimum 
interest  in  the  loss  oompa'  y  before  the  reorganization.  For  example,  assume  fliat  cori)o- 
ration  HC  owns  100  percent  of  the  one  class  of  stock  of  loss  company  L  throughout  calen- 
dar 19S0  and,  in  1981,  unrelated  company  I'  acquires  HC's  stock  in  a  "B"  reorganization. 
Ij  suffers  an  operating  loss  in  1980.  The  minimum  ownership  rule  does  not  apply  to  permit 
L's  1980  loss  to  carry  over  in  full  after  the  exchange. 

--For  example,  assume  that  P,  a  profit  company,  owns  20  percent  (wortli  .SIO.OOO) 
of  the  one  class  of  loss  company  L's  stock  whose  total  value  is  $50,000  and  that 
unrelated  persons  own  the  remaining  $40,000  in  value  of  L's  stock.  The  fair  market 
value  of  P's  one  class  of  stock  is  $100,000.  If  P  acquires  L's  assets  by  merger,  the 
combined  asset  value  after  the  mer:;er  v  11  be  .i;i40,000  ($10,000  of  P's  value  is  extin- 
.guished  in  the  combination).  L's  former  shareholders,  other  tlian  P,  will  actually  receive 
stock  worth  $40,000  in  the  combined  entity.  Under  the  revised  credit  rule,  the  .saiue  group 
of  former  L  shareholders  will  also  own  con.^^ructively  an  additional  $1'>,000  lu  value 
ol  the  surviving  company.  The  total  combined  value,  $G0,000,  will  represent  a  35.7  percent 
eciuity  ownership  of  tlie  combined  company  (the  same  result  reached  by  the  former  rule). 
This  percentage,  in  turn,  will  require  a  15.05  percent  reduction  in  L's  loss  carryovers 
under  the  general  rules  of  section  382(b)  (4.3  percentage  point  continuity  below  40 
times  314  =  15.05  percent  reduction). 


200 

In  order  to  discourage  the  owners  of  a  profit  company  from  arti- 
ficially satisfying  the  continuity  rules  by  buying  stock  in  a  loss  com- 
pany and  then  merging  with  it  within  a  short  period  of  time,  a 
three-year  rule  disqualifies  certain  owners  of  a  loss  company  from 
being  included  in  the  continuity  test  of  section  382(b)  (1)  (sec.  382(b) 
(4)  ( A) ) .  This  rule  applies  to  stock  acquired  in  the  loss  company  witti- 
in  36  months  before  the  reorganization  by  one  or  more  shareholders 
who  own  more  than  50  percent  of  the  fair  market  value  of  the  stock  of 
another  party  to  the  reorganization,  or  by  a  controlled  subsidiary  of 
such  other  party.  Any  such  stock  must  be  disregarded  in  measuring 
continuity  under  section  382(b)  (1).^^ 

A  similar  rule  applies  to  disregard,  in  computing  continuity  of  own- 
ership for  purposes  of  section  382(b)  (1),  stock  in  the  loss  company 
acquired  within  36  months  before  a  reorganization  by  the  other  party 
to  the  reorganization  (section  382(b)  (4)  (B)  and  (5)  (B) )  .2* 

A  liberalizing  change  is  made  in  the  common  ownership  exception 
of  former  section  382(b)  (3),  which  preserved  loss  carryovers  in  full 
if  the  acquired  and  acquiring  corporations  were  owned  substantially  by 
the  same  persons  in  the  same  proportions.  Since  constructive  owner- 
ship rules  did  not  apply  under  this  exception,  it  was  often  difficult  to 
combine  second-tier  subsidiaries  witliin  an  affiliated  group.  The  Act 
makes  clear  that  the  common  ownership  exception  applies  only  to  stock 
ownership,  but  also  adds  limited  constructive  ownership  rules  which 
permit  certain  controlled  subsidiaries  below  a  first  tier  to  be  combined 
with  each  other  without  loss  of  carryovers.  If  the  acquired  or  ac- 
quiring company  is  a  controlled  subsidiary  of  a  third  company,  the 
shareholders  of  the  parent  company  will  be  considered  to  own  the  sub- 
sidiary's stock  owned  by  the  parent  in  proportion  to  the  fair  mar- 
ket value  of  their  stock  in  the  parent  (sec.  382  (b)  (6) )  .^^ 

If  a  loss  company  acquires  the  stock  of  a  profit  company  in  a  "B"  re- 
organization, the  general  rules  of  section  382(b)  will  apply  to  produce 
the  proper  results  (that  is,  continuity  of  ownership  will  be  determined 
by  reference  to  the  stock  owned  by  the  loss  company's  shareholders 
in  their  own  company  after  the  exchange).  However,  if  a  profit  com- 
pany acquires  the  stock  of  a  loss  company,  the  Act  contains  special 

23  For  example,  assiii^e  that  In  1979  A,  an  over-50  percent  Individual  shareholder  in 
profit  company  P,  buys  55  percent  of  the  sole  class  of  stock  of  loss  company  L  and  that 
in  1980  L  mertres  into  P  for  40  percent  of  P's  sole  class  of  stock.  Since  L's  shareholders 
other  than  A  owned  45  percent  of  L,  their  ratable  share  of  the  ownership  of  P  after  the 
merger  is  18  percent  (45  percent  of  40  percent).  L's  carryovers  will  therefore  be  reduced 
by  73  ttercent  (20  percentage  points  below  40  times  314  =70  percent,  plus  2  percentage 
points  below  20  times  1  %  =3  percent). 

-^  These  .3(5-month  rules  in  sections  3S2(b)(4)  and  (5)  (B)  apply  to  purchases 
and  other  acquisitions  covered  by  section  382(a)  other  than  acquisitions  excepted  from 
that  subsection.  The  minimum  ownership  rule  of  section  382(b)(6)(B)  overrides  these 
36-month  rules,  but  only  as  to  the  carryover  of  operating  losses  incurred  in  years  in 
wh'ch  the  minimum  ownership  is  satisfied. 

25  For  example,  if  a  common  parent  company,  P.  merges  L.  a  wholly  owned  loss  sub- 
sidiary, into  S-2,  a  wholly  owned  second-tier  profit  subsidiary  of  P,  the  common  ownership 
exception  will  apply  because  P  will  be  treated  as  being  the  common  owner  of  both  L  and 
S-2.  Similarly,  if  P  causes  two  second-tier  subsidiaries  in  separate  chains  to  be  merged- 
together,  P  will  also  be  treated  as  the  common  owner  of  both  merging  companies. 

The  common  ownership  exception  is  intended  to  apply  only  to  situations  where 
neither  the  acquired  nor  acquiring  company  controls  the  other.  Therefore,  the  exception 
will  not  apply  to  "upstream"  or  "downstream"  mergers  (or  C  reorganizations)  of  a 
parent  company  and  its  controlled  subsidiary.  The  minimum  ownership  rule  of  sec. 
382(b)  (6)  (B)  may  apply,  however,  to  a  downstream  merger  of  this  kind. 


201 

provisions  requiring  the  continuity  rules  of  section  382(b)  to  be 
applied  by  direct  reference  to  the  stock  ownership  of  the  loss  company 
after  the  exchange.  Exchanging  shareholders  will  be  treated  as  owning 
a  percentage  of  the  loss  company's  stock  acquired  by  the  acquiring 
company  equal  to  the  percentage  of  the  latter's  stock  which  such  share- 
holders received  in  the  exchange.-^  This  percentage  will  then  be  com- 
bined with  the  percentage  (if  any)  of  the  loss  company's  stock  which 
its  shareliolders  did  not  exchange.  Where  the  acquiring  company  itself 
owned  stock  in  the  loss  company  before  the  exchange,  such  stock  will 
also  be  counted  toward  satisfying  the  continuity  rule  (except,  as  dis- 
cussed earlier,  for  stock  acquired  wathin  36  months  before  the 
exchange) . 

Under  a  special  rule  in  i:)rior  law  (former  sec.  382(b)  (6)),  a  prof- 
it company  could  arrange  for  a  controlled  subsidiary  to  acquire 
the  assets  of  a  loss  company  for  stock  of  the  parent  company  and  a 
full  carryover  could  be  obtained  if  the  fair  market  value  of  the  loss 
company  shareholders'  stock  in  the  parent  equalled  at  least  20  percent 
of  the  fair  market  value  of  all  the  stock  of  the  acquiring  subsidiary. 
If  the  acquiring  company  were  a  newly  created  shell,  this  rule  would 
almost  always  be  satisfied,  even  though  the  loss  company  sharehold- 
ers' stock  in  the  parent  may  have  been  less  than  a  20-percent  interest 
in  the  parent  (and  thus  less  than  a  20-percent  indirect  interest  in  their 
former  company). 

The  Act  now  requires  that  in  this  type  of  "triangular"  reorganiza- 
tion, the  continuity  rules  are  to  be  applied  by  reference  to  the  loss  com- 
pany shareholders'  actual  percentage  ownership  of  participating  stock 
and  of  all  stock,  respectively,  of  the  parent  company  (sec.  382(b)  (3) 
(B).^"  In  the  case  of  a  triangular  B  reorganization,  where  a  subsi- 
diary of  a  profit  company  acquires  the  stock  of  a  loss  company  in  ex- 
change for  stock  of  the  profit  company,  a  special  rule  requires,  in  ef- 
fect, a  two-step  calculation  converting  the  loss  shareholders'  percentage 
ownership  in  the  parent  of  the  acquiring  company  into  an  equivalent 
])ercentage  ownership  of  the  acquiring  subsidiary  and  then,  in  turn, 
into  an  indirect  percentage  ownership  of  the  loss  company  (sec.  382(b) 
(5)(C)).- 

Rifles  relating  to  stock. — The  statute  narrows  the  exception  in  prior 

^This  rule  excludes  stock  of  the  acquiring  company  which  shareholders  of  the  loss 
company  may  have  owned  before  the  exchange 

'■'''  This  new  rule  also  applies  to  "forward"  and  "revprse"  triangular  reorganiza- 
tions pursuant  to  section  368(a)(2)  (D)  and  (E)  of  the  Code.  It  applies  to  the  situation 
existing  immediately  after  the  exchange  and,  at  that  point,  the  loss  company's  share- 
holders will  own  stock  in  a  corporation  which  controls  the  loss  company. 

^  Ti>  illustrate,  assu!i\e  that  pro'it  company  P  funds  a  new  wholly  owned  subsidiary 
S  with  shares  of  P  stock,  which  S  then  uses  to  acquire  all  the  stock  of  loss  company  L 
in  a  tax-free  B  reorganization  in  exchange  for  20  percent  of  the  participating  stock  and 
of  all  the  stock  of  P.  As  a  result,  L  becomes  a  second-tier  subsidiary  of  P.  Under  the  rule 
stated  above.  L's  shareholders  will  be  deemed  to  own  20  percent  of  the  equivalent  stock  of 
S.  In  turn,  this  interest  will  be  treated  as  a  20-percent  ownership  of  L,  so  that  30  percent 
of  L's  carryovers  will  survive  the  exchange  (20  percentage  point  continuity  below  40  times 
314  =  70  percent  reduction). 

If  S  had  acqui  d  oniy  80  i)ercent  of  L's  stock  for,  say,  17  percent  of  P's  stock,  evchang- 
ing  shareholders  would  be  considered,  by  reason  of  their  receipt  of  P  stock,  to  own  13.6  per- 
cent of  L  after  the  exchange  (17  percent  of  S  s  80  percent  ownership  of  L).  After  adding 
the  20  percent  of  L  stock  not  exchanged,  a  total  of  33.6  percent  continuity  would  result,  so 
that  77.6  percent  of  L's  carryovers  would  survive  the  exchange  (6.4  percentage  point  con- 
tinuity below  40  times  3%  =22.4  percent  reduction). 


202 

law  for  nonvoting  preferred  stock  which  must  be  ignored  for  purposes 
of  section  382.  The  new  exception  is  limited  to  nonvoting  stock  which 
has  fixed  and  preferred  dividends  and  does  not  participate  in  corpo- 
rate growth  to  any  significant  extent,  has  redemption  and  liquidation 
rights  which  do  not  exceed  paid-in  capital  or  par  value  (except  for 
a  reasonable  redemption  premium),  and  is  not  convertible  into  another 
class  of  stock. 

The  Act  also  defines  "participating  stock"  to  mean  stock  (including 
common  stock)  whicli  represents  an  interest  in  the  corporate  eainings 
iind  assets  not  limited  to  a  stated  amount  of  money  or  property  or 
l)crcentage  of  paid-in  capital  or  par  value,  or  by  any  similar  formula. 
The  reorganization  rules  will  thus  not  be  fully  satisfied  by  giving  loss 
company  sliareholders  only  conventional  preferrred  stock  (whether 
looting  or  nonvoting)  .^^ 

The  new  rules  require  the  Service  to  determine  by  regulation 
vvhether  a  variety  of  instruments  (however  denoted)  wliich  may  be 
difficult  to  classify  undei*  gc^neral  definitions  are  to  hv.  considered 
stock  or  participating  stock  for  purposes  of  this  provision.  For  this 
{Hirposo,  the  Service  v.ill  deal  by  regulation  Avith  conversion  and 
f-ali  rights,  rights  iu  earnings  and  assets,  priorities  and  preferences, 
and  similar  factors  (including  collateral  agreements  and  "puts"  back 
to  the  issuing  company)  in  determining  whether  or  not  a  particular 
Distj-unicnt  will  be  treated  as  "stock"'  or  as  "participatirig  stock."-'" 

The  Libson  Shops  doctrine. — In  Lihson  Shops,  Inc.  v.  Kochler.,  35-" 
U.S-  3S-2  (1957),  the  Supreme  Court,  in  a  case  decided  under  the  1939 
Code,  adopted  an  approach  to  the  loss  carryover  area  under  which  loss 
carryovers  would  basically  follow  the  specific  business  activities  which 
gave  rise  to  the  losses.  Some  uncertainty  existed  after  this  decision  as 
io  vvhetiier  the  business  continuity  approach  represents  a  separate, 
nonstatutory  test  for  determining  carryovei^  of  net  operating  losses. 
As  a  result  of  the  changes  made  by  the  Act,  Congress  intends  that  the 
so-called  Lihson  Shops  test  should  have  no  application  to  determining 
net  operating  loss  carryovers  after  stock  purchases  or  reorganizations 
to  tax  years  governed  by  the  now  rules.  However,  Congress  intends 
•hat  no  inference  should  be  drawn  concerning  the  applicability  or 


*'  As  Indicated  earlier,  section  382  Is  applied  In  effect  by  reference  to  the  lesser  percentage 
ct  participating  stock  or  of  all  stock  retained  by  former  owners  of  a  loss  company.  Under 
fiectiou  .SS'ifa),  for  example.  If  a  loss  company  recapitalizes  by  freezing  the  bulk  (e.g.,  95 
percent)  of  its  current  value  Into  voting  preferred  stock,  and  the  balance  into  common  stock 
which  the  owners  then  sell  to  outsiders,  the  iatters'  purchase  may  cause  a  reduction  In 
ca.-rycvers.  Although  the  common  (participating)  stock  represents  only  5  percent  of  the 
company's  current  vi'.lue.  it  also  represents  100  percent  of  Its  future  value.  Since  the  former 
owners  retained  no  share  in  this  future  value,  the  company's  loss  carryovers  wUl  be  elimi- 
nated entirely. 

3"  I'nrter  some  cirrunistances,  fully  participating  preferred  stock  may  properly  be  treated 
as  participating  stock  la  light  of  the  practical  economic  effect  of  its  preferential  right 
tt)  earnings. 

Under  this  delegation,  the  Service  can  also  deal  with  contingent  share  reorganizations 
and  with  nonvoting  preferred  stock  which  obtains  voting  rights  only  if  and  when  certain 
events  occur  (such  as  missing  a  stated  number  of  dividends).  The  delegation  will  also 
permit  the  Service,  on  appropriate  facts,  to  ignore  stock  held  as  security  for  a  loan  to 
the  corporation  (see  regulation  sec.  1.305-3(e),  example  (14)),  or  stock  held  in  escrow 
(st>e  G:oier  I'uckmg  Co.  of  Tewa-a  v.  U.S.,  32S  F.  2d  342  (Ci.  CI.  1964).  This  delegation  also 
gives  the  Service  specific  luithority  under  section  382  to  treat  convertible  preferred  stock 
br  bonds,  warrants  and  other  options  as  equivalent  to  the  underlying  stock  where  appro- 
priate to  prevent  manipulations  of  stock  structures  designed  to  circumvent  the  basic 
policies  underlying  section  382. 


203 

nonapplicability  of  theLibson  Shops  case  in  determining  net  operating 
loss  carryovers  to  tax  years  governed  by  prior  law." 

The  general  tax  avo? dance  test. — Congress  did  not  change  the  basic 
provisions  of  section  209  of  the  Code.  Congress  believes,  however,  that 
section  269  should  not  be  applied  to  disallow  net  operating  loss  carry- 
overs in  situations  where  part  or  all  of  a  loss  carryover  is  permitted 
under  the  sj)ecific  rules  of  section  382,  unless  a  device  or  scheme  to 
circumvent  the  purpose  of  the  carryover  restrictions  appears  to  be 
present.''-  Congress  also  concluded  that  this  general  disallowance  pro- 
vision should  be  retained  for  transactions  not  expressly  within  the 
fixed  rules  of  section  382.  Section  269  is  retained,  for  example,  to  deal 
with  "built-in-loss"  transactions,  other  post-acquisition  losses,  ac(iiiisi- 
tions  expressly  excepted  from  section  382,  and  other  exchanges  or 
transfers  which  are  apparent  devices  to  exploit  continuing  gaps  in  the 
technical  rules  for  tax  avoidance  purposes. 

Effective  date 

In  order  to  allow  a  reasonable  time  for  the  Internal  Revenue  Service 
to  issue  regulations  under  the  new  rules,  the  Act  delays  the  effective 
date  of  the  new  rules  generally  for  one  year.  The  new  rules  apply 
to  reorganizations  pursuant  to  plans  adopted  by  one  or  more  of  the 
parties  on  or  after  January  1,  1978.  A  reorganization  plan  will  be 
considered  adopted  on  the  date  tlie  board  of  directors  adopts  the  plan 
or  recommends  its  adoption  to  the  shareholders,  or  on  the  date  the 
shareholders  approve  the  plan,  whichever  is  earlier.  If  the  new  limi- 
tations affect  a  reorganization  occurring  in  1978,  net  operating  loss 
carryovers  to  1977  from  earlier  years  will  not  be  affected  by  the  new 
rules,  but  carryovers  of  operating  losses  to  1978  and  later  years  may  be 
limited.  A  loss  occurring  in  1977  (or  in  a  fiscal  year  ending  in  1978) 
may  also  be  limited  as  a  carryover  to  1978  (or  to  a  fiscal  year  ending  in 
1979)  and  later  years. 

In  the  case  of  purchases  of  stock  of  a  loss  company  and  other 
acquisitions  subject  to  new  sec.  382(a),  the  new  rules  take  effect  for 
taxable  years  of  a  loss  corporation  beginning  after  June  30,  1978. 


SI  Congress  does  not  Intend  the  changes  In  section  382  to  af?ect  the  "continuity  of  busi- 
ness enterprise"  requirement  which  the  courts  and  the  Service  have  long  established  as 
ii  condition  for  basic  nonrecognltlon  treatment  of  a  corporate  reorganization  (see  sec. 
1.368-1  (b)  of  theregalatlons). 

Congress  also  does  not  Intend  to  deprive  the  Service  of  other  weapons  to  attack  trans- 
actions in  which  the  benefits  of  loss  carryovers  are  Improperly  transferred  In  ways  other 
than  by  transfers  of  stock,  or  transactions  where  section  382  is  otherwise  satisfied  (In 
whole  or  part).  For  example,  the  new  rules  do  not  affect  the  principles  of  substance  over 
form,  step  transaction  (see,  e.g.,  the  examples  In  regulations  sec.  1.382  (b)-l  (c),  corpo- 
rate entity,  assignment  of  income,  or  the  rules  of  Code  sections  482  or  704(b)  (relating 
to  allocations).  Nor  do  the  new  rules  prevent  the  Service,  in  appropriate  cases,  from  chal- 
lenging situations  where  a  loss  company  pays  more  than  fair  market  value  for  stock  or 
assets  of  another  company. 

*•  For  example,  section  269  could  still  apply  to  a  case  where  the  capital  structure  of 
a  company  is  arranged  principally  to  avoid  a  "control"  relationship  under  section  382, 
or  where  a  permanent  Interest  by  former  owners  of  a  loss  company  Is  diluted  for  tax 
avoidance  purposes.  Thus,  If  a  profit  company  buys  less  than  all  the  stock  of  a  loss  company 
and  then  transfers  in  a  short-term  Income  asset  such  as  certain  kinds  of  royalties  or  an 
installment  note  receivable  (or  liquidates  the  loss  company  Into  a  company  which  owns 
such  assets),  section  269  might  still  be  Invoked  If  the  after-tax  benefits  to  the  new  owner 
exceed  the  price  paid  for  the  loss  company's  stock  and  If  the  company  remains  a  shell 
after  the  last  payment  ou  the  receivable  Is  received. 


204 

However,  the  "lookback"  period  under  these  rules  may  include  earlier 
taxable  years.  The  earliest  lookback  point,  liowever,  is  January  1, 1978. 
For  example,  section  382(a)  as  amended  will  take  effect  for  a  calendar 
year  corporation  during  calendar  1979.  The  first  "lookback"  period  for 
a  calendar  year  corporation  under  the  new  rules  will  be  a  transitional 
24-month  period  from  December  31, 1979,  back  to  elanuarv  1, 1979.  and 
then  back  to  January  1,  1978.  When  the  new  rules  become  fully  effec- 
tive, the  lookback  period  will  cover  three  years,  so  that  for  a  corpora- 
tion whose  taxable  year  ends  on  December  31,  1980,  reference  will  be 
made  back  to  the  first  day  of  that  year  and  then  back  to  January  1, 
1979,  and  then  to  January  1, 1978. 

In  this  example,  the  prior  rules  of  section  382(a)  will  govern  the 
allowance  of  loss  carryovers  of  the  company  to  its  calendar  years  1977 
and  1978.  The  new  rules  will  govern  loss  carryovers  from  1978  and 
earlier  years  to  1979  and  later  years.  Although  the  new  rules  will  thus 
not  actually  limit  carryovers  in  this  example  until  1979,  the  new  limi- 
tations may  affect  loss  carryovers  to  1979  from  earlier  years,  as  well  as 
carryovers  from  1979  to  later  years.  Also,  changes  in  stock  ownership 
occurring  during  1978  will  be  taken  into  account  as  part  of  the  look- 
back period  from  December  31, 1979,  for  purposes  of  testing  loss  carry- 
overs to  1979  and  later  years.  This  means  that  changes  in  the  stock 
ownership  of  a  calendar  year  loss  company  during  1978  will  be  taken 
into  account  in  applying  former  section  382(a)  at  the  end  of  1978  and 
also  in  applying  ncAv  section  382(a)  at  the  end  of  1979  and  1980  as 
pai"t  of  the  lookback  period  from  the  end  of  each  of  those  years."*^ 

For  a  fiscal  year  corporation  whose  taxable  year  begins,  for  ex- 
ample, on  July  1,  the  rules  of  prior  section  382(a)  will  govern  loss 
carryovers  to  fiscal  1977  and  1978.  The  new  rules  will  govern  loss  carry- 
overs to  fiscal  1979,  and  for  this  purpose  changes  in  stock  ownership 
measured  by  reference  back  to  stock  ownership  on  July  1,  1978,  and 
on  January  1, 1978,  will  be  taken  into  account.^* 

The  statements  above  concerning  the  relationship  between  the  new 
section  382  rules  and  section  269  of  present  law  and  the  Lihson  Shops 
case  are  intended  to  operate  initially  with  respect  to  the  first  taxable 
year  to  which  carryovers  are  governed  by  the  new  rules  of  section  382. 

Revenue  effect 
It  is  estimated  that,  when  fully  effective  in  1978  and  later  years, 
the  provision  will  increase  budget  receipts  in  light  of  the  reduced  off- 

'2  For  a  calendar  year  company,  chanpes  in  Its  stock  ownership  during  1978  will  thus 
be  taken  Into  account  under  the  "old"  rules  in  testing  loss  carryovers  to  1978.  The  same 
ownership  changes  will  also  be  taken  into  account  under  the  new  rules  in  testing  carryovers 
to  1979  and  later  years.  If  no  change  In  the  stock  ownership  of  a  calendar  year  company 
occurs  during  1978,  new  section  382(a)  will  not  reduce  its  loss  carryovers  to  1979  (unless 
ownership  changes  occur  in  1979).  If  changes  in  stock  ownership  do  occur  during  1978. 
those  changes  may  reduce  (under  the  new  rules)  a  carryover  of  prior  losses  to  1979  and 
Inter  years.  This  reduction  of  carryovers  to  1979  and  later  years  may  occur  even  If  the 
old  rules  (applied  at  the  end  of  1978)  did  not  limit  carryovers  to  1978. 

Similar  principles  also  apply  to  fiscal  year  companies. 

^*  For  a  fisf'nl  year  corporation  whose  tnxa^'le  year  begins  before  July  1.  the  rules  of 
prior  section  382(a)  will  govern  loss  carryovers  to  fiscal  1977,  1978  and  1979.  The  new 
rules  will  govern  loss  carryovers  to  fiscal  1980.  and  for  this  purpose  changes  in  stock 
ownership  measured  by  reference  back  to  stock  ownership  on  the  first  day  of  fiscal  1980 
and  1979  and  on  January  1,  1978,  will  be  taken  into  account. 


205 

set  of  past  losses  against  current  profits.  Howe vcr,  the  amount  of  tlie 
revenue  increase  is  considered  indeterminate  because  the  amount  of  the 
reduction  in  the  use  of  carryovers  depends  on  the  relative  sizes  of  the 
companies  imolved  and  also  because  some  acquisitions  of  loss  com- 
panies by  })rofitable  companis  may  not  be  made. 

7.  Small  Commercial  Fishing  Vessel  Construction  Reserves  (sec. 
807  of  the  Act  and  sec,  607  of  the  Merchant  Marine  Act) 

Prior  laio 
Under  prior  law,  domestic  shipping  vessels  had  to  weigh  at  least  5 
net  tons  in  order  to  be  eligible  for  the  capital  construction  fund  (under 
which  the  tax  on  shipping  income  can  be  deferred  if  placed  in  a  capital 
construction  fund  for  future  use  in  obtaining  additional  ships). 

Reasons  for  change 
In  reviewing  the  operation  of  the  capital  construction  fund.  Con- 
gress was  concerned  that  the  5-ton  limitation  discriminated  unfav- 
orably against  small  shipowners,  especially  those  engaged  in  small 
scale  commercial  fishing-  Accordingly,  Congress  concluded  that  a 
lower  weight  limitation  would  better  achieve  the  general  goal  of  re- 
vitalizing the  U.S.  commercial  fleet. 

Explanation  of  provision 
The  Act  permits  a  commercial  fishing  vessel  which  is  under  5  net 
tons,  but  not  under  2  net  tons,  to  be  an  eligible  vessel  under  the  capital 
construction  fimd  (sec.  607  of  the  Merchant  Marine  Act,  46  U.S.C. 
1177),  if  the  vessel  is  constructed  (or  reconstructed)  in  the  United 
States,  is  owned  by  a  citizen  of  the  United  States,  has  a  home  port  in 
the  T"''nitod  States,  rnd  is  operated  in  the  commercial  fisheries  of  the 
United  States. 

Effective  daze 
The  provision  is  effective  upon  the  date  of  enactment  (October  4. 
1976). 

Revenue  effect 
It  is  estimated  that  this  provision  will  reduce  revenues  by  less  than 
$5  million  a  year. 


H.  SMALL  BUSINESS  PROVISIONS 

1.  Extension  of  Certain  Corporate  Income  Tax  Rate  Reductions 
(Sec.  901  of  the  Act  and  sees.  11  and  821  of  the  Code) 

Prior  law 

Prior  to  the  1975  Tax  Reduction  Act,  corporate  income  was  subject 
to  a  22-percent  normal  tax  and  a  26-percent  surtax  (for  a  total  tax  rate 
of  48  percent).  However,  the  first  $25,000  of  corporate  income  was 
exempt  from  the  surtax.  As  a  result,  the  first  $25,000  of  corporate  in- 
come was  taxed  at  a  22-percent  rate  and  the  income  in  excess  of  $25,000 
was  taxed  at  a  48-percent  rate. 

In  the  Tax  Reduction  Act  of  1975,  the  surtax  exemption  was  in- 
creased to  $50,000  and  the  normal  tax  was  reduced  to  20  percent  on 
the  initial  $25,000  of  taxable  income.  This  resulted  in  a  20-percent  rate 
on  the  first  $25,000  of  income,  a  22-percent  rate  on  the  next  $25,000  of 
income,  and  a  48-percent  rate  on  income  in  excess  of  $50,000.  These 
changes  were  extended  by  the  Revenue  Adjustment  Act  of  1975 
through  June  30, 1976. 

Reasons  for  change 

The  temporary  changes  in  the  corporate  surtax  exemption  provided 
by  the  1975  Tax  Reduction  Act  were  adopted  for  two  reasons :  First,  to 
grant  tax  relief  to  small  businesses  which  are  not  likely  to  derive  sub- 
stantial benefits  from  the  liberalizations  in  the  investment  credit  be- 
cause they  are  not  capital  intensive ;  and  second,  to  provide  temporary 
tax  relief  to  small  business  as  part  of  a  program  of  tax  reduction  de- 
signed to  help  sustain  the  economy  and  promote  economic  recovery. 
These  reasons  for  increasing  the  surtax  exemption  and  lowering  the 
normal  corporate  tax  rate  continue  to  apply  in  the  current  economic 
situation. 

The  changes  in  the  surtax  exemption  and  the  normal  corporate  tax 
rate  made  in  the  1975  Tax  Reduction  Act  did  not  apply  to  mutual 
insurance  companies,  because  of  a  technical  oversight  [resulting  from 
the  fact  that  nuitual  insurance  companies'  tax  rates  are  determined 
under  a  different  section  of  the  Code  (sec.  821)]. 

Explanation  of  provision 
The  Act  extends  the  increase  in  the  surtax  exemption  and  the 
reduction  in  the  normal  tax  rates  through  December  31.  1977,  and 
applies  these  changes  to  mutual  insuranc^i  companies. 

Effective  date 
These  provisions  make  the  changes  in  corporate  tax  rates  and  the 
increase  in  the  surtax  exemption  applicable  in  the  case  of  all  taxable 
years  ending  after  December  31,  1975  and  before  January  1,  1978. 
They  are  made  applicable  to  mutual  insurance  companies  for  taxable 
years  ending  after  December  31,  1974  and  before  January  1,  1978. 

(206) 


207 

Revenite  effect 

This  provision  will  reduce  budget  receipts  by  $1,676  million  in  fiscal 
year  1977  and  $1,177  million  in  fiscal  year  1978. 

In  accordance  with  the  provision's  objective,  the  larger  part  of  the 
resulting  tax  reductions  will  accrue  to  small  corporations.  For  ex- 
ample, about  63  perc^^nt  of  the  aggregate  tax  reductions  resulting 
from  the  liberalized  surtax  exemption  and  the  decrease  in  the  normal 
tax  rate  will  accrue  to  corporations  with  incomes  of  less  than  $100,000, 

2.  Changes  in  Subchapter  S  Rules 

a.  Subchapter  S  Corporation  Shareholder  Rules  (sees.  902  (a)  and 
(c)  of  the  Act  and  sec.  1371  of  the  Code) 

Prior  Ioajo 

Subchapter  S  was  enacted  in  1958  in  order  to  minimize  the  effect  of 
Federal  income  taxes  on  businessmen's  choices  of  the  form  of  business 
organization  in  which  they  conduct  their  businesses,  and  to  permit  the 
incorporation  and  operation  of  certain  small  businesses  without  the 
incidence  of  income  taxation  at  both  the  corporate  and  shareholder 
levels.  The  subchapter  S  rules  allow  corporations  engaged  in  active 
trades  or  businesses  an  election  to  be  treated  for  income  tax  purposes  in 
a  manner  similar  to  that  accorded  partnerships.  Where  an  eligible  cor- 
poration elects  under  the  subchapter  S  provisions,  the  income  or  loss 
(except  for  certain  capital  gains)  is  not  taxed  to  the  corporation,  but 
each  shareholder  reports  a  share  of  the  corporation's  income  or  loss 
each  year  in  proportion  to  his  sliare  of  the  corporation's  total  stock. 

An  election  under  subchapter  S  is  made  by.  and  requires  the  consent 
of,  all  shareholders.  It  may  be  terminated  either  voluntarily  or  invol- 
untarily in  certain  circumstances. 

In  order  to  be  eligible  for  subchapter  S  treatment,  the  stock  owner- 
ship of  the  corporation  must  meet  certain  qualifications.  First,  it  must 
be  a  corporation  with  only  one  issued  and  outstanding  class  of  stock. 
Under  prior  law  the  corporation  was  required  to  have  10  or  fewer 
shareholders,  all  of  whom  were  individuals  or  estates  and  none  of 
whom  were  trusts  or  nonresident  aliens.^ 

For  purposes  of  determining  the  number  of  shareholders,  stock 
which  is  community  property  of  a  husband  and  wife  (or  the  income 
from  which  is  community  property  income)  under  the  law  of  a  com- 
munity property  St«<te  is  treated  as  owned  by  one  shareholder.  Sim- 
ilarly, a  husband  and  wife  are  treated  as  one  shareholder  where  they 
own  the  stock  as  joint  tenants,  tenants  in  common,  or  tenants  by  the 
entirety. 

Rea.'ions  for  change 
One  of  the  most  common  uses  of  the  subchapter  S  election  has  been 
in  the  situation  of  a  family  owned  or  controlled  corix>ration.  During 
the  eighteen  years  that  subchapter  S  has  been  in  effect,  many  corpora- 
tions which  have  been  electing  corporations  during  much  of  this 
period,  and  their  sliareholders,  find  that  their  subchapter  S  status  is 
imperiled  because  of  the  10-shareholder  linvitation.  This  often  occurred 


■  In  addition  to  the  stock  ownership  requirements,  the  corporation  must  be  a  domestic 
corporation  and  may  not  be  a  member  (parent  corporation)  of  an  affiliated  group  of 
corporations  ellgiole  to  file  consolidated  income  tax  returns. 


208 

where  one  of  the  original  shareholders  retires  from  the  family  busi- 
ness and  transfers  the  stock  to  his  children  or  leaves  it  to  them  in  his 
will.  The  death  of  a  spouse  could  also  cause  a  problem  under  this  rule. 
Although  a  husband  and  wife  were  treated  as  one  shareholder,  the 
deceased  spouse's  estate  was  considered  to  be  a  separate  shareholder. 
Because  of  these  difficulties  and  in  order  to  maintain  the  viability  of 
the  subchapter  S  corporation  for  family  o-svned  businesses,  Congress 
decided  to  make  several  changes  in  the  subchapter  S  shareholder  rules. 

Explanation  of  provimms 

The  Act  makes  several  changes  in  the  stock  ownership  rules  in  the 
subchapter  S  provisions.  First,  the  number  of  shareholders  permitted 
in  order  for  a  corjwration  to  qualify  for  and  maintain  subchapter  S 
status  is  increased  from  10  to  15  after  the  corporation  has  been  an 
electing  subchapter  S  corporation  for  5  taxable  years.  Under  this 
rule,  an  electing  corporation  may  have  no  more  than  10  shareholders 
during  the  first  5  years  of  its  subchapter  S  status,  but  may  increase 
its  number  of  qualifying  shareholders  to  15  after  this  period.  The 
5-year  period  in  this  provision  means  5  consecutive  taxable  years  of 
the  corporation. 

Congress  intends  that  once  the  corporation  has  satisfied  the  5-year 
rule  under  any  subchapter  S  election,  it  qualifies  for  the  additional 
5  shareholders  even  though  this  election  has  been  terminated  or  revoked 
and  it  has  subsequently  made  a  new  subcliapter  S  election.  This  is  to 
prevent  a  potential  problem,  where  an  electing  corporation's  status 
is  terminated  or  revoked  after  it  has  satisfied  the  5-year  rule  and  the 
number  of  sliareliolders  has  increased  to  more  than  10.  Under  prior 
statutory  rules,  a  corporation  whose  subchapter  S  status  has  been 
terminated  or  revoked  is  not  eligible,  without  the  permission  of  the 
Secretary,  to  make  a  new  election  for  subchapter  S  treatment  until 
the  sixth  taxable  year  following  the  last  year  the  previous  election  was 
in  effect.  If  the  corporation  were  required  to  satisfy  the  10-shareholder 
5-year  rule  after  this  new  election,  the  rule  could  force  divestitures 
(or  encourage  sham  transactions)  by  as  many  as  5  of  the  shareholders. 
Since  this  rule  avouM  create  hardships  in  some  situations,  such  as  a 
family-owned  small  business.  Congress  believes  that  the  5-year  rule 
should  not  be  required  to  be  satisfied  in  conjunction  with  a  subsequent 
election  where  it  was  previously  satisfied  under  an  earlier  election 
and  the  corporation  had  in  fact  more  than  10  shareholders  on  the  last 
day  of  the  last  taxable  year  covered  by  the  previous  election. 

Othei"  statutory  changes  relate  to  situations  where  ownership  of  a 
subchapter  S  corporation's  stock  changes  as  a  result  of  the  death  of 
a  shareholder.  One  change  provides  an  exception  to  the  5-year  thresh- 
old requirement  to  allow  shareholders  in  excess  of  10  (but  in  no  event 
more  than  15  total  shareholders)  during  the  5-year  period  if  the  initial 
additional  shareholders  acquire  their  stock  by  inheritance. 

In  order  not  to  restrict  the  transferability  of  the  shares  (during  the 
5-year  period)  by  the  inheriting  shareholders,  these  shareholders  may 
sell  or  otherwise  transfer  their  shares  during  the  5-year  period  to  a 
noninheriting  shareholder  without  violating  the  5-year  requirement. 
However,  the  total  number  of  shareholders  during  the  5-year  period 
is  not  permitted  to  exceed  the  number  of  previous  shareholders  plus 


209 

the  number  of  inheriting  shareholders.  For  this  ])urpose,  the  term 
"inheritance"  is  given  a  broad  definition  to  inchide  the  passing  of 
property  by  legacy,  devise  or  intestate  succession. 

Congi-ess  also  decided  to  mitigate  potential  adverse  effects  of  the 
shareholder  rules  where  husband  and  wife  are  treated  as  one  share- 
holder and  one  or  both  of  the  spouses  die.  The  Act  provides  that  where 
either  husband  or  wife,  or  both,  die,  the  estate  of  the  deceased  will  be 
treated  as  one  shareholder  with  the  surviving  spouse  (or  that  spouse's 
estate)  if  husband  and  wife  were  treated  as  one  shareholder  while  botli 
were  living  and  the  stock  continues  to  be  held  in  the  same  proportions 
as  before  death. 

The  final  change  to  the  shareholder  rules  concerns  the  eligibility  of 
trusts  as  shareholders  in  subchapter  S  corporations.  I'^nder  the  Act, 
grantor  trusts  and  voting  trusts  may  be  shareholders  in  a  subchapter 
S  corporation.  A  grantor  trust  is  defined  as  one  treated  as  owned  by 
the  grantor  under  subpart  E  of  part  I  of  subchai:)ter  J  of  the  income 
tax  provisions  (Code  sees.  671-678).  In  addition,  each  beneficial  owner 
of  stock  in  a  voting  trust  will  be  considered  the  shareholder  for  pur- 
poses of  determining  the  number  of  shareholders.  Any  type  of  trust 
may  also  be  a  shareholder  where  it  acquires  stock  in  a  subchapter  S 
corporation  pursuant  to  the  terms  of  a  will.  However,  the  eligibility 
of  trusts  as  subchapter  S  sliareholders  in  this  situation  extends  only 
for  a  period  of  60  days  beginning  with  the  day  on  which  the  trust  ac- 
quired the  stock.  Thereafter,  the  trusit  becomes  an  ineligible  share- 
holder and  retention  of  the  stock  beyond  the  60-day  period  will  cause 
a  termination  of  subchapiter  S  status. 

Effective,  date 
These  provisions  are  effective  for  taxable  years  beginning  after 
December  31, 1976. 

Revenue  ejfect 
The  revenue  loss  from  these  provisions  is  estimated  to  be  negligible. 

6.  Distributions  by  Subchapter  S  Corporations  (sec.  902(b)  of  the 
Act  and  sec.  1377  of  the  Code) 

Prioi'  law 

The  shareholders  of  a  subchapter  S  corporation  are  taxed  each  year 
on  the  income  of  the  corporation,  regardless  of  whether  this  income 
is  distributed  currently  as  dividends  to  the  shareholders.  If  the  share- 
holders of  a  subchapter  S  corporation  have  been  taxed  on  income  of 
the  corporation  which  has  not  been  distributed  to  them,  the  corpora- 
tion in  a  subsequent  year  can  distribute  this  previously  taxed  income 
without  the  shareholders  incurring  any  additional  tax  liability.  How- 
ever, before  a  distribution  will  constitute  a  distribution  of  previously 
taxed  incoii.e,  the  corporation  nmst  first  have  distributed  an  amount 
o(jual  to  its  current  earnings  and  profits  in  tiie  yera-  of  sucii  distribution. 

An  earnings  and  profits  rule  applicable  generall)^  to  corporations 
(sec.  312(m),  enacted  in  1969)  requires  that  the  earnings  and  profits 
of  corporations,  including  subchapter  S  corporations,  be  computed 
using  straight  line  depreciation,  rather  than  the  accelerated  deprecia- 
tion methods  taxpayei-s  may  use  for  computing  taxable  income.  Thus, 
under  prior  law,  where  a  corporation  elects  an  accelerated  deprecia- 


210 

tion  method,  the  earnings  and  profits  of  the  corporation  could  be 
greater  than  its  taxable  income. 

Reasons  for  change 
In  tax  years  vhere  a  subchapter  S  corporation  claimed  an  acceler- 
ated depreciation  deduction  which  exceeded  the  amount  allowable 
under  the  straight  line  method,  the  corporation  had  current  earnings 
and  profits  which  exceeded  its  taxable  income.  If  the  corix)ration  made 
cash  distributions  for  that  year  in  amounts  in  excess  of  its  current 
taxable  income  (which  is  taxed  to  the  shareholders,  whether  dis- 
tributed or  not),  the  oxcess  distributions  were  considered  dividend  in- 
come to  the  stockholders  to  the  extent  that  the  corporation's  current 
earnings  and  profits  exceeded  its  taxable  income.  This  (x*curred 
even  though  the  corpoj-ation  had  undistributed  taxable  income  which 
had  previously  been  taxed  to  the  shareholders.  Congress  decided  that 
this  unintended  interplay  between  tlie  subchapter  S  rules  and  section 
312 (m)  should  be  changed  so  that  a  corporation  can  distribute  pre- 
viously taxed  income  to  the  extent  its  distributions  exceed  its  taxable 
income  even  though,  as  a  result  of  section  312 (m),  its  current  earn- 
ings and  profits  exceed  its  taxable  income. 

E xplan/itiov.  of  jyrovision 

Under  the  Act,  current  year  earnings  and  profits  are  to  be  computed 
without  regard  to  section  312 (m)  solely  for  purposes  of  determining 
whetlier  a  distribution  by  a  subchapter  S  corporation  is  considered  to 
come  from  the  corporation's  previously  taxed  income  or  from  its  cui- 
rent  earnings  and  profits.  As  a  result,  where  the  current  earnings  and 
profits  of  a  subchapter  S  corporation  exceed  its  taxable  income  because 
of  section  312 (m)  for  a  year  when  it  makes  a  cash  distribution  in  excess 
of  its  taxable  income,  that  excess  will,  to  the  extent  of  its  undistrib- 
uted previously  taxed  income,  be  considered  to  be  a  distribution  of 
this  previously  taxed  income.  Consequently,  it  will  not  be  taxable  to 
the  shareholders  and  will  not  reduce  earnings  and  profits  of  the  corpo- 
ration. If  the  distribution  exceeds  the  sum  of  the  previously  taxed  in- 
come and  the  taxable  income  in  the  year  of  distribution,  the  excess 
will  be  considered  a  taxable  dividend  to  the  extent  of  the  current  and 
accumulated  earnings  and  profits,  in  accordance  with  the  rules  gen- 
erally applicable  to  corporations.  Accordingly,  any  such  excess  dis- 
tribution would  be  taxable  as  a  dividend  to  the  extent  of  current  earn- 
ings and  profits  (determined  with  regard  to  section  312 (m))  even 
though  the  corporation  had  a  deficit  in  accumulated  earnings  and 
profits. 

For  example,  assume  a  subchapter  S  corporation  has  $100  of  tax- 
able income,  $120  of  current  earnings  and  profits  (the  $20  difference 
between  taxable  income  and  current  earnings  and  profits  representing 
the  accelerated  portion  of  depreciation  which  is  not  deducted 
for  purposes  of  current  earnings  and  profits  as  a  result  of  section 
312 (m) ),  and  $10  of  undistributed  taxable  income  previously  taxed  to 
shareliolders  in  a  prior  year.  Assume  further  that  in  such  year  the 
corporation  distributes  $120  to  its  shareholders.  lender  the  Act,  solely 
for  purpos?s  of  determining  whether  the  corporation  has  distributed 
previously  taxed  income,  the  corporation's  current  earnings  and  profits 
are  considered  to  be  $100.  Accordingly,  $10  of  the  amount  distributed 
is  treated  as  a  distribution  of  previously  taxed  income  and  is  received 


211 

without  additional  tax  liability  by  the  shareholders,  and  $110  of  the 
amount  is  treated  as  a  distribution  of  current  earnings  and  profits  and 
is  taxed  to  the  shareholders  as  a  dividend.  The  remaining  $10  of  undis- 
triimted  current  earnings  and  profits  increases  accumulated  earnings 
and  profits.  The  result  of  the  above  example  would  be  the  same  even 
if  the  corporation  had  a  deficit  in  accumulated  earnings  and  profits. 

Effective  date 
Tliis  amendment  applies  to  taxable  years  beginning  after  Decem- 
ber 31,  1975. 

Revenue  effect 
It  is  estim.ated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

c.  Changes  to  Rules  Concerning  Termination  of  Subchapter  S 
Election  (sec.  902(c)  of  the  Act  and  sec.  1372(e)  of  the  Code) 

Prior  lav 
Statutory  rules  provide  generally  that  all  shareholders  of  a  corpora- 
tion must  consent  to  either  an  election  of  subchapter  S  status  or  io  a 
voluniary  revocation  of  this  election.  However,  prior  law  provided 
that  an  election  of  su]>chapter  S  status  would  be  involuntarily  termi- 
nated if  any  new  shareholder  of  the  corporation  did  not  affirmatively 
consent  to  the  election,  generally  within  "a  period  of  30  days  from  the 
day  he  became  a  new  shareholder.  A  consent  for  this  purpose  involved 
a  formal  filing  with  the  Internal  Revenue  Service. 

Reason  for  change 
The  requirement  of  a  new  shareholder's  affirmative  consent  to  a  sub- 
chapter S  election  within  a  limited  period  of  time  could  result  in  an 
inadveitent  termination  of  the  election  if  the  new  shareholder  failed 
to  file  a  timely  consent  or  was  not  aware  of  the  necessity  of  filing  a 
consent,  (congress  was  concerned  that  a  termination  of  subchapter  S 
status  in  these  circumstances  would  cause  a  severe  hardship  not  only 
to  the  new  shareholder  but  to  all  shareholders  of  the  corporation.  It 
therefore  decided  to  require  that  a  new  shareholder  must  affirmatively 
refuse  to  consent  to  a  subchapter  S  election  in  order  to  terminate  such 
an  election. 

Explanation  of  provision 
Under  the  Act,  in  order  for  a  subchapter  S  election  to  be  terminated, 
a  new  shareholder  must  affirmatively  refuse  to  consent  to  the  election 
within  60  days  from  the  time  he  acquired  his  stock  in  the  corporation. 
In  the  case  where  a  decedent's  estate  is  the  new  shareholder,  the  60- 
day  period  for  filing  an  affirmative  refusal  will  begin  upon  the  earlier 
of  either  the  day  on  which  the  executor  or  administrator  of  the  estate 
qualifies  or  the  last  day  of  the  corporation's  taxable  year  during  which 
the  decedent's  death  occurred.  The  Secretary  is  authorized  to  issue  reg- 
ulations prescribing  the  manner  in  which  an  affirmative  refusal  is  to 
be  filed. 

Effective  date 
These  jH'ovisirns  are  effective  for  tax  years  beginning  after  Decem- 
ber 31, 1976. 

Revenue  effect 
This  provision  involves  a  negligible  revenue  loss. 


I.  TAX  TREATMENT  OF  FOREIGN  INCOME 

1.  Exclusion  for  Income  Earned  Abroad  (sec.  1011  of  the  Act  and 
sees.  36  and  911  of  the  Code) 

Prior  law. 

U.S.  citizens  are  generally  taxed  by  the  United  States  on  their 
worldwide  income  with  the  provision  of  a  foreign  tax  credit  for 
foreign  taxes  paid.^  However,  under  prior  law  l^.S.  citizens  Avho  were 
working  abroad  could  exclude  from  their  income  up  to  $20,000  of 
earned  income  for  periods  during  which  they  were  present  in  a  foreign 
country  for  17  out  of  18  months  or  during  the  period  they  were  l)ona 
-fide  residents  of  foreign  countries  (sec.  911).  In  the  case  of  individuals 
who  had  been  hona  -fide  residents  of  foreign  countries  for  three  years  or 
more,  the  exclusion  was  increased  to  $25,000  of  earned  income. 

The  above  exclusions  did  not  apply  to  employees  of  the  U.S.  Govern- 
ment working  abroad.  However,  prior  law  provided  that  certain 
special  governmental  allowances  given  to  these  employees  were  exclud- 
ed from  gross  income  and  were  not  taxed  by  the  United  States  (sec. 
912).  These  allowances,  Avhich  included  liousing,  cost-of-living,  educa- 
tion and  travel  allowances  (established  by  various  statutes)  were  ex- 
empt under  the  tax  laws.  (Allowances  received  by  members  of  the 
armed  forces  were  exempted  under  provisions  of  law  outside  of  the 
Internal  Revenue  Code.)  Any  employee  was  entitled  to  exclude  from 
gross  income  lodging  furnished  by  the  employer  on  the  business  prem- 
ises if  the  em])loyee  was  required  to  accept  it  as  a  condition  of  employ- 
ment (sec.  119). 

Reasons  for  change 

The  Congress  believed  that  the  exclusion  for  income  earned  abroad 
should  be  retained  so  that  the  competitive  position  of  U.S.  firms 
abroad  is  not  jeopardized.  Therefore,  the  Congress  did  not  repeal  the 
provision  or  phase  it  out.  However,  the  Congress's  attention  had  been 
called  to  the  presence  of  unintended  results  under  prior  law.  For 
example,  compensation  was  excluded  under  section  911  even  though 
it  was  not  subject  to  tax  by  the  foreign  country  where  the  employee 
was  employed  if  the  compensation  was  paid  outside  that  foreign  coun- 
try (e.c.,  if  the  salary  is  sent  to  a  bank  outside  of  that  country). 

In  those  cases  where  a  foreign  tax  was  naid  by  the  U.S.  citizen, 
that  tax  was  creditable  directly  asrainst  any  U.S.  tax  that  niijrht  other- 
wise exist  on  income  above  the  $20,000  or  $25,000  excludable  limits. 
This  combination  of  an  exclusion  of  $20,000  or  $25,000  of  income,  plus 
the  allowance  of  tlie  full  foreign  tax  credit  attributable  to  all  income 
(including  the  excluded  income)  gave  taxpayers  who  did  pay  tax  to 
foreign  governments  in  effect  a  double  benefit,  in  that  they  could  offset 

1  A  foreign  tax  credit  was  not  allowed  under  prior  law  to  those  Individuals  who  took  the 
standard  deduction. 

(212) 


213 

the  foreign  taxes  paid  on  the  excluded  income  against  any  U.S.  tax 
which  might  be  due  on  additional  foreign  income.  The  result  "was  that 
substantially  more  than  $20,000  of  earned  income  coukl  be  exempted 
from  U.S.  tax  if  tlie  U.S.  employee  paid  any  significant  income  tax 
to  the  foreign  government. 

In  addition,  compensation  in  excess  of  tlie  excluded  amount  Avas 
taxed  by  the  United  States  at  a  marginal  rate  that  would  apply  to  an 
employee  who  had  not  earned  the  excluded  amount.  The  Congress 
felt  that  this  treatment  was  inconsistent  with  our  progressive  tax 
system  and  that  the  marginal  rate  applicable  to  the  employee  having 
the  advantage  of  the  exclusion  should  take  into  account  the  excluded 
amount. 

Evi'plaimtion  of  fromsions 

The  Act  generally  reduces  the  exclusion  for  earned  income  of  in- 
dividuals abroad  to  $15,000,  except  that  the  Act  retains  a  $20,000 
exclusion  for  employees  of  charitable  organizations.  If  an  individual 
performs  services  for  an  employer  who  was  created  or  organized 
under  the  laws  of  the  United  States  (or  any  State,  including  the  Dis- 
trict of  Columbia)  Avhich  meets  the  requirements  of  section  501  (c)  (3) , 
the  employee,  if  he  otherwise  meets  the  )-equirements  of  section  911, 
will  be  entitled  to  exclude  earned  income  attributable  to  those  services 
in  an  amount  not  in  excess  of  $20,000  computed  on  a  dail^^  basis.  An 
individual  is  not  entitled  to  full  benefits  of  the  charitable  exclusion  and 
the  $15,000  exclusion  provided  to  other  individuals.  Accordingly  the 
amount  of  earned  income  entitled  to  be  excluded  by  reason  of  the  gen- 
eral $15,000  exclusion  may  not  exceed  $15,000  reduced  by  the  amount  of 
earned  income  excluded  by  reason  of  the  fact  that  it  is  attributable  to 
qualified  charitable  services. 

In  addition,  the  Act  makes  three  changes  that  deal  with  tlie  amount 
eligible  for  the  exclusion  and  the  computation  of  tax  liability  for  those 
individuals  who  claim  the  exclusion. 

First,  the  Act  ])rovides  tliat  any  individual  entitled  to  the  earned 
income  exclusion  is  not  to  be  allowed  a  foreign  tax  credit  with  respect 
to  foreign  taxes  allocable  to  the  amounts  that  are  excluded  from  gross 
income  under  the  earned  income  exclusion.  Thus,  foreign  income  taxes 
that  are  paid  on  excluded  amounts  are  not  to  be  creditable  or 
deductible. 

Second,  the  Act  provides  that  any  additional  income  derived  by 
individuals  beyond  the  income  eligible  for  the  earned  income  exclusion 
is  subject  to  I"^.S.  tax  at  the  higher  rate  brackets  which  would  apply 
if  the  excluded  earned  income  were  not  so  excluded.  For  the  purpose  of 
determining  the  rate  brackets  applicable  to  the  nonexcluded  income, 
the  taxpayer  is  entitled  to  subtract  those  deductions  which  woidd  be 
otherwise  disallowed  by  reason  of  being  allocable  to  the  excluded 
earned  income.  Thus,  for  example,  if  a  tax[)ayer-  has  $15,000  of  gross 
income  Avhich  is  excluded  under  the  earned  income  exclusion  and  also 
has  $5,000  of  deductions  which  are  not  allowable  by  reason  of  the 
deductions  being  allocable  to  the  excluded  earned  incoiuo.  the  taxpayer 
is  treated  as  having  an  additional  $10,000  of  taxable  income  for  pur- 
poses of  computing  the  tax  rates  on  the  nonexcluded  income. 


234-120  O  -  77  -  15 


214 

Since  earned  income  is  now  subject  to  an  exclusion  with  the  other 
income  being  taxed  at  the  higher  brackets,  any  foreign  tax  credits  dis- 
allowed by  reason  of  being  allocable  to  the  excluded  earned  income  are 
to  be  considered  as  those  taxes  paid  on  the  first  $15,000  of  excluded 
income.  P\)i-oign  taxes  are  allocable  to  the  amount  excluded  in  the 
proportion  that  the  tax  on  net  excluded  earned  income  bears  to  the  tax 
on  the  net  taxable  income.  Thus,  the  foreign  taxes  allocable  to  the  ex- 
cluded amount  and  disallowed  are  those  foreign  laxes  imposed  on  the 
first  $15,000  (or  other  excluded  amount)  of  income  assuming  a  foreign 
effective  tax  rate  as  progressive  as  the  IT.S.  tax  rate.- 

Third,  the  Act  makes  ineligble  for  the  exclusion  any  income  earned 
abroad  which  is  received  outside  the  counti-y  in  which  earned  if  one  of 
the  purposes  of  receiving  such  income  outside  of  the  country  is  to  avoid 
tax  in  that  country.  The  tax  avoidance  purpose  does  not  have  to  be 
the  only  purpose  for  receiving  the  money  outside  of  the  country  in 
which  earned,  nor  does  it  have  to  be  the  principal  reason  for  receiving 
the  money  outside  of  that  country.  It  is  sufficient  that  it  be  one  of  the 
purposes.  It  is  the  Congress's  intention  that  the  fact  that  the  country 
in  which  the  income  is  earned  does  not  tax  amounts  received  outside 
of  the  country  be  viewed  as  a  strong  indication  of  a  tax  avoidance 
purpose. 

The  Act  provides  an  election  to  an  individual  not  to  have  the  earned 
income  exclusion  apply.  To  prevent  shifting  from  an  exclusion  to  a 
credit  system  from  year  to  year,  the  Act  provides  that  once  an  elec- 
tion is  made  not  to  have  the  exclusion  apply,  it  is  binding  for  all 
subsequent  years  and  may  be  revoked  only  with  the  consent  of  the 
Internal  Revenue  Service. 

While  the  Act  makes  no  change  in  the  taxation  of  housing  allow- 
ances provided  to  overseas  employees,  the  Congress  is  aware  that  ques- 
tions have  been  raised  as  to  the  entitlement  to  the  exclusion  for  hous- 
ing furnished  to  employees  on  the  employer's  premises  when  the 
employee  is  employed  on  a  large  construction  project  in  a  remote  area. 
Quite  often  no  housing  other  than  that  furnished  by  the  employer 
is  available.  Congress  expects  that  the  Internal  Revenue  Service  will 
administer  the  exclusion  of  existing  law  in  as  liberal  a  manner  as 
possible  given  the  confines  and  limitations  of  the  existing  provision  so 
that  as  many  employees  as  possible  who  are  involved  in  construction 
projects  in  remote  areas  will  be  entitled  to  this  exclusion. 

Finally,  the  Act  provides  that  individuals  taking  the  standard 
deduction  are  to  be  allowed  the  foreiirn  tax  credit. 


2  The  Impact  of  these  modifications  may  be  illustrated  by  the  following  example  (drawn 

from  an  example  presented  to  the  Senate  Committee  on  Finance  durilnp  the  mark-up  session 

on  the  provision)  of  a  family  of  four  who  files  a  joint  return  and  whose  income  is  all  for- 
eign source  income  subject  to  foreign  tax  : 

(1)  Gross    income $32,000 

(2)  Deductions    4,000 

(3)  Personal  exemptions 3,  000 

(4)  Net  taxable  income 25,000 

(5)  Earned  income  exclusion 15,  000 

(6)  Deductions  allocable  to  amount  excluded 1,  000 

(7)  Net  excluded  earned  income 14,  000 

(S)    Tax  on  net  taxable  income 6,020 

(9)    Tax  on  net  excluded  ear':ed  Income 2,760 

(10)  Tax  prior  to  foreign  tax  credit  (No.  8  iess  No.  9) 3,  260 

(11)  Foreign  tax  paid 3,000 

(12)  Foreign   tax   allocable   to   excluded   amount    ($3,000X2,760    divided 

by     6,020) 1,  375 

(13)  Foreign  tax  credit  (No.  11  less  No.  12) 1,  625 

(14)  U.S.  tax  (No.  10  less  No.  13) 1,635 

(15)  Aggregate  U.S.  and  foreign  tax  (No.  14  and  No.  11) 4,635 


215 

E-ffective  date 
These  provisioTis  are  effective  for  taxable  years  beg^inning  after 
December  31,  1975.  Tlie  rule  disallowing  the  credit  for  foreign  taxes 
allocable  to  excluded  amounts  only  applies  to  taxes  paid  on  income 
excluded  in  taxable  years  beginning  after  that  date. 

Revenue  effect 
This  pi-o\  ision  will  increase  budget  receipts  by  $44  million  in  fiscal 
year  1977,  $38  million  in  fiscal  year  1978,  and  $38  million  in  fiscal 
year  1981. 

2.  U.S.  Taxpayers  Married  to  Nonresident  Aliens  (sec.  1012  of  the 
Act  and  sees.  879,  891,  6013  and  6073  of  the  Code) 

Prior  law 

Under  prior  law,  a  husband  and  wife  could  file  a  joint  income  tax 
return  even  though  one  of  the  spouses  had  no  gross  income  or  deduc- 
tions. However,  a  joint  return  could  not  be  made  if  either  the  husband 
or  the  wife  at  any  time  during  the  taxable  year  was  a  nonresident 
alien.  Under  prior  law,  nonresident  aliens  were  generally  required  to 
file  estimated  tax  returns  by  April  15  of  the  year  in  question,  although 
they  had  until  June  15  to  file  the  income  tax  return  for  the  previous 
year. 

Reasons  for  cliange 

As  a  rule,  a  husband  and  wife  find  it  desirable  to  file  a  joint  return 
since  it  generally  results  in  a  lower  aggregate  tax  liability  than  if  they 
each  filed  separate  returns  of  tlieir  own  income  and  deductions.  Tax- 
payers are  encouraged  to  file  joint  returns  due  to  the  fact  that  it 
eliminates  the  administrative  problems  of  otherwise  having  to  allocate 
income  and  deductions  betw^een  married  taxpayers. 

The  inability  of  a  husband  and  wife  to  file  a  joint  return  where  one 
of  them  is  a  nonresident  alien  has  resulted  in  the  possibility  of  a  heavier 
tax  burden  being  placed  upon  this  group  of  taxpayers  than  other  mar- 
ried taxpayers.  For  example,  even  though  a  joint  return  was  not  al- 
lowed, the  spouse  who  filed  a  tax  return  was  required  to  use  the  higher 
rate  table  for  married  individuals  filing  separately.  In  addition,  these 
married  individuals  could  not  obtain  the  benefits  of  the  50-percent 
maximum  tax  on  earned  income  because  married  taxpayers  must  file  a 
joint  return  in  order  to  obtain  the  benefits  of  that  provision.  There  are 
approximately  10,000  U.S.  taxpayers  who  are  married  to  nonresident 
alien  individuals. 

These  disadvantages  under  the  U.S.  tax  laws  were,  however,  offset 
by  a  number  of  tax  advantages  for  certain  of  these  taxpayers.  First, 
the  foreign  source  income  attributable  to  the  nonresident  alien  spouse 
was  not  subject  to  any  U.S.  taxation  if  not  effectively  connected  with 
a  T'nited  States  trade  or  business.  Second,  if  the  taxpayers  were  sub- 
ject to  community  property  rules,  one-half  of  the  earned  income  of  the 
taxable  spouse  was  treated  as  being  the  income  of  the  nonresident  alien 
spouse  and  was  not  subject  to  U.S.  taxation  if  it  was  from  foreign 
sources  and  not  effectively  connected  with  a  TTnited  States  trade  or 
business. 

A  second  problem  involved  the  fact  that  certain  nonresident 
alien  individuals  who  were  required  to  file  declarations  of  esti- 
mated income  tax   for   a   taxable   year   were   required   to   file   two 


216 

months  before  the  time  required  for  filing  a  return  of  income  for  the 
previous  taxable  year,  while  domestic  taxpayers  could  file  the  declara- 
tion at  the  time  the  return  for  the  previous  year  was  due.  It  is  normally 
helpful  to  compute  tax  liability  for  the  previous  year  before  estimat- 
ing the  income  tax  for  the  current  year. 

Explanation  of  'provisions 

The  Act  allows  a  U.S.  citizen  or  resident  married  to  a  nonresident 
alien  to  file  a  joint  return  provided  that  an  election  is  made  by  both 
individuals  to  be  taxed  on  their  worldwide  income.  The  nonresident 
alien  is  treated,  in  effect,  as  a  resident  of  the  Unit^'d  States  for  pur- 
poses of  the  income  tax  laws.  A  requirement  of  the  election  is  that 
the  husband  and  wife  agree  to  supply  all  the  necessary  books  and 
records  and  other  information  pertinent  to  the  determination  of  tax 
liability ;  failure  to  do  so  could  result  in  termination  of  the  election 
by  the  Secretary. 

The  election  applies  for  the  taxable  year  for  which  made  and  for 
all  subsequent  years  until  tenninated.  However,  the  election  does  not 
apply  in  a  taxable  year  in  which  neither  spouse  is  a  U.S.  citizen  or 
resident  at  any  time  during  the  taxable  year  (i.e.,  one  of  the  spouses 
must  be  a  resident  for  the  full  taxable  year).  Only  individuals  who 
are  residents  under  the  normal  rules  of  the  Code  are  residents  for 
purposes  of  satisfying  the  requirement  that  one  spouse  must  be  a  citi- 
zen or  resident  who  would  otherwise  be  able  to  file  a  joint  return. 

The  election  continues  imtil  terminated.  Either  spouse  may  revoke 
the  election  for  any  taxable  year  so  long  as  the  revocation  is  made 
prior  to  the  prescribed  time  for  the  filing  of  the  income  tax  return  for 
such  year.  The  election  is  terminated  in  the  event  of  the  death  of 
either  spouse  or  the  legal  separation  of  the  spouses  under  a  decree 
of  divorce  or  of  separate  maintenance.  In  the  event  of  the  death  of 
either  spouse,  the  election  will  ordinarily  terminate  for  the  year  of 
the  surviving  spouse  following  the  year  in  which  the  death  occurred. 
However,  if  the  sui'A^iving  spouse  is  a  U.S.  citizen  or  resident  who, 
for  years  subsequent  to  the  death  of  the  spouse,  is  entitled  to  use  the 
joint  return  rate^  (as  provided  under  sees.  1(a)  (2)  and  2),  the  elec- 
tion will  not  terminate  until  the  close  of  the  last  year  for  which  joint 
return  rates  may  be  used.  In  the  event  of  legal  divorce  or  separation, 
the  election  terminates  as  of  the  beginning  of  the  taxable  year  in 
which  the  divorce  or  separation  occui*s. 

The  Secretary  may  terminate  an  election  if  he  deteiTnines  that  either 
spouse  has  failed  to  keep  adequate  tax  records,  to  give  the  IRS  ade- 
quate access  to  such  records,  or  to  supply  such  other  information  as 
may  be  reasonably  necessary  to  ascertain  the  taxpayer's  income  tax 
liability  for  the  taxable  year. 

If  an  election  is  terminated  for  any  two  individuals  for  any  of  the 
reasons  stated  above,  neither  of  them  will  be  eligible  to  make  the 
election  for  any  subsequent  taxable  year.  For  example,  if  a  divorced 
individual,  who  had  previously  made  the  election,  were  to  remarry, 
he  or  she  would  not  be  eligible  to  make  the  election. 

The  above  rules  apply  in  the  case  of  a  citizen  or  resident  who  is 
married  to  an  alien  individual  who  does  not  become  a  resident  of  the 
United  States.  The  Act  provides  a  special  rule  for  a  nonresident  alien 


217 

individual  who  becomes  a  resident  of  the  United  States  at  the  close  of 
the  taxable  year  if  married  to  a  citizen  or  resident  of  the  United  States 
at  the  close  of  the  year.  Prior  law  prevented  this  couple  from  filing  a 
joint  return,  since  they  both  were  not  citizens  or  residents  of  the 
United  States  for  the  entire  taxable  year. 

The  Act  provides  that  a  nonresident  alien  who  at  the  close  of  a 
taxable  year  is  a  U.S.  resident  and  is  married  to  a  U.S.  citizen  or 
resident  at  the  close  of  the  year  may  elect  with  the  other  spouse  to  be 
eligible  for  the  joint  return  provision.  If  both  spouses  were  nonresi- 
dent aliens  at  the  beginning  of  the  year,  they  may  make  the  election 
if  both  become  residents  by  the  close  of  the  year.  In  that  case,  a 
spouse  who  was  a  nonresident  alien  for  the  first  part  of  the  year  is 
treated  as  a  resident  of  the  United  States  for  the  entire  taxable 
year  for  purposes  of  the  income  tax  law  and  thus  is  taxable  on  his 
worldwide  income.  Since  this  provision  is  a  limited  exception  for 
individuals  when  they  first  become  residents  of  the  ITnited  States,  the 
election  does  not  apply  to  any  subsequent  taxable  year,  and  the  tax- 
payers are  not  eligible  to  make  a  second  election  for  any  such  subse- 
quent year. 

The  Act  makes  certain  community  property  laws  inapplicable  for 
income  tax  purposes  Avhere  the  election  is  not  made.  Earned  income 
of  a  spouse,  otlier  than  trade  or  business  or  partnership  distributive 
share  income,  is  treated  as  the  income  of  the  spouse  whose  services 
generated  such  income.  Trade  or  business  and  partnership  distribu- 
tive share  income  subject  to  community  property  laws  Avill  receive 
the  same  treatment  as  that  provided  under  section  1402(a)  (5)  (defin- 
ing net  earnings  from  self -employment.)  Under  section  1402(a)(5) 
(A),  trade  or  business  income  (other  than  that  derived  by  a  partner- 
ship) which  is  treated  as  community  income  is  treated  as  the  income 
of  the  husband  imless  the  wife  exercises  substantially  all  of  the  man- 
agement and  control  of  such  trade  or  business,  in  which  case  the  income 
of  the  trade  or  business  is  treated  as  that  of  the  wife.  Under  section 
1402(a)  (5)  (B),  any  portion  of  a  partners  distributive  share  of  the 
ordinary  income  or  loss  from  a  trade  or  business  carried  on  by  a 
partnership  which  is  community  income  or  loss  is  treated  as  the 
income  or  loss  of  such  partner,  and  no  part  of  such  distributive  share 
is  attributed  to  the  other  spouse. 

Community  income  derived  from  separate  property  of  one  spouse 
(and  which  is  neither  earned  income,  trade  or  business  income,  nor 
partnership  distributive  share  income)  is  treated  as  the  income  of 
that  spouse.  All  other  community  income  is  treated  as  provided  by 
the  applicable  community  property  law% 

In  addition,  the  Act  provides  for  a  delay  in  the  time  for  filing  a 
declaration  of  estimated  tax  for  a  taxable  year  by  certain  nonresident 
alien  individuals  until  the  time  required  for  filing  a  return  of  income 
for  the  prior  taxable  year.  The  Act  provides  that  in  the  case  of  non- 
resident alien  individuals  who  are  not  subject  to  wage  withholding, 
the  due  date  for  filing  the  estimated  tax  return  is  not  to  be  anv  earlier 
tlian  the  due  date  for  the  tax  return. 

Effective  dates 
The  provisions  of  the  Act  pertaining  to  the  election  to  be  treated 
as  residents  of  the  United  States  apply  to  taxable  years  ending  on 


218 

and  after  December  31,  1975.  The  provisions  of  the  Act  pertaining 
to  the  tax  treatment  of  certain  community  income,  and  to  the  due 
date  for  filing  estimated  tax  returns,  apply  to  taxable  years  beginning 
after  December  31,  1976. 

Revenue  ejfect 
It  is  estimated  that  this  provision  will  decrease  budget  receipts 
$1  million  in  fiscal  year  1977,  and  $5  million  in  1981. 

3.  Income  of  Foreign  Trusts  and  Transfers  to  Foreign  Trusts 
and  Other  Foreign  Entities  (sees.  1013  to  1015  of  the  Act  and 
sees.  643(a)  (b),  668,  670,  679,  1056,  1491,  1492,  6048,  and  6677 
of  the  Code) 

Prior  law 

Under  prior  law,  the  income  of  a  trust  Mas  taxed  basically  in  the 
same  manner  as  the  income  of  an  individual,  with  limited  exceptions 
(sec.  642).  Just  as  nonresident  alien  individuals  are  generally  taxed 
only  on  their  U.S.  source  income  other  than  capital  gains  ^  and  on 
their  income  effectively  connected  with  a  U.S.  trade  or  business  (and 
not  on  their  foreign  source  income) ,  so  any  trust  which  could  qualify  as 
being  comparable  to  a  nonresident  alien  individual  was  generally  not 
taxed  on  its  foreign  source  income. 

If  a  trust  is  taxed  in  a  manner  similar  to  nonresident  alien  individ- 
uals, it  is  considered  (under  sec.  7701  (a)  (31))  to  be  a  foreign  trust. 
The  Internal  Revenue  Code  does  not  specify  what  characteristics 
must  exist  before  a  trust  is  treated  as  being  comparable  to  a  nonresi- 
dent alien  individual.  However,  Internal  Revenue  Service  rulings  and 
court  cases  indicate  that  this  status  depends  on  various  factors,  such  as 
the  residence  of  the  trustee,  the  location  of  the  trust  assets,  the  country 
under  whose  laws  the  trust  is  created,  the  nationality  of  the  grantor, 
and  the  nationality  of  the  beneficiaries.-  If  an  examination  of  these 
factors  indicates  that  a  trust  has  sufficient  foreign  contacts,  it  is 
deemed  comparable  to  a  nonresident  alien  individual  and  thus  is  a 
foreign  trust. 

Under  prior  law,  grantors  and  other  persons  were  treated  as  the 
owners  of  that  portion  of  a  trust  (under  the  grantor  trust  rules)  as 
to  which  they  had  certain  powers  or  interests.  The  grantor  trust  rules 
which  tax  the  income  of  those  trusts  to  the  grantor  (see  sees.  671  to 
678)  apply  equally  to  foreign  and  domestic  trusts.  If  a  I".S.  grantor 
establislies  a  foreign  trust  which  comes  within  these  provisions,  the 
worldwide  income  attributable  to  him  of  that  trust  is  taxed  by  the 
United  States  to  the  grantor. 

If  a  U.S.  taxpayer  was  a  beneficiary  of  a  foreign  trust,  distributions 
to  him  were  taxed  in  basically  the  same  manner  as  were  distributions  to 
a  beneficiary  of  a  domestic  trust.  Distributions  of  ordinary  income 
received  from  foreign  trusts  which  could  accumulate  income  were  sub- 
ject to  the  same  throwback  rules  (sec.  668)  which  applied  to  domestic 
trusts.  Under  these  rules  a  beneficiary  determined  his  tax  on  a  dis- 
tribution of  income  earned  by  the  trust  in  an  earlier  year  either  under 


1  Sec.  1041  of  thp  4ct  provides  an  exception  to  the  rule  that  nonresident  alien  Individuals 
(and  thus  comparable  trusts)  are  taxed  on  their  U.S.  source  Income.  That  provision  exempts 
certain  U.S.  source  interest  of  nonresident  aliens  from  U.S.  taxation. 

2  For  example,  see  Rev.  RuL  60-lSl  (C.B.  1960-1.  257)  and  B.  ^y .  Jones  TruM  v. 
Commissioner,  46  B.T.A.  531,  aff'd  132  F.  2d  914. 


219 

the  "exact  method'  or  under  the  alternative  three-year  "shortcut 
method."  Also  distributions  of  capital  gain  income  from  a  foreign 
trust  were  treated  similarly  to  such  distributions  from  domestic  trusts 
(i.e.,  the  income  was  excluded  from  distributable  net  income  ^  and  was 
taxed  under  the  special  capital  gains  throwback  rules  (sec.  669) ),  but 
only  if  the  foreign  trust  was  created  by  a  foreign  person.  If  a  foreign 
trust  was  created  by  a  U.S.  person,  gains  from  the  sale  or  exchange 
of  capital  assets  were  included  in  the  distributable  net  income  and 
thus  were  treated  as  received  by  a  beneficiary  proportionally  with  any 
ordinary  income  earned  by  the  trust  in  the  same  year.  This  exception 
favored  foreign  trusts  created  by  U.S.  persons  over  domestic  trusts 
because  a  beneficiary  could  receive  a  distribution  of  capital  gain 
income,  Avhich  was' taxed  at  a  lower  rate,  without  requiring  the 
trust  first  to  distribute  all  of  its  ordinary  income.  Under  prior 
law,  any  capital  gains  income  retained  its  character  in  the  hands  of  the 
beneficiary,  thus  being  eligible  for  tlie  capital  gains  deduction  (under 
sec.  1202)  upon  the  distribution  of  the  income. 

In  addition  to  the  above  provisions  which  governed  the  taxation  of 
foreign  trusts,  prior  law  imposed  (sec.  1491)  an  excise  tax  of  271/2 
percent  on  certain  transfers  of  property  to  foreign  trusts,  as  well  as  to 
foreign  corporations  (if  the  transfer  was  a  contribution  to  capital) 
and  to  foreign  partnerships.  Under  prioi-  law  the  excise  tax  was  im- 
posed on  all  transfers  of  stock  or  securities  to  such  an  entity  by  a 
U.S.  citizen,  resident,  corporation,  partnership  or  trust.  The  amount  of 
the  excise  tax  was  equal  to  271/2  percent  of  the  amount  of  the  excess  of 
the  value  of  the  stock  or  securities  over  the  adjusted  basis  in  the  hands 
of  the  transferor. 

Reasons  por  change 

The  rules  of  prior  law  permitted  U.S.  persons  to  establish  foreign 
trusts  e-o  that  funds  could  be  accumulated  free  of  I^.S.  tax.  Further,  the 
funds  of  these  foreign  trusts  were  generally  invested  in  countries  which 
did  not  tax  interest  and  dividends  paid  to  foreign  investors,  and  the 
trusts  generally  were  administered  through  countries  which  did  not  tax 
such  entities.  Thus,  these  trusts  generally  paid  no  income  tax  anywhere 
in  the  world.  Although  the  beneficiaries  were  taxed  (and  the  throwback 
rules  were  applied)  upon  any  distributions  out  of  these  trusts,  never- 
theless the  use  of  foreign  trusts  permitted  a  grantor  to  jirovide  a  tax- 
free  accumulation  of  income  while  the  income  remained  in  the  trust. 
The  Congress  believed  that  allowing  this  tax-free  accumulation  of  in- 
come was  inappropriate  and  jn-ovided  an  unwarranted  advantage  to 
the  use  of  a  foreign  trust  over  the  use  of  a  domestic  ti'ust.  Accordingly, 
the  Act  provides  that  where  there  is  a  U.S.  grantor  the  income  of  a  for- 
eign trust  is  taxable  to  him  if  the  funds  are  being  accumulated  for  a 
U.S.  beneficiary.  The  Act  also  provides  for  an  interest  charge  on  the 
amount  of  any  tax  paid  by  a  U.S.  beneficiary  in  cases  where  the  income 
of  the  trust  is  not  taxable  to  a  U.S.  grantor. 

In  addition,  the  Act  has  made  a  number  of  changes  in  the  treatment 
of  domestic  ti-usl^s  (see  sec.  701 ).  These  changes.  ])articularly  the  modi- 
fication of  the  throwback  rules  and  the  elimination  of  the  cliai-acter  of 
capital  gains  upon  accumulation  distributions  to  beneficiaries,  are  in- 

=>  Tlip  effppt  of  exclnclinc  cnpitnl  L'nins  from  distrihntnblo  net  inoomo  was  to  treat  such 
inponie  as  being  received  by  a  beneficiary  only  after  all  ordinary  income  for  all  years  of  the 
trust  had  been  distributed. 


220 

tended  to  simplify  the  administration  of  the  tax  laws.  Adjustments  in 
the  rules  applicable  to  forei^rn  trusts  must  be  made  in  light  of  these 
changes  in  order  to  prevent  foreign  trust  from  receiving  relatively 
advantageous  tax  treatment. 

A  final  problem  that  has  come  to  the  Congress's  attention  relates  to 
the  effectiveness  of  the  provision  in  the  Internal  Revenue  Code  pro- 
viding for  a  271^  percent  excise  tax  on  certain  transfers  to  foreign 
entities,  including  foreign  trusts.  The  excise  tax  was  intended  to  pre- 
vent U.S.  taxpayers  from  transferring  appreciated  property  to 
foreign  trusts  or  other  foreign  entities  without  payment  of  a  capital 
gains  tax.  However,  under  prior  law  the  excise  tax  of  27%  percent  of 
the  amount  of  appreciation  was  less  than  the  maximum  capital  gains 
tax  on  individuals  (which  can  be  as  high  as  35  percent).  Furthermore, 
the  excise  tax  provision  had  been  interpreted  by  some  tax  advisors  to 
exclude  transfers  to  foreign  entities  to  the  extent  that  the  entity  pro- 
vides some  consideration  to  the  transferor.  For  example,  a  U.S'.  tax- 
payer could  transfer  appreciated  stock  to  a  trust  established  by  him 
and  receive  in  return  from  the  trust  a  private  annuity  contract  or  other 
deferred  payment  obligation.*  The  Congress  believes  it  is  appropriate 
to  tax  a  transfer  of  assets  in  these  situations. 

Explanation  of  provisions 

The  Act  includes  three  separate  sets  of  provisions  which  revise  the 
treatment  of  foreign  trusts.  First,  a  foreign  trust,  the  corpus  of  which 
is,  in  whole,  or  in  part,  transferred  to  the  trust  by  a  U.S.  person  and 
which  has  a  U.S.  beneficiary,  is  made  subject  to  a  new  grantor  trust 
provision.  This  provision  generally  taxes  the  income  of  such  a  trust  to 
the  U.S.  person  transferring  property  to  the  trust.  Second,  in  the  case 
of  a  foreign  trust  the  income  of  which  is  not  taxed  to  the  grantor,  the 
taxation  of  any  distribution  to  a  U.S.  beneficiary  is  revised  by  chang- 
ing the  rules  for  taxing  capital  gains  income  and  by  adding  an  interest 
charge  on  accumulation  distributions.  Finally,  the  excise  tax  on  trans- 
fers to  foreign  entities,  such  as  foreign  trusts,  is  expanded  in  its  scope 
and  iho,  rate  of  the  excise  tax  is  increased. 

Grantor  trust  rules. — The  Act  contains  a  now  grantor  trust  pro- 
vision undci"  which,  in  general,  any  U.S.  person  transferring  prop- 
erty to  a  foreign  trust  which  has  a  U.S.  beneficiary  is  treated  as 
owner  of  the  portion  of  the  trust  attributable  to  the  property  trans- 
ferred by  the  U.S.  person.^  The  Act  specifically  excludes  trusts 
described  in  section  404(a)  (4)  (relating  to  employee  trusts  created 
or  organized  outside  of  the  United  States)  from  this  new  provision. 

*  Since  the  contract  is  viewed  as  consideration  for  tlie  assets  transferred,  section  1491 
had  been  interpreted  by  some  tax  advisers  not  to  apply  to  the  transfer.  Under  this  view, 
the  transferor  could  transfer  an  asset  to  a  foreign  trust  and  cause  It  to  be  sold  without 
payment  of  tax  and  could  receive,  in  return,  annual  payments  which  were  taxed  over  a 
number  of  years.  (But  c.f.  Rev.  Rul.  68-18.3,  1968-1  Cum.  Bull.  308.)  The  effect  of  this 
transaction  was  that  the  transferor  deferred  payment  of  a  substantial  amount  of 
tax  attributable  to  the  sale  of  the  appreciated  asset  and  obtained  the  benefit  of  a 
tax-free  accumulation  of  the  proceeds  of  the  sale.  The  Congress  believes  that 
.'inv  policy  in  favor  of  permitting  deferral  of  tax  In  private  annuity  trans- 
actions should  not  apply  to  a  private  annuity  transaction  with  a  foreijrn  trust.  These 
trusts  have  limited  assets,  so  that  if  the  transferor  outlives  his  life  expectancy  the  trust 
will  often  be  unable  to  continue  annuity  payments,  and  if  the  transferor  dies  prematurely 
his  beneficiaries  receive  the  remaining  trust  assets.  These  facts  make  the  transaction 
qiiite  different  from  a  conventional  private  annuity. 

"  This  provision  does  not  affect  the  definition  of  a  foreign  trust  provided  in  sec.  7701 
(a)  (.31)  of  the  Internal  Revenue  Code  since  the  foreign  source  income  of  a  grantor  trust 
is  taxed  to  the  owner  and  not  the  trust  itself. 


221 

Any  U.S.  person  treated  under  this  provision  as  owner  of  a  portion 
of  a  trust  is  taxed  on  the  income  of  that  portion  of  the  trust  in  the 
same  manner  as  an  owner  of  a  trust  is  taxed  under  the  existing  grantor 
trust  rules  (part  IE  of  subchapter  J  of  the  Internal  Revenue  Code). 
If  another  person  would  be  treated  as  owner  of  the  same  portion 
of  the  trust  under  the  grantor  trust  rule  (sec.  678  which  applies  to 
persons  other  than  the  grantor),  that  other  person  is  not  to  be  treated 
as  owner  of  that  portion  of  the  trust  for  tax  purposes.  For  purposes 
of  determining  the  portion  of  a  trust  over  which  the  U.S.  grantor  is 
treated  as  owner,  loans  to  the  trust  by  the  grantor  may  be  treated  as 
transfers  of  corpus." 

The  new  grantor  trust  provision  applies  to  transfers  of  property  by 
any  U.S.  person,  as  that  term  is  defined  in  the  Internal  Revenue  Code 
(sec.  7701(a)  (30)).  Thus,  transfers  by  U.S.  citizens  or  residents,  by 
domestic  partnerships,  by  domestic  corporations,  and  by  estates  or 
trusts  which  are  not  foreign  estates  or  foreign  trusts  are  included. 
However,  transfers  by  U.S.  persons  which  take  place  b}^  reason  of  the 
death  of  the  U.S.  person  are  not  included.  For  example,  the  income  of 
a  foreign  testamentary  trust  created  by  a  U.S.  person  is  not  taxed  to 
the  estate  of  the  I"''.S.  person.  In  addition,  an  inter  vivos  trust  which  is 
treated  as  owned  by  a  TLS.  person  under  this  provision  is  not  treated 
as  owned  by  the  estate  of  that  person  upon  his  death. 

These  rules  apply  only  for  income  tax  purposes.  Whether  tlie  corpus 
of  the  inter  vivos  trust  is  included  in  the  estate  of  the  U.S.  person 
depends  on  the  estate  tax  provisions  of  the  Code.  Such  provisions,  as 
well  as  the  gift  tax  provisions  of  the  Code,  are  unaffected  by  this 
amendment. 

The  new  grantor  trust  provision  applies  to  transfers  of  property 
by  U.S.  persons  whether  the  transfers  are  accomplished  directly  or 
indirectly.  A  transfer  by  a  domestic  or  foreign  entity  in  which  a  U.S. 
])erson  has  an  interest  may  ])e  regarded  as  an  indirect  transfer  to  the 
foreign  trust  by  the  T^.S.  person  if  tlie  entity  merely  serves  as  a  conduit 
for  the  transfer  by  the  I"^.S.  person  or  if  the  T^.S.  ])erson  has  sufficient 
control  over  the  entit}-  to  direct  the  transfer  by  the  entity  rather  than 
himself."  Further,  if  a  foreign  trust  borrows  money  or  other  ])roperty 
the  repayment  of  which  is  guaranteed  by  a  U.S.  person,  tliat  U.S.  per- 
son may  be  treated  as  having  transferred  to  the  ti'ust  tlie  property 
to  which  the  guarantee  applies.  Foi-  this  purpose,  a  guarantee  may 
consist  of  any  understanding,  formal  or  informal,  ])y  which  payment 
of  an  obligation  is  assured. 

8  For  example.  If  a  U.S.  person  transfers  $10  to  a  foreign  trust  having  F.S.  bene- 
ficiaries, and  also  lends  $90  to  that  trust,  he  may  he  treated  as  the  owner  of  trust  income 
attributable  to  $100.  For  this  purpose,  if  a  U.S.  person  makes  a  deposit  In  a  hank  (or  a 
contribution  to  another  entity)  and  that  deposit  (or  contribution)  l.s  followed  (or  pre- 
ceded) by  a  loan  of  a  similar  amount  to  a  forelprn  trust,  the  U.S.  person  may  he  considered 
to  have  made  the  loan  directly  to  the  trust. 

"For  example  If  a  T'.S.  person  transfcs  property  to  a  foreign  person  or  entity  and  If 
that  person  transfers  that  property  for  Its  equivalent)  to  a  foreign  trust  that  has  U.S. 
beneficiaries,  the  U.S.  person  transferring  the  property  to  the  foreign  person  or  entity  is 
treated  as  having  made  a  transfer  to  a  foreign  trust  unless  It  can  be  shown  that  the 
transfer  of  property  to  the  trust  was  unrelated  to  the  T\S.  person's  transfer  of  property  to 
the  foreign  person  or  entity.  A  similar  rule  apnlles  to  tran.sfers  Mnclnding  certain  deferred 
sales)  through  domestic  entities  or  persons.  For  evnmnlp.  if  a  I\S.  person  transfers  prop- 
erty to  a  domestic  trust  or  corporation  and  that  entity  subsequently  transfers  the  .same  or 
couivalent  property  to  a  foreign  trust,  the  U.S.  person  may  be  treated  as  having  made  a 
transfer  of  property  indirectly  to  a  foreign  trust.  Moreover,  transfers  to  a  domestic  trust 
which  subsequently  becomes  a"  foreign  trust  may  be  regarded  as  Indirect  transfers  to  a  for- 
eign trust. 


222 

Transfers  by  U.S.  persons  are  subject  to  the  grantor  trust  provision 
regardless  of  whether  the  transfers  are  made  without  receipt  of  con- 
sideration from  the  trust  or  whether  the  transfers  constitute  sales  or 
exchanges  (including  tax-free  exchanges)  of  the  property  to  the  trust. 

However,  the  Act  provides  an  exception  for  transfers  of  property 
to  a  foreign  trust  pursuant  to  a  sale  or  exchange  of  the  property  at 
its  fair  market  value  if,  in  the  transaction,  the  transferor  realizes  and 
recognizes  all  of  the  gain  at  the  time  of  the  transfer  or  if  the  gain  is 
taxed  to  the  transferor  as  provided  in  section  453  (providing  for 
installment  reporting  of  gains  under  certain  circumstances).  If  this 
exception  applies,  the  transferor  is  not  treated  as  owner  of  any  portion 
of  the  trust  by  reason  of  that  transfer.  But  the  transferor  is  treated 
as  an  owner  of  the  trust  if  gain  is  realized  from  the  transaction  and  if 
the  transferor  reports  the  gain  as  an  open  transaction  or  as  a  private 
annuity. 

A  U.S.  person  transferring  property  to  a  foreign  trust  is  treated  as 
an  owner  of  the  trust  only  if  the  trust  has  a  l^.S.  beneficiary.  The  Act 
provides  that  a  trust  is  treated  as  having  a  U.S.  beneficiary  if  the 
trust  instrument  includes  existing  U.S.  persons  as  beneficiaries  or 
if  the  trust  instrument  (taken  together  with  any  related  written  or 
oral  agreements  l3otween  the  trustee  and  persons  transferring  property 
to  the  trust)  gives  to  any  person  the  authority  to  distribute  income  or 
corpus  to  unnamed  persons  generally  or  to  any  class  of  pereons  which 
includes  XLS.  persoiis.  This  authority  exists,  for  example,  if  any  person 
(wiu4her  or  not  adverse  to  the  grantor)  has  the  power  to  appoint  U.S. 
beneficiaries  or  to  amend  the  trust  instrument  in  such  a  way  as  to  in- 
clude TLS.  beneficiaries.  A  trustee  (or  other  person)  can  have*  authority 
to  distribute  income  or  corpus  to  unnamed  persons  and  can  avoid  being 
treated  as  having  a  ILS.  beneficiary  if  terms  of  the  trust  (which  can- 
not be  amended)  provide  that  no  part  of  income  or  corpus  of  the  trust 
may  be  paid  or  accumulated  for  the  benefit  of  a  U.S.  person.  Of  course, 
the  fact  that  a  named  foreifrn  beneficiary  could  become  a  U.S.  person 
bv  residency  or  citizenship  does  not  cause  a  foreign  trust  to  be  treated 
as  a  grantor  trust  before  the  event  actually  occurs. 

In  addition,  the  Act  provides  that  a  trust  is  treated  as  having  a  XLS. 
beneficiarv  for  any  taxable  year  if,  assuming  the  trust  terminated  in 
the  taxable  year,  any  part  of  the  remaining  income  or  corpus  of  the 
trust  could  be  paid  to  or  for  the  benefit  of  a  U.S.  person.  Tlie  same 
rules  that  apply  to  determine  whether  a  trust  has  a  U.S.  beneficiary  in 
any  year  during  its  existence  are  to  apply  to  this  tennination 
provision.^ 

The  Act  provides  that  a  vear-by-year  determination  be  made  of 
whether  or  not  a  trust  has  a  XLS.  beneficiary.  If  a  foreign  beneficiary 
becomes  a  U.S.  person  (and  thus  becomes  a  U.S.  beneficiary ^,  the  new 
grantor  trust  provision  applies  to  th-^  transferor  beginning  with  the 
transferor's  first  taxable  year  in  which  the  foreign  person  becomes  a 
U.S.  beneficiary.^ 


*  For  example.  If  any  person  has  a  power  to  appoint  a  remainder  beneficiary  or  to 
amend  the  triist  provisions  to  name  such  a  beneficiary,  the  trust  Is  treated  as  havlnjr  a  U.S. 
beneficiary.  Also,  if  under  the  law  applicable  to  the  trust,  distributions  are  required  to  be 
made  to  U.S.  persons  (notwithstanding  the  trust  instrument),  the  trust  Is  treated  as  hav- 
inp  a  U.S.  beneficiary. 

"  For  example,  if  a  trust  names  X,  a  French  cltiz'^n  and  resident,  plus  X's  oifsprinq:  as 
beneficiaries,  the  trust  would  have  no  U.S.  beneficiaries  until  X's  offspring  or  X  himself 
became  a  U.S.  person. 


223 

The  Act  provides  a  special  rule  for  cases  in  which  a  foreign  trust 
acquires  a  U.S.  beneficiary  in  any  taxable  year  and  has  undistributed 
net  income  (i.e.,  accumulated  income  which  would  be  taxable  to  a 
beneficiary  upon  distribution)  as  of  the  close  of  the  immediately  pre- 
ceding taxable  year.  In  such  a  case,  the  transferor  of  property  to  the 
trust  is  treated  as  having  additional  income  in  the  first  taxable  year 
in  which  the  taxpayer  is  treated  as  an  owner  of  a  portion  of  the  trust. 
The  amount  of  the  additional  income  is  equal  to  the  undistributed  net 
income  for  all  prior  taxable  years  to  the  extent  that  sucli  undistributed 
net  income  remains  in  the  trust  at  the  end  of  the  last  taxable  year  before 
the  trust  had  a  U.S.  beneficiary." 

The  Act  provides  attribution  rules  for  determining  whether  a 
trust  lias  a  U.S.  beneficiary.  A  trust  having  a  foreign  corporation  as  a 
beneficiary  is  treated  as  having  a  U.S.  beneficiary  if  more  than  50 
percent  of  the  total  combined  voting  power  of  all  classes  of  stock  is 
owned  or  considered  to  be  owned  by  U.S.  shareholders  under  the  rules 
for  determining  stock  ownership  of  controlled  foreign  corporations. 
Similarly,  if  a  foreign  trust  has  a  foreign  partnership  as  a  beneficiary, 
the  trust  is  treated  as  having  a  U.S.  beneficiary  if  any  U.S.  person  is  a 
partner  (directly  or  indirectly)  of  the  partnership.  Finally,  if  a  for- 
eign trust  has  as  a  beneficiary  another  foreign  trust  or  a  foreign  estate, 
the  first  trust  is  considered  to  have  a  U.S.  beneficiary  if  the  second 
foreign  trust  or  the  foreign  estate  has  a  U.S.  beneficiary. 

The  Act  also  provides  that  persons  subject  to  the  grantor  trust  rule 
are  to  file  an  annual  information  return  with  the  Internal  Revenue 
Service,  setting  out  such  information  as  is  prescribed  by  the  Secretary. 
A  penalty  equal  to  5  percent  of  the  corpus  of  the  trust  is  provided  for 
failure  to  file  this  return. 

Taxation  of  heneficiarifs  of  foreign  trusts. — In  those  cases  where  the 
income  of  a  foreign  trust  is  not  taxed  to  the  grantor  under  the  grantor 
trust  rules,^^  the  Act  provides  for  an  interest  charge  based  on  the 
length  of  time  during  which  that  tax  was  deferred  because  of  the 
trust's  accumulation  of  income.  This  charge  is  in  addition  to  any  tax 
which  is  incurred  by  beneficiai-ies  receiving  distributions  from  foreign 
trusts  not  taxed  under  the  grantor  trust  rules.  The  interest  charge  is 
to  equal  6  percent  per  year  times  the  amount  of  tax  imposed  on  the 
beneficiary  (after  reduction  for  any  taxes  paid  by  the  trust).  It  is 
not  compomided.^^ 

In  cases  where  the  distribution  in  one  year  consists  of  amounts 
earned  in  more  than  one  year,  the  interest  charije  is  calculated  by  aver- 
aging the  years  in  which  amounts  were  actually  earned  (even  though 
the  amount  of  income  tax  to  be  paid  by  the  beneficiary  is  determined 


30  por  example,  if  a  trust  Instrnment  provides  that  income  is  to  accumulate  until  dis- 
tributed to  Swiss  citizen  X's  offspring,  the  amount  accumulated  is  not  taxed  to  the 
transferor  of  the  property  as  long  as  the  oflfsprinp  are  not  U.S.  persons.  However,  if  any 
of  X's  offsprinjr  becomes  a  IT.S.  person,  the  transferor  of  the  property  is  treated  as  having 
income  in  the  amount  of  the  undistributed  net  income  for  all  taxable  years  (attributable 
to  the  property  transferred)  remaining  in  the  trust  at  the  end  of  the  last  taxable  year  be- 
fore the  year  in  which  that  offspring  became  a  U.S.  beneficiary.  For  this  purpose  any  power 
over  a  trust  (described  by  sees.  671-678)  held  by  a  nonresident  alien  shall  be  ignored. 

"For  example.  If  the  T'.S.  grantor  of  the  trust  has  died  or  if  the  trust  has  a  foreign 
grantor,  the  new  grantor  trust  rules  do  not  apply. 

"For  examnle,  the  tax  on  a  distribution  in  year  S  of  amounts  earned  in  year  2  (and 
thus  deemed  to  be  distributed  in  year  2)  is  subject  to  an  interest  charge  of  6  percent  for 
6  years,  or  a  total  of  36  percent  of  the  amount  of  tax. 


224 

under  the  new  five-year  throwback  rules  provided  for  under  sec.  701 
of  the  Act)  and  computing  the  entire  charge  based  on  that  average 
period.^^ 

The  interest  charge  is  to  be  calculated  on  an  annual  basis.  Amounts 
deemed  to  be  distributed  to  a  beneficiary  in  year  1  but  actually  dis- 
tributed in  year  2  carry  one  full  year's  interest  charge,  regardless  of 
when  in  year  1  the  amounts  were  earned  by  the  trust  or  when  in  year  2 
the  amounts  were  distributed. 

The  total  of  the  interest  charge  plus  the  tax  incurred  is  limited  by 
the  amount  of  the  distribution  (not  including  any  amounts  deemed 
distributed  as  taxes  paid  by  the  trust).  Thus,  in  no  case  can  the  in- 
terest charge  plus  the  tax  on  the  distribution  exceed  the  amount  actu- 
ally distributed.  The  amount  of  interest  paid  or  assessed  under  the 
provision  is  not  deductible  as  interest  for  Federal  tax  purposes  and 
may  itself  be  subject  to  interest  charges  in  c'ases  of  late  payment. 

The  interest  charge  applies  to  distributions  made  in  taxable  years  of 
beneficiaries  beginning  after  December  31.  1976.  Solely  for  purposes 
of  the  interest  charge,  undistributed  net  income  existing  in  a  foreign 
trust  as  of  the  beginning  of  the  first  taxable  year  beginning  after 
December  81.  1976.  is  treated  as  having  been  earned  b}-  the  trust  in 
that  taxable  year.  Thus,  any  distribution  out  of  earnings  deemed  to 
have  been  distributed  prior  to  taxable  years  beginning  after  Decem- 
ber 31,  1976.  bears  an  interest  charge  beginning  with  the  first  taxable 
year  beginning  after  December  31, 1976. 

Tender  the  provisions  of  the  Act,  U.S.  beneficiaries  receiving  dis- 
tributions from  foreign  trusts  not  taxed  under  the  grantor  trust  rules 
are  subject  to  the  new  five-year  throwback  provisions  established  for 
beneficiaries  of  trusts  generally  (see  sec.  701  of  the  Act).  Thus,  the 
exact  throwback  rules  and  the  three-year  shortcut  method  for  taxing 
ordinary  income,  plus  the  capital  gains  throwback  rules,  no  longer 
apply  to  distributions  from  foreign  trusts. 

In  addition,  the  new  multiple  trust  rules  (of  sec.  701  of  the  Act) 
apply  equally  to  foreign  trusts  as  to  domestic  trusts.  A  beneficiary 
receiving  distributions  attributable  to  the  same  taxable  year  from 
three  or  more  trusts  is  not  permitted  to  gross  up  his  distributions  by 
the  amount  of  trust  tax  paid  or  to  receive  a  tax  credit  for  distributions 
from  any  trust  bevond  the  first  two  trusts.  However,  the  Act  limits  to 
domestic  trusts  the  provision  permitting  trusts  to  accumulate  income 
for  unborn  children  or  children  under  the  ago  of  twenty-one  and  to 
avoid  the  throwback  rules  upon  later  distribution  of  the  accumulated 
income;  the  throwback  rules  apply  to  distributions  from  foreign  trusts 
without  regard  to  the  age  of  any  beneficiary. 

The  Act  provides  (in  Code  sec.  667(a)  as  amended  by  sec.  701  of  the 


"  For  exaninle.  if  anionnts  distributed  In  year  8  were  earned  in  jears  2.  .3,  and  4,  the 
number  of  years  for  which  Interest  Is  charged  Is  determined  first  by  calculating  the  num- 
ber of  years  of  accumulation  for  each  year  In  which  amounts  distributed  were  originally 
earned  (in  this  case  8—2  or  6  years  for  amounts  earned  in  year  2,  8 — 3  or  5  years  for 
p mounts  earned  in  year  3.  and  S— 4  or  4  years  for  amounts  earned  in  year  4).  The  total  of 
these  number  of  years  of  accumulation  (here  6-1-5  +  4.  or  15  years)  is  then  divided  by  the 
number  of  different  years  from  which  the  amounts  distributed  were  earned  (3  different 
years).  The  result  (5  years)  is  the  average  number  of  years  of  accumulation  and  is  multi- 
plied bv  the  6  percent  interest  rate  to  produce  the  total  percentage  of  interest  (30  percent) 
which  is  applied  against  the  amount  of  the  tax. 


225 

Act)  that  the  character  of  capital  g:ains  is  to  be  disreofarded  for  pur- 
poses of  taxing  accumulation  distributions  to  the  beneficiary.Further- 
more,  in  the  case  of  distributions  of  capital  gain  income  from  foreign 
trusts,  the  provision  of  prior  law  requiring  that  the  capital  gain  be 
allocated  to  income  and  not  to  corpus  if  the  foreign  trust  is  created  by 
a  U.S.  pei-son  has  been  expanded  to  apply  to  all  foreign  trusts.  The 
effect  of  ending  the  separate  characterization  of  income  from  capital 
gain  in  the  new  throwback  provisions  and  of  allocating  to  income  all 
capital  gains  in  foreign  trusts  is  to  treat  income  from  capital  gains  the 
same  as  ordinary  income  when  it  is  distributed  from  a  foreign  trust  as 
an  accumulation  distribution.  No  exclusion  of  50  percent  of  net  long- 
term  capital  gains  is  available  to  the  beneficiary  of  a  foreign  trust  upon 
such  a  distribution.  However,  if  a  foreign  trust  has  undistributed  net 
income  at  the  end  of  the  last  taxable  year  ending  before  January  1, 
1976,  which  is  attributable  to  income  from  capital  gains  from  any  prior 
taxable  year,  the  trust  is  permitted  to  reduce  undistributed  net  income 
as  of  the  beginning  of  the  next  taxable  year  by  the  amount  of  the  50 
percent  of  lonaf-term  capital  ,<rain  exclusion  which  would  be  permitted 
to  any  beneficiary  upon  the  distribution  of  all  undistributed  net  income. 
However,  no  reduction  in  undistributed  net  income  is  permitted  for 
foreign  trus*^s  attributable  to  income  from  capital  gains  earned  after 
the  effective  date  of  these  provisions. 

Excise  tax  on  transfers  to  foreign  entities. — The  Act  increases  the 
excise  tax  imposed  under  prior  law  (sec.  1491)  on  certain  transfers  of 
property  to  foreign  trusts,  foreign  corporations,  and  foreign  partner- 
ships from  271/^  percent  to  35  percent.  In  addition,  the  scope  of  the  tax 
has  been  altered.  First,  the  tax  is  to  apply  to  transfei-s  of  all  types  of 
property  rather  than  onl  v  to  transfers  of  securities.  Second,  the  tax  is  to 
apply  to  the  amount  of  irain  which  is  not  recognized  by  the  trans- 
feror at  the  time  of  the  transfer. 

Under  prior  law,  it  was  not  clear  whether  the  provision  applied  to 
all  transfers  of  appreciated  securities  regardless  of  whether  gain  is 
recognized.  Some  tax  advisors  have  interpreted  the  provision  to  apply 
primarily  to  donative  transactions.  The  excise  tax  as  amended  by  the 
Act  is  to  apply  to  all  transfers  (including  tax-free  exchanges)  whether 
or  not  at  fair  market  value  and  whether  or  not  the  transfer  is  made 
with  donative  intent.  However,  in  the  case  of  transfers  to  corporations, 
the  provision  is  to  apply  only  to  transfers  treated  as  paid-in  surplus 
or  as  a  contribution  to  capital.  The  amount  against  which  the  excise 
tax  is  applied  is  to  be  reduced  by  the  amount  of  frain  recognized  bv 
the  transferor  upon  the  transfer  of  the  property.  Thus,  all  sales  and 
exchanges  (includinir  tax  free  exchansres,  installment  sales,  and  private 
annuity  transactions),  regardless  of  how  any  gain  on  these  transac- 
tions is  reported,  are  within  the  scope  of  the  excise  tax  provision.  But 
to  the  extent  the  transferor  immediately  recogmizes  gain  in  the  trans- 
fer, the  amount  against  which  the  tax  is  applied  is  reduced. 

The  Act  adds  a  new  section  to  the  Code  imder  which  a  taxpayer 
may  elect  (under  remilations  prescribed  by  the  Secretary)  to  treat  a 
transfer  described  above  as  a  sale  or  exchan.cre  of  the  property  trans- 
ferred and  to  recognize  as  gain  (but  not  loss)  in  the  year  of  the 
transfer  the  excess  of  the  fair  market  value  of  the  property  transferred 


226 

over  the  adjusted  basis  (for  determining  gain)  of  the  property  in  the 
hands  of  the  transferor.  Thus,  to  the  extent  that  gain  is  recognized 
pursuant  to  the  election  in  the  year  of  the  transfer,  the  transfer  is 
not  subject  to  the  excise  tax,  and  normal  rules  will  apply  to  increase 
the  basis  to  the  transferee  by  the  amount  of  grain  received.  Since  the 
objective  of  section  1491  is  to  prevent  a  transfer  which  is  in  pursuance 
of  a  plan  having  as  one  of  its  principal  purposes  the  avoidance  of 
Federal  income  taxes  without  payment  of  tax,  the  making  of  an 
election  which  has  as  one  of  its  principal  purposes  the  avoidance  of 
Federal  income  taxes  is  not  permitted. 

As  under  prior  law,  the  excise  tax  does  not  apply  if  the  transferor 
can  establish  to  the  satisfaction  of  the  Secretary  that  the  transfer 
is  not  in  pursuance  of  a  plan  having  as  one  of  its  principal  purposes 
the  avoidance  of  Federal  income  taxes.  It  is  contemplated  that 
ordinarv  business  sales  or  exchanges  involving  an  unrelated  foreign 
trust  will  normally  be  determined  not  to  be  in  pursuance  of  a  plan 
of  tax  avoidnnre.^*  However,  where  the  transferor  of  the  property  is 
directly  or  indirectly  related  in  some  way  to  the  foreign  entity  receiv- 
ing the  property,  then  under  normal  circumstances,  the  transfer  could 
be  one  in  pursuance  of  a  plan  having  as  one  of  its  principal  purposes 
the  avoidance  of  Federal  income  taxes.  Such  a  transfer  would  thus 
normally  be  subject  to  the  excise  tax. 

A  final  change  in  the  excise  tax  made  by  the  Act  provides  that 
transfers  to  foreign  entities  to  which  section  367  of  the  Code  applies 
(dealing  with  reorganizations  and  transfers  involving  foreign  cor- 
porations) are  not  to  be  subject  to  the  new  35  percent  excise  tax.  The 
taxation  of  any  transfer  to  which  section  367  applies,  as  that  section 
is  amended  by  the  Act  (see  sec.  1042),  is  determined  entirely  by  that 
section  and  the  regulations  and  rulings  of  the  Internal  Revenue  Service 
under  that  section. 

Ejfective  dates 

The  new  grantor  trust  rule  is  to  apply  to  transfers  of  property  to 
existing  foreign  trusts  after  May  21, 1974,  and  to  all  new  trusts  created 
after  May  21, 1974.  However,  the  rule  is  to  apply  to  income  received  in 
taxable  years  beginning  after  December  31,  1975. 

The  interest  charge  on  distributions  to  beneficiaries  of  foreign  trusts 
is  to  apply  to  taxable  years  beginning  after  December  31,  1976.  The 
provision  applies  to  income  from  trusts  whenever  created.  The  change 
in  the  capital  gains  rule  for  foreign  trusts  not  created  by  XLS.  persons 
is  to  apply  to  taxable  years  beginning  after  December  31, 1975. 

The  amendment  to  the  excise  tax  on  certain  transfers  to  foreign 
entities  is  to  apply  to  transfers  of  property  after  October  2,  1975. 

Revenue  ejfect 
It  is  estimated  that  these  provisions  will  result  in  an  increase  in 
budget  receipts  of  $12  million  in  fiscal  year  1977  and  of  $10  million 
thereafter. 


'♦  For  example,  a  sale  of  real  estate  to  an  unrelated  real  estate  trust  In  a  case  where 
the  gain  from  the  sale  Is  reported  on  the  Installment  basis  should,  under  normal  circum- 
stances, be  considered  not  a  transfer  In  pursuance  of  a  plan  of  avoidance  of  Federal  taxes 
and  thus  would  not  normally  be  subject  to  the  35  percent  excise  tax. 


227 

4.  Amendments  Affecting  Tax  Treatment  of  Controlled  Foreign 
Corporations  and  Their  Shareholders  (sees.  1021  through 
1024  of  the  Act  and  sees.  951,  %4,  956,  958,  963,  and  1248  of  the 
Code) 

Prior  law 

The  United  States  imposes  its  income  tax  upon  the  worldwide  income 
of  any  domestic  corporation,  whether  this  income  is  derived  from 
sources  within  or  from  witlioiit  the  United  States.  A  tax  credit  (sub- 
ject to  limits)  is  allowed  for  foreign  income  taxes  imposed  on  its  for- 
eign source  income. 

Foreign  corporations  generally  are  taxed  by  the  TTnited  States  only 
to  the  extent  they  are  engaged  in  business  in  the  United  States  (and 
to  some  extent  on  other  income  derived  here).  As  a  result,  the  United 
States  generally  does  not  impose  a  tax  on  the  foreign  source  income 
of  a  foreign  corporation  even  though  it  is  owned  or  controlled  by 
a  U.S.  corporation  or  group  of  U.S.  corporations  (or  by  U.S.  citizens 
or  residents).  Such  a  corporation  is  subject  to  tax,  if  at  all,  by  the 
foreign  country  or  countries  in  which  it  operates. 

Generally,  the  foreign  source  income  of  a  foreign  corporation  is 
subject  to  U.S.  income  tax  only  when  it  is  actually  i-emitted  to  the 
U.S.  corporate  or  individual  shareholders  as  a  dividend.  The  tax  in 
this  case  is  imposed  on  the  U.S.  shareholder  and  not  the  foreign  cor- 
poration. The  fact  that  no  U.S.  tax  is  imposed  in  this  case  until  (and 
unless)  the  income  is  distributed  to  the  U.S.  shareholders  (usually 
corporations)  is  what  is  generally  referred  to  as  tax  deferral.^ 

An  exception  is  provided,  however,  to  the  general  rule  of  deferral 
under  the  so-called  subpart  F  provisions  of  the  Code.  Under  these  pro- 
visions income  from  so-called  tax  haven  activities  conducted  by  cor- 
porations controlled  by  U.S.  shareholders  is  deemed  to  be  distributed 
to  the  U.S.  shareholders  and  currently  taxed  to  them  before  they  actu- 
ally receive  the  income  in  the  form  of  a  dividend. 

The  rules  generally  apply  to  U.S.  persons  owning  10  percent  or 
more  of  the  voting  power  of  a  foreign  corporation,  if  more  than  fifty 
percent  of  the  voting  power  in  the  corporation  is  owned  by  U.S.  per- 
sona owning  10  percent  interests. 

The  categories  of  income  subject  to  current  taxation  as  tax  haven 
income  are  foreign  pereonal  holding  company  income,  sales  income 
from  property  purchased  from,  or  sold  to,  a  related  person  if  the 
property  is  manufactured  and  sold  for  use,  consumption,  or  dispo- 
sition outside  the  country  of  the  corporation's  incorporation,  income 
from  services  performed  outside  the  country  of  the  corporation's 
incorporation  for  or  on  behalf  of  any  related  per-^on,  and  shipping 
income  (unless  reinvested  in  shipping  assets).  The  statute  refers 
to  these  types  of  income  as  "foreign  base  company  income."  In  addi- 
tion, the  income  derived  by  a  controlled  foreign  corporation  from 
the  insurance  of  U.S.  risks  is  subject  to  current  taxation.  Foreign  base 
company  income  and  income  from  the  insurance  of  T".S.  risks  are  col- 
lectively referred  to  as  subpart  F  income. 


iWhp'-p  it  is  not  nntioinatpfl  t'lnt  the  incotnp  will  be  hronc'^t  back  to  tlip  TTnited  States, 
for  financial  accounting  purposes  (in  accountinfr  for  tbe  income  of  a  consolidated  group 
consisting  of  one  or  more  domestic  corporations  and  Its  foreign  subsidiaries)  this  income 
in  effect  Is  often  shown  as  income  exempt  from  U.S.  tax. 


228 

Also  earnings  of  controlled  foreign  corporations  are  taxed  cur- 
rently to  U.S.  shareholders  if  they  are  invested  in  U.S.  property.  Under 
prior  law,  U.S.  property  was  generally  defined  as  all  tangible  and  in- 
tangible property  located  in  the  United  States. 

In  addition  to  denying  deferral  on  certain  categories  of  income  un- 
der subpart  F,  the  Code  treats  as  a  repatriation  of  tax-deferred  earn- 
ings the  gain  realized  on  the  sale,  exchange  or  redemption  of  stock 
in  a  controlled  foreign  corporation  (sec.  1248).  If  a  U.S.  shareholder 
owns  10  percent  or  more  of  the  total  combined  voting  stock  of  a  for- 
eign corporation  at  any  time  during  the  5-year  period  ending  on  the 
date  of  the  sale  or  exchange  (while  the  corporation  was  a  controlled 
foreign  corporation) ,  the  recognized  gain  is  treated  as  a  dividend  to  the 
extent  of  the  foreign  corporation's  post-1962  earnings  and  profits  at- 
tributable to  the  stock  during  the  time  it  was  held  by  the  taxpayer 
and  was  a  controlled  foreign  corporation.  Under  prior  law,  however, 
this  provision  did  not  apply  to  earnings  and  profits  accumulated  by 
a  foreign  corporation  while  it  was  a  less-developed  country  corpora- 
tion if  the  stock  of  that  corporation  was  owned  by  the  U.S.  share- 
holders for  at  least  10  years  before  the  date  of  the  sale  or  exchange. 

a.  Investment  in  US.  property 

Reasons  for  change 

As  indicated  above,  an  investment  in  U.S.  property  by  a  controlled 
foreign  corporation  is  treated  as  a  taxable  distribution  to  its  U.S. 
shareholders.  The  reason  why  this  provision  was  adopted  was  the  be- 
lief that  the  use  of  untaxed  earnings  of  a  controlled  foreign  corpora- 
tion to  invest  in  U.S.  property  was  "substantially  the  equivalent  of  a 
dividend"  being  paid  to  the  U.S.  shareholders.  Therefore,  it  was  con- 
cluded that  this  sliould  be  the  occasion  for  the  imposition  of  a  tax  on 
those  earnings  to  the  XT.S.  shareholders  of  the  controlled  foreign  cor- 
poration making  the  U.S.  investment.  However,  prior  law  was  very 
broad  as  to  the  types  of  property  which  were  to  be  classified  as  U.S. 
investments  for  purposes  of  this  rule.  For  example,  the  acquisition  by 
the  foreign  corporation  of  stock  of  a  domestic  corporation  or  obliga- 
tions of  a  U.S.  person  (even  though  unrelated  to  the  investor)  was  con- 
sidered an  investment  in  U.S.  property  for  purposes  of  imposing  a  tax 
on  the  untaxed  earnings  to  the  investor's  U.S.  shareholders. 

The  Congress  believed  that  the  scope  of  the  provision  was  too  broad. 
In  its  prior  form  it  may,  in  fact,  have  had  a  detrimental  effect  upon 
our  balance  of  ])ayments  by  encouraging  foreign  corporations  to  invest 
their  profits  abroad.  For  example,  a  controlled  foreign  corporation 
looking  for  a  temporary  investment  for  its  working  capital  was,  by 
this  provision,  induced  to  purchase  foreign  ratlier  than  U.S.  obliga- 
tions. In  the  Congress's  view  a  provision  which  acts  to  encourage, 
rather  than  prevent,  the  accumulation  of  funds  offshore  should  be 
altered  to  minimize  any  hannful  balance  of  payments  impact  while 
not  permitting  the  U.S.  shareholders  to  use  the  earnings  of  controlled 
foreign  corporations  without  payment  of  tax. 

In  the  Con<rress's  view,  since  the  investment  by  a  controlled  foreign 
corporation  in  the  stock  or  debt  obligations  of  a  related  XT.S.  person  or 
its  domestic  affiliates  makes  funds  available  for  use  by  the  U.S.  share- 
holders,  it  constitutes  an  effective  repatriation  of  earnings  which 


229 

should  be  taxed.  The  classification  of  other  investments  in  stock  or 
debt  of  domestic  corporations  as  the  equivalent  of  dividends  is,  in  the 
Congress's  view,  detrimental  to  the  promotion  of  investments  in  the 
United  States.  Accordingly,  the  Act  provides  that  an  investment  in 
U.S.  property  does  not  result  when  the  controlled  foreign  corporation 
invests  in  the  stock  or  obligations  of  unrelated  U.S.  persons. 

In  addition,  the  Congress  believes  that  the  inclusion  of  oil-drilling 
rigs  used  on  the  U.S.  continental  shelf  acted  as  a  disincentive  to 
explore  for  oil  in  the  United  States.  Since  these  rigs  are  movable, 
they  can  easily  be  used  in  a  foreign  countrv.  Accordingly,  the  Act 
excludes  these  rigs  from  the  definition  of  U.S.  property. 

Explanation  of  provision 

The  Act  adds  three  exceptions  to  the  types  of  U.S.  property  the 
investment  in  which  by  a  controlled  foreign  corporation  results  in 
taxation  to  its  U.S.  shareholders  (see  sec.  951(a)  (1)  (B) ).  It  provides 
that  the  term  "United  States  property"  does  not  include  stock  or  debt 
of  a  domestic  corporation  (unless  the  corporation  is  itself  a  U.S. 
shareholder  of  the  controlled  foreign  corporation),  if  the  U.S. 
shareholders  of  the  controlled  foreign  corporation  own  or  are  con- 
sidered to  own,  in  the  aggregate,  less  than  25  percent  of  the  total  com- 
bined voting  power  of  all  classes  of  stock  of  such  domestic  corporation 
which  are  entitled  to  vote.  Thus,  under  this  provision,  a  controlled 
foreign  corporation  cannot  buy  the  stock  of,  or  lend  money  to,  any  of 
its  U.S.  shareholders.  In  addition,  a  controlled  foreign  corporation  can- 
not buy  the  stock  of,  or  lend  money  to,  U.S.  corporations  who  are  not 
U.S.  shareholders  of  that  controlled  foreign  corporation  if  those  U.S. 
shareholders  own  25  percent  or  more  of  the  stock  of  the  U.S.  corpora- 
tion. This  25  percent  test  is  to  be  applied  immediately  after  the  invest- 
ment by  the  controlled  foreism  corporation. 

For  purposes  of  determining  who  is  a  U.S.  shareholder  of  a  con- 
trolled foreign  corporation,  the  constructive  ownership  rules  apply 
(sec.  958 (^bU.  Hnwpver,  the  exception  to  those  rnles  for  certain  per- 
sons other  than  U.S.  persons  (contained  in  sec.  958(b)(1)  and  (4)) 
do  not  apply.  Thus,  for  example,  stock  owned  by  foreign  persons  is  at- 
tributed to  U.S.  persons  for  purposes  of  determining  whether  U.S. 
shareholders  of  the  controlled  foreign  corporation  own  25  percent  or 
more  of  a  domestic  corporation,  the  stock  of  which  is  acquired  by  the 
controlled  foreign  corporation,  in  determinina:  whether  there  has  been 
an  investment  in  US.  T>roperty.  If  at  any  time  there  is  an  investment 
in  U.S.  property,  the  U.S.  shareholders  of  the  controlled  foreio^n  cor- 
poration will  be  treated  as  having  received  a  distribution  under  sec- 
tion 956  equal  to  the  amount  of  the  investment  of  the  controlled  for- 
eign corporation.  It  is  intended  that  if  the  facts  indicate  that  the  con- 
trolled foreign  subsidiarv  facilitnted  a  loan  to,  or  borrowing  bv,  a  U.S. 
shareholder,  the  controlled  foreign  corporation  is  considered  to  have 
made  a  loan  to  (or  acquired  an  obligation  of)  the  U.S.  shareholder 
(seo.  956(oU. 

The  Act  also  excludes  from  the  definition  of  U.S.  property  movable 
drilling  rigs  (other  than  a  vessel  or  aircraft)  and  other  oil  and  jras  ex- 
ploration nnd  exploitation  equipment,  including  barges  which  are 
used  for  oil  exploration  and  exploitation  activities  on  the  continental 
shelf  of  the  United  States.  Basically,  this  exception  includes  that  prop- 


234-120  O  -  77  -  16 


230 

erty  which  is  entitled  to  the  investment  credit  if  used  outside  the 
United  States  in  certain  geographical  areas  of  the  Western  Hemis- 
phere (see  sec,  48(a)  (2)  (R)  (x) ).  For  this  purpose,  the  definition  of 
continental  shelf  as  used  in  section  638  is  to  be  applied. 

E-ffective  dates 

The  amendments  relating  to  investment  in  U.S.  property  by  a  con- 
trolled foreign  corporation  apply  to  taxable  years  of  foreign  corpora- 
tions beginning  after  December  31,  1975,  and  to  taxable  years  of  U.S. 
shareholders  within  which,  or  with  which,  such  taxable  years  of  such 
foreign  corporations  end. 

For  purposes  of  determining  the  increase  in  investment  in  U.S. 
property  for  years  after  1975,  the  cumulative  amount  invested  in 
U.S.  property  as  of  the  close  of  the  last  taxable  year  of  a  corpora- 
tion beginning  before  January  1,  1976,  is  computed  under  the  amend- 
ments made  by  this  section.  Consequently,  in  determining  the  increase 
in  earnings  invested  in  U.S.  property  (under  sec.  951(a)  (1)  (B))  in 
years  beginning  after  December  31,  1975,  only  the  investment  in 
U.S.  property  as  defined  in  the  Act  as  of  the  close  of  the  last  taxable 
year  beginning  before  1976  is  considered.^ 

Revenue  ejfect 

It  is  estimated  that  this  provision  will  have  little  or  no  effect  on  tax 
liabilities. 

6.  Exception  for  investments  in  less-developed  countries 

Reasons  for  change 
As  indicated  above,  prior  law  contained  an  exception  to  the  rules 
providing  for  dividend  treatment  on  the  sale  of  stock  of  a  subsidiary 
which  is  classified  as  a  less-developed  country  corporation.  The  extent 
to  which  this  exception  provided  an  incentive  to  invest  in  less- 
developed  countries  is  questionable.  The  size  of  the  tax  benefit  to  the 
U.S.  investor  depended  on  a  variety  of  factors,  such  as  the  foreign 
tax  rate  in  the  country  where  the  investment  is  made  and  in  other 
countries,  and  the  capital  gains  tax  rate  in  the  United  States.  Further, 
the  relationship  of  the  tax  benefits  to  the  investor  to  the  benefits  ob- 
tained bv  the  developing  country  was  erratic  since  the  size  of  the  tax 
benefit  could  bear  no  relationship  to  the  amount  of  development 
capital  invested.  While  these  factors  might  have  occasionally  combined 
to  encourage  investment  in  a  certain  less-developed  country,  the  Con- 
gress believes  that  it  would  be  preferable  to  provide  Avhatever  assist- 
ance is  appropriate  to  less-doveloped  coimtries  in  a  direct  manner 
where  the  economic  costs  can  be  accurately  measured. 

Explanation  of  provision 
The  Act  repeals  tl)e  los«-developed  country  exception  Avhich  excludes 
earnings  accumulated  while  a  corporation  was  a  less-developed  coun- 
try corporation  from  those  earnings  and  profits  which  are  subject  to 
tax  as  a  dividend  if  there  is  gain  from  the  sale  or  exchange  of  stock 

2  For  pvamnlp.  if  for  tlio  Inst  tnxable  vear  bpforo  this  Act  applies  a  controlled 
foreign  corporation  Is  considered  to  have  $100  Invested  in  U.S.  property  under  the  law  in 
effpct  prior  to  the  nmendmont  and  .?75  invested  in  U.S.  property  under  the  law  as  amended, 
$75  is  the  amount  considered  as  invested  in  U.S.  pronertv  for  purposes  of  determining 
whether  there  has  been  an  increase  in  investment  in  the  following  year. 


231 

in  the  controlled  foreign  corporation  (sec.  1248(d)  (3)  of  the  Code). 
However,  the  exclusion  is  still  applicable  with  respect  to  those  earn- 
ings of  a  controlled  foreign  corporation  which  were  accumulated  dur- 
ing any  taxable  year  beginning  before  Januaiy  1,  1976,  while  the  cor- 
poration was  a  less-developed  country  corporation  (as  defined  in  sec. 
902(d)  as  in  effect  prior  to  the  enactment  of  this  Act).  The  e:'"3lusion 
applies  to  pre-1976  earnings  regardless  of  whether  the  U.S.  share- 
holder owned  the  stock  for  ten  years  as  of  that  date. 

Effective  date 
The  provision  repealing  the  less-developed  country  exception  under 
section  1248  applies  to  taxable  years  beginning  after  December  31, 
1975. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in 
budget  receipts  of  $14  million  in  fiscal  year  1977  and  of  $10  million 
thereafter. 

c.  Exclusion  from  subpart  F  of  certain  earnings  of  insurance 
companies 

Reasons  for  change 

As  indicated  above,  one  of  the  principal  categories  of  tax  haven  in- 
come subject  to  current  taxation  is  foreign  personal  holding  company 
income  (sec.  954(c) ).  This  item  of  tax  haven  income  consists  of  passive 
investment  income  such  as  dividends,  interests,  rents  and  royalties. 
Prior  law  provided  an  exception  for  income  of  a  foreign  insurance  com- 
pany from  its  investment  of  unearned  premiums  or  reserves  which  are 
ordinary  and  necessary  for  the  proper  conduct  of  its  business. 

In  order  to  write  insurance  and  accept  reinsurance  premiums,  for- 
eign insurance  companies  may  be  required  by  the  laws  of  various  juris- 
dictions in  which  they  operate  to  meet  various  solvency  requirements  in 
addition  to  specified  capital  and  legal  reserve  requirements.  Many 
jurisdictions  also  employ  an  internal  rule-of -thumb  as  to  what  the  ratio 
of  surplus  to  earned  premiums  should  be.  In  the  United  States,  the 
National  Association  of  Insurance  Commissioners  employs  a  ratio  of 
1  to  3  (surplus  to  earned  premiums)  as  the  guideline  by  which  State 
regulatory  agencies  can  measure  the  adequate  solvency  of  companies 
insuring  casualty  risks.  If  Fuch  a  company's  ratio  were  less  than  1  to 
3,  for  instance  1  to  4,  the  State  resfulatory  agencv  may  question  its 
ability  to  accept  additional  risks.  Surplus  maintained  in  compliance 
with  the  1  to  3  ratio,  althou.o-h  not  necessarilv  required  by  law,  has  been 
considered  as  ordinary  and  necessary  to  the  proper  conduct  of  a 
casualty  insurance  business  in  the  United  States. 

Similar  ratios  often  are  employed  in  some  foreign  jurisdictions  with 
respect  to  companies  insuring  casualty  risks.  Even  where  the  foreign 
jurisdiction  does  not  imnose  reouirements  as  severe  as  those  required 
in  the  United  States,  a  foreiern  insurance  company  participating:  in  a 
reinsurance  pool  composed  princinally  of  companies  doine:  business 
in  the  United  States  must,  for  all  practical  purposes,  maintain  this 
ratio  to  satisfv  the  State  insurance  authorities  involved.  In  these 
situations,  the  State  regulatory  a<Tencv,  emplovinjr  the  relatively  hiq^h 
ratio,  will  review  the  solvency  of  the  foreign  insurer  before  allowing 


232 

the  placement  of  the  reinsurance  policy  with  such  foreign  insurer. 
This  effectively  causes  any  f oreifjn  insurance  company  participating  in 
a  reinsurance  pool  to  adhere  to  the  high  ratio.  Those  assets  maintained 
by  these  insurance  companies  in  order  to  meet  this  ratio  test  are  neces- 
sarily in  the  form  of  investments,  which,  in  turn,  generate  passive 
income  such  as  dividend  and  interest  income.  Just  as  in  the  case  of  the 
maintenance  and  investment  of  unearned  premiums  or  reserves,  these 
insurance  companies,  in  compliance  w^ith  the  high  ratio  requirement, 
must  maintain  and  invest  a  certain  portion  of  their  assets  in  connection 
with  the  active  conduct  of  their  trade  or  business.  The  Congress  be- 
lieves that  it  is  appropriate  to  provide  the  same  type  of  exception  from 
subpart  F  for  surplus  which  is  required  to  be  retained  as  is  provided  for 
unearned  premiums  or  reserves. 

Explanation  of  provision 

The  Act  adds  a  new  exception  to  the  definition  of  foreign  personal 
holding  company  income  (sec.  954(c)  (3)  (C)).  Under  the  exception, 
foreign  personal  holding  company  income  does  not  include  dividends, 
interest,  and  gains  from  the  sale  or  exchange  of  stock  or  securities 
derived  from  investments  made  by  an  insurance  company  of  an  amount 
of  assets  equal  to  one-third  of  its  premiums  earned  (as  defined  under 
sec.  832  (b)  (4) )  during  the  taxable  year  on  insurance  contracts  (other 
than  for  life  insurance  and  annuity  benefits  under  life  insurance  and 
annuity  contracts,  to  w^hich  sec.  801  pertains) . 

The  exception  only  applies  to  passive  income  received  from  a  person 
other  than  a  related  person  (as  defined  in  sec.  954(d)  (3)).  Also,  the 
exception  only  applies  with  respect  to  premiums  which  are  not  directly 
or  indirectly  attributable  to  the  insurance  or  reinsurance  of  related 
persons.  Where  an  insurance  company  participates  in  an  insurance  or 
reinsurance  pool,  it  is  not  intended  that  the  risk  insured  or  reinsured 
by  such  company  be  treated  as  a  risk  of  a  related  person  merely  because 
of  the  existence  of  the  pooling  arrangement,  the  existence  of  joint  lia- 
bility on  the  risk,  or  because  a  related  insurance  company  may  jointly 
share  in  the  risk  on  a  policy  issued  by  one  member  of  the  pool. 

Effective  date 
The  provision  applies  ilo  taxable  years  of  foreign  corporations  be- 
ginning after  December  31,  1975,  and  to  taxable  years  of  U.S.  share- 
holders within  which  or  with  v/hich  the  taxable  years  of  the  foreign 
corporations  end. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  $14  million  in  fiscal  year  1977  and  of  $10  million  per  year 
thereafter. 

d.  Shipping  profits  of  foreign  corporations 

Reasons  for  change 
As  indicated  above,  one  of  the  categories  of  tax  haven  income  sub- 
ject to  current  taxation  under  the  subpart  F  provisions  of  the  Code  is 
income  derived  from,  or  in  connection  with,  the  use  of  an  aircraft  or 
vessel  in  foreign  commerce,  except  to  the  extent  that  the  profits  are 
reinvested  in  shipping  assets.  In  general,  foreign  base  company  income 
is  defined  for  purposes  of  the  tax  haven  provisions  to  mean  income 


233 

earned  by  a  corporation  outside  the  country  of  incorporation.  In  the 
case  of  foreigTi  base  company  shipping  income,  however,  no  distinction 
was  made  under  prior  law  for  cases  where  a  corporation  derived  ^ts 
shipping  income  in  the  same  country  where  it  was  incorporated.  As  in 
the  case  of  other  tax  haven  income,  the  Congress  believes  that  ship- 
ping activities  should  not  be  categorized  as  a  base  company  activity 
when  the  corporation  involved  carries  on  its  activities  entirely  in  the 
country  in  which  it  is  organized  and  the  aircraft  or  vessel  is  registered. 

The  Congress  also  is  aware  that  the  law^  is  unclear  as  to  what  ship- 
ping profits  are  considered  as  reinvested  in  shipping  assets  and  thus 
entitle  a  controlled  foreign  corporation  to  an  exclusion  from  the 
subpart  F  provisions.  The  Congress  wants  to  insure  that  in  any  case 
where  a  controlled  foreign  corporation  discharges  an  unsecured  lia- 
bility which  constitutes  a  general  claim  against  its  shipping  assets, 
the  payment  in  discharge  of  that  liability  should  be  considered  a  pay- 
ment toward  the  acquisition  of  a  shipping  asset  as  much  as  the  pay- 
ment on  an  obligation  which  constitutes  a  specific  charge  against  a 
shipping  asset. 

Explanation  of  provision 

The  Act  provides  that  base  company  income  does  not  include  ship- 
ping income  derived  by  a  controlled  foreign  corporation  from  the 
operation  (or  hiring  or  leasing  for  use)  of  a  vessel  or  airplane  between 
two  points  in  the  country  in  which  the  vessel  or  airplane  is  registered 
and  the  controlled  foreign  corporation  is  incorporated.  Thus,  income 
earned  by  a  lessee  from  the  operation  of  the  vessel  or  aircraft  between 
two  points  within  the  country  of  registration  qualifies  for  this  excep- 
tion if  the  lessee  is  incorporated  in  that  country  whether  or  not  the 
owner  of  the  vessel  is  incorporated  there.  Similarly,  income  derived 
by  the  owner  from  the  hiring  or  leasing  of  a  vessel  or  airplane  for  use 
between  two  points  within  the  country  of  registration  qualifies  for  the 
exception  if  the  owner  is  incorporated  in  that  country  whether  or  not 
the  lessee  is  also  incorporated  there. 

Effective  date 
The  changes  made  by  the  Act  are  applicable  as  of  the  date  of  the 
provisions  which  added  the  foreign-base  company  shipping  rules  and 
thus  apply  to  taxable  years  of  foreign  corporations  beginning  after 
December  31,  1975,  and  to  taxable  years  of  U.S.  shareholders  within 
which  or  with  which  such  taxable  years  of  the  foreign  corporations 
end. 

Revenue  effect 
It  is  estimated  that  this  provision  will  decrease  receipts  by  less  than 
$5  million  on  an  annual  basis. 

5.  Amendments  to  the  Foreign  Tax  Credit  (sees.  1031  to  1037  of 
the  Act  and  sees.  78, 901, 902, 904, 908,  and  960  of  the  Code) 

Prior  law 
Taxpayers  subject  to  U.S.  tax  on  foreign  source  income  may  take 
a  foreign  tax  credit  for  the  amount  of  foreign  taxes  paid  on  income 
from  sources  outside  of  the  United  States.  The  credit  is  provided  only 
for  the  amount  of  income,  war  profits  or  excess  profits  taxes  paid  or 
accrued  during  the  taxable  year  to  any  foreign  country  or  to  a  posses- 
sion of  the  United  States. 


234 

This  foreign  tax  credit  system  embodies  the  principle  that  the  coun- 
try in  which  a  business  activity  is  conducted  (or  in  which  any  income 
is  earned)  has  the  first  right  to  tax  the  income  arising  from  activities 
in  that  country,  even  though  the  activities  are  conducted  by  corpora- 
tions or  individuals  resident  in  other  countries.  Under  this  principle, 
the  home  country  of  the  individual  or  corporation  has  a  residual  right 
to  tax  income  arising  from  these  activities,  but  recognizes  the  obliga- 
tion to  insure  that  double  taxation  does  not  result.  Some  countries  avoid 
double  taxation  by  exempting  foreign  source  income  from  tax  alto- 
gether. For  U.S.  taxpayers,  however,  the  foreign  tax  credit  system, 
providing  a  dollar-for-dollar  credit  against  U.S.  tax  liability  for  in- 
come taxes  paid  to  a  foreign  country,  is  the  mechanism  by  which  double 
taxation  is  avoided. 

The  foreign  tax  credit  is  allowed  not  only  for  taxes  paid  on  income 
derived  from  operations  in  a  specific  country  or  possession  of  the 
United  States,  but  it  is  also  allowed  for  dividends  received  from  for- 
eign corporations  operating  in  foreign  countries  and  paying  foreign 
taxes.  This  latter  credit,  called  the  deemed-paid  credit,  is  provided  for 
dividends  paid  by  foreign  corporations  to  U.S.  corporations  which 
own  at  least  10  percent  of  the  voting  stock  of  the  foreign  corporation. 
Dividends  to  these  U.S.  corporations  carry  with  them  a  proportionate 
amount  of  the  foreign  taxes  paid  by  the  foreign  corporation. 

The  computation  of  the  amount  of  the  foreign  taxes  allowed  as  a 
deemed-paid  credit  in  the  case  of  a  dividend  distribution  differed  de- 
pending upon  whether  or  not  the  payor  of  the  dividend  was  a  less- 
developed  country  corporation.  Initially,  a  question  arose  as  to  how 
much  of  the  foreign  taxes  for  purposes  of  this  credit  should  be  attrib- 
uted to  the  earnings  out  of  which  dividends  were  paid  and  how  much 
should  be  attributed  to  the  portion  of  earnings  used  to  pay  the  foreign 
taxes.  This  was  decided  in  the  Supreme  Court  case,  American  Chide 
Company^  which  required  the  foreign  taxes  paid  for  purposes  of  the 
credit  to  be  allocated  between  the  dividend  distribution  and  the  por- 
tion of  the  earnings  used  to  pay  the  foreign  taxes.  The  Congress  in 
1962,  however,  recognized  tliat  this  resolution  obtained  less  than  the 
full  U.S.  tax  on  the  dividend  income  because  it  omitted  from  the  U.S. 
tax  base  the  portion  of  the  earnings  used  to  pay  the  foreign  tax.  A^Hiere 
the  foreign  tax  was  less  than  the  U.S.  tax  (but  above  zero) ,  this  gave 
an  advantage  to  dividend  income  over  income  subject  to  the  full 
United  States  tax.  In  1962.  the  Congress  corrected  this  problem  for 
all  coi-porations  other  than  less-developed  country  corporations. 

The  correction  made  in  1962  took  the  form  of  requiring  the  earn- 
ings used  to  pay  the  foreign  tax  to  be  included  in  the  deemed  distribu- 
tion base  and  then  allowing  the  credit  for  foreign  taxes  paid  to  be 
based  upon  the  earnings,  including  the  amount  paid  as  foreign  taxes, 
and  not  merely  the  portion  paid  as  a  dividend. 

These  rules  for  the  deemed-paid  credit  apply  to  distributions  to  a 
domestic  corporation  from  a  first-tier  foreign  corporation  in  which 
the  domestic  corporation  is  a  10-percent  shareholder  and  to  distribu- 
tions from  a  second-tier  or  third-tier  foreign  corporation  (through  a 
firet-tier   foreign  corporation).   However,   distributions  originating 

'■American  Chicle  Company  v.  United  States,  316  U.S.  450  (1942). 


235 

from  a  foreign  corporation  that  is  more  than  three-tiers  beyond  the 
domestic  corporate  sliareholder  do  not  carry  with  them  any  deemed- 
paid  foreign  tax  credit. 

In  order  to  prevent  a  taxpayer  from  using  foreign  tax  credits  to 
reduce  U.S.  tax  liability  on  income  from  sources  within  the  United 
States,  two  alternative  limitations  on  the  amount  of  foreign  tax 
credits  which  could  be  claimed  were  provided  by  prior  law.  Under  the 
overall  limitation,  the  amount  of  foreign  tax  credits  which  a  tax- 
payer can  apply  against  his  U.S.  tax  liability  on  his  worldwide  in- 
come is  limited  to  his  U.S.  tax  liability  multiplied  by  a  fraction  the 
numerator  of  which  is  taxable  income  from  sources  outside  the  United 
States  and  the  denominator  of  which  is  worldwide  taxable  income. 
Under  this  limitation,  the  taxpayer  thus  aggregates  his  income  and 
taxes  from  all  foreign  countries;  a  taxpayer  may  credit  taxes  from 
any  foreign  country  as  long  as  the  total  amount  of  foreign  taxes 
applied  as  a  credit  in  each  year  does  not  exceed  the  amovmt  of  tax 
which  the  United  States  would  impose  on  the  taxpayer's  income  from 
all  sources  without  the  United  States. 

The  alternative  limitation  was  the  per-country  limitation.  Under 
this  limitation  the  same  calculation  made  under  the  overall  limitation 
was  made  on  a  country -by-country  basis.  The  allowable  credits  from 
any  single  foreign  country  could  not  exceed  an  amount  equal  to  U.S. 
tax  on  worldwide  income  multiplied  by  a  fraction  the  numerator  of 
which  was  the  taxpayer's  taxable  income  from  that  country  and  the 
denominator  of  which  was  worldwide  taxable  income.  Taxpayers  were 
required  to  use  the  per-country  limitation  unless  they  elected  the 
overall  limitation.  Once  the  overall  limitation  was  elected,  it  could 
not  be  revoked  except  with  the  consent  of  the  Secretary  or  his  delegate. 

The  Tax  Eeduction  Act  of  1975  prohibited  the  limitation  on  the 
foreign  tax  credit  on  income  from  oil-related  activities  from  being 
calculated  under  the  per-country  method.  Instead,  this  income  (and 
anj''  losses)  is  computed  under  a  separate  overall  limitation  which 
applies  only  to  oil-related  income.  Any  losses  from  oil-related  activity 
are  to  be  "recaptured"  in  future  years  through  a  reduction  in  the 
amount  of  allowable  foreign  tax  credits  which  can  be  used  to  offset 
subsequent  foreisrn  oil -related  income. 

In  addition,  the  Tax  Reduction  Act  of  1975  requires  that  the  amount 
of  any  taxes  paid  to  foreign  governm^ents  which  will  he  allowed  as  a 
tax  credit  on  foreign  oil  and  gas  extraction  income  be  limited  to  52.8 
percent  of  that  income  in  1975,  50.4  percent  in  1976,  and  50  percent 
in  subsequent  years. 

Finally,  the  Tax  Reduction  Act  of  1975  requires  that  no  tax  credit 
at  all  be  allowed  with  respect  to  payments  to  a  foreign  country  in 
connection  with  the  purchase  and  sale  of  oil  or  gas  where  the  tax- 
payer has  no  economic  interest  in  the  oil  or  gas  and  the  purchase  or 
sale  is  at  a  price  which  differs  from  the  fair  market  value. 

In  computing  taxable  income  from  any  particular  country  or  from 
all  foreign  countries  for  purposes  of  the  fractions  used  in  the  tax  credit 
limitations,  all  types  of  income  were  included  under  prior  law  as  well 
as  the  deductions  which  related  to  that  income  and  a  proportionate 
part  of  deductions  unrelated  to  any  specific  item  of  income.  Thus, 
for  example,  income  from  capital  gains  was  included  in  the  numerator 


236 

and  denominator  of  the  limiting  fraction  as  well  as  the  deductions 
allocable  to  those  ffains  (e.g.,  the  50-percent  exclusion  of  capital  gains 
for  individuals).  However,  an  exception  was  provided  for  interest  in- 
come if  that  income  was  not  derived  from  the  conduct  of  a  banking  or 
financing  business,  or  was  not  otherwise  directly  related  to  the  active 
conduct  of  a  trade  or  business  in  the  foreign  country.  Such  interest 
income  and  the  taxes  paid  on  it  was  subject  to  a  separate  per-country 
limitation  to  be  calculated  without  regard  to  the  other  foreign  income 
of  the  taxpayer. 

In  cases  where  the  applicable  limitation  on  foreign  tax  credits  re- 
duces the  amount  of  tax  which  can  be  used  by  the  taxpaj^er  to  offset 
U.S.  tax  liability  in  any  one  year,  the  excess  credits  not  used  may  be 
carried  back  for  two  years  and  carried  forward  for  five  years.  How- 
ever, if  a  person  using  the  per-country  limitation  in  any  year  elected 
subsequently  to  use  the  overall  limitation,  no  carryovers  were  per- 
mitted from  years  in  which  the  per-country  limitation  was  used  to 
yeare  in  which  the  overall  limitation  was  elected. 

The  prior  foreign  tax  credit  system,  and  in  particular  the  alternative 
methods  of  computing  the  limitation  on  allowable  foreign  tax  credits, 
contained  a  number  of  problems  which  resulted  in  inequities  between 
taxpayers  and  which,  in  some  cases,  resulted  in  a  reduction  of  U.S.  tax 
on  U.S.  source  income. 

a.  Per-country  limitation  and  foreign  losses 

Reasons  for  change 

The  use  of  the  per-country  limitation  often  permitted  a  U.S.  tax- 
payer who  had  losses  in  a  foreign  country  to  obtain  what  was,  in 
effect,  a  double  tax  benefit.  Since  the  limitation  was  computed  sep- 
arately for  each  foreign  country,  losses  in  any  foreign  country  did  not 
have  the  effect  of  reducing  the  amount  of  credits  allowed  for  foreign 
taxes  paid  in  other  foreign  countries  from  which  other  income  was 
derived.  Instead,  such  losses  reduced  U.S.  taxes  on  U.S.  source  income 
by  decreasing  the  worldwide  taxable  income  on  which  the  U.S.  tax  was 
based.  In  addition,  when  the  business  operations  in  the  loss  country 
became  profitable  in  a  subsequent  tax  year,  a  credit  was  allowed  for 
the  taxes  paid  in  that  country.  Thus,  unless  the  foreign  country  in 
which  the  loss  occurred  had  a  tax  rate  no  higher  than  the  U.S.  rate 
and  had  a  net  operating  loss  carryforward  provision  (or  some  similar 
method  of  using  prior  losses  to  reduce  subsequent  taxable  income) ,  the 
taxpaver  received  a  second  tax  benefit  when  income  was  derived  from 
that  foreign  country  because  no  U.S.  tax  was  imposed  on  the  income 
from  that  country  (to  the  extent  of  foreign  taxes  paid  on  that  income) 
even  tJiou<rh  earlier  losses  from  that  country  had  reduced  U.S.  tax 
liability  on  U.S.  source  income. 

The  Congress  does  not  believe  that  taxpayers  should  be  permitted 
to  obtain  the  double  tax  benefits  described  above.  Accordingly,  the  per- 
counti'v  limitation  was  repealed.  In  addition,  where  a  taxpayer  on  the 
overall  limitation  reduces  U.S.  tax  on  domestic  income  by  means  of  a 
loss  from  foreign  sources,  the  Congress  believes  that  this  tax  benefit 
should  be  subiect  to  recapture  by  the  United  States  wliere  foreign 
source  income  is  subsequently  derived. 


237 

(1)  Pe7'-country  limitation 

Explanation  of  provisions 

The  Act  includes  two  provisions  which  prevent  losses  incurred 
from  activities  abroad  from  reducing  U.S.  tax  on  U.S.  source  income. 
The  Act  repeals  the  per-country  limitation.  Taxpayers  will  be  re- 
quired to  compute  the  limitation  of  the  amount  of  foreign  tax  which 
can  be  used  to  reduce  U.S.  tax  under  the  overall  limitation.  The  effect 
of  this  provision  is  that  losses  from  any  foreign  country  will  reduce 
income  from  other  foreign  countries  for  purposes  of  calculating  the 
foreign  tax  credit  limitation,  and  thus  will  reduce  the  amount  of  for- 
eign taxes  which  can  be  used  from  those  countries  as  a  credit  against 
U.S.  tax.  Foreign  losses  will  reduce  U.S.  tax  on  U.S.  income  only  in 
cases  where  foreign  losses  exceed  income  from  all  foreign  countries 
for  the  taxable  year.  The  Act  also  provides  that  the  separate  limita- 
tion for  interest  income,  w^hich  under  prior  law  was  computed  on  a 
country-by-country  basis,  is  to  be  computed  on  an  overall  basis. 

It  is  the  Congress's  understanding  that  the  per-country  limitation 
is  not  required  under  the  provisions  of  any  recent  income  tax  treaty 
between  a  foreign  country  and  the  United  States.  It  is  the  Congress's 
intent  that  all  existing  treaties  are  to  be  applied  consistently  with  this 
provision  by  using  the  overall  limitation  in  computing  the  allowable 
foreign  tax  credit.* 

Because  the  provisions  of  this  Act  require  taxpayers  to  compute 
their  tax  credit  limitation  on  the  overall  method,  special  rules  are 
included  for  taxpayers  previously  on  the  per-country  limitation  to 
permit  some  excess  credits  to  be  carried  over  from  years  in  which  the 
per-country  limitation  applied  to  years  in  which  the  overall  limita- 
tion applies;  similarly,  special  rules  are  provided  to  permit  carry- 
backs from  overall  years  to  per-country  years.  The  Congress  recog- 
nizes that  the  repeal  of  the  per-country  limitation  may  have  a  sub- 
stantial adverse  impact  on  the  consolidated  tax  liability  of  an  affiliated 
group.  It  is  anticipated  that  in  these  cases  the  Internal  Revenue  Serv- 
ice will  permit  these  companies  to  discontinue  filing  consolidated 
returns. 

Carryovers  from  years  beginning  before  January  1,  1976,  during 
which  the  taxpayer  was  on  the  per-country  limitation,  to  years  begin- 
ning after  December  31, 1975  (i.e.,  years  during  which  the  taxpayer  is 
required  to  be  on  the  overall  limitation)  are  permitted  if  such  carry- 
overs were  created  under  the  rules  of  prior  law  (i.e.,  if,  under  the 
per-country  limitation,  the  taxpayer  had  excess  credits  from  one  or 
more  countries  which  could  be  carried  forward).  lender  the  Act  these 
excess  credits  are  further  limited  in  that  they  mav  be  used  only  to  the 
extent  they  would  be  used  had  the  per-country  limitation  continued 
to  apply  in  the  succeeding  taxable  years.  This  computation  is  to  be 
made  iii  the  following  steps.  If  the  excess  credits  attributable  to  any 
specific  country  from  prior  years  could  have  been  vised  under  the  per- 
coimtry  limitation  in  the  current  vear,  the  use  of  these  credits  in  the 
current  year  is  further  restricted  if  the  overall  limitation  produces  a 
lower  amount  of  total  credits.  If  this  limitation  applies,  the  amount 


*  Thp  roncTPss  f'Tthpr  Intends  that,  as  is  the  case  with  other  recent  letrlslatlon  modi- 
fying the  forelen  tax  credit,  the  changes  made  by  the  Act  are  to  be  used  In  computing 
the  credit  allowed  under  all  treaties. 


238 

of  the  carryovers  which  may  be  used  as  credits  are  reduced  to  the 
amount  allowed  under  the  overall  limitation.  The  amount  of  credits 
attributable  to  any  country  which  are  treated  as  being  used  in  the 
current  year  is  to  be  reduced  by  the  amount  of  credits  allowed  under 
the  per-country  limitation  that  are  not  allowed  under  the  overall 
limitation.  This  reduction  in  the  credits  to  be  available  is  allocated 
among  the  credits  attributable  to  each  of  the  foreign  countries  in  the 
ratio  of  the  credits  allowable  under  the  per-country  limitation  for  each 
country  to  the  aggregate  of  the  credits  allowable  on  this  basis  for  all 
countries.^  The  remaining  ct  edits  from  each  country  which  cannot  be 
used  in  the  current  year  can  continue  to  be  carried  forward  until  the 
end  of  the  5-year  carryforward  period. 

A  slightly  different  rule  is  provided  for  foreign  taxes  which  arise  in 
taxable  years  beginning  after  December  31,  1975  (overall  limitation 
years),  which  may  be  carried  back  to  years  beginning  before  Janu- 
ary 1,  1976,  during  which  the  taxpayer  was  on  the  per-country  lim- 
itation. First,  the  taxpayer  is  to  determine  if,  under  the  normal  rules 
applying  to  the  overall  limitation,  any  excess  credits  arise  in  the  cur- 
rent year  which  are  available  to  be  carried  back.  If  such  excess  credits 
do  arise,  the  taxpayer  is  to  make  a  country-by-country  computation 
for  the  current  year  to  determine  what,  if  any,  excess  credits  would 
arise  from  each  country  in  that  year  under  the  per-country  limitation. 
If  excess  credits  arise  from  any  country,  those  credits  can  be  carried 
back.  The  credits  which  are  available  to  be  carried  back  for  each 
country  can  then  be  applied  to  the  appropriate  earlier  years  if  these 
excess  credits  could  have  been  used  in  those  years  under  the  per- 
country  limitation.  Credits  which  are  not  available  to  be  carried  back 
may  be  carried  forward  to  subsequent  yeai"S  under  the^-year  carry- 
forward rules. 

Effective  date 

The  repeal  of  the  per-country  provision  and  the  related  carryback 
and  carryover  rules  apply  to  taxable  years  beginning  after  De- 
cember 31, 1975. 

The  Congress  is  aware  of  the  fact  that  certain  existing  mining  ven- 
tures were  begun  with  substantial  investments  of  capital  under  the 
assumption  that  the  foreign  tax  credit  could  be  computed  under  the 
per-country  limitation.  The  Congress  l)elieves  that  it  is  appropriate 
to  provide  a  limited  transitional  rule  for  these  cases.  The  Act  provides 
that  in  the  case  of  a  domestic  corporation  (whether  or  not  it  joins  in 
the  filing  of  a  consolidated  return  with  other  cor])orations)  which  as 


"  The  followlnj?  example  illustrates  this  reduction.  Assume  company  X  has  operations  in 
countries  A,  B,  and  C  as  follows  : 


A 

B 

c 

Total 

Income .  . 

40 

60 
30 

-40 
0 

60 

Taxes  (current  plus  carried  forward)                   .  - 

25 

55 

With  a  50-percent  U.S.  tax  rate,  company  X  could  use  50  credits  under  the  per-country  limitation 
(20  in  A  and  30  in  B)  and  30  under  the  overall.  Thus  the  amount  of  the  reduction  is  20  (50  minus  30), 
and  is  allocated  8  to  country  A  (20/50X20)  and  12  to  country  B  (30/.50X20).  Tn  this  case,  13  credits 
will  be  carried  forward  to  subsequent  years  from  country  A  (.5  originally  disallowed  by  the  per- 
country  limitation,  plus  8  disallowed  under  the  overall)  and  12  credits  will  be  carried  forward  from 
country  B. 


239 

of  October  1,  1975,  has  satisfied  four  conditions,  the  per-country  lim- 
itation may  be  used  for  all  taxable  years  beginning  before  January  1, 
1079.  The  four  conditions  are  that  the  corporation  has  as  of  October  1, 
1975:  (1)  been  engaged  in  the  active  conduct  of  the  mining  of  hard 
minerals  (of  a  character  for  which  a  percentage  depletion  deduction 
is  allowable  (under  sec.  613) )  outside  the  United  States  or  its  posses- 
sions for  less  than  5  years ;  (2)  has  had  losses  from  the  mining  activity 
in  at  least  2  of  the  5  years ;  (3)  derived  80  percent  of  its  gross  receipts 
since  the  date  of  its  incorporation  from  the  sale  of  the  minerals  that 
it  mined ;  and  (4)  made  commitments  for  substantial  expansion  of  its 
mining  activities. 

A  commitment  for  substantial  expansion  of  mining  activities  means 
a  commitment  of  additional  capital  for  the  purpose  of  substantially 
expanding  mining  production.  For  example,  if  the  production  of  a 
mine  for  the  period  immediately  before  October  1,  1975,  averaged 
less  than  75  percent  of  designed  capacity  and  if  additional  capital  is 
required  in  order  to  increase  production  to  reach  designed  capacity, 
the  commitment  of  that  additional  capital,  if  substantial,  would  be  a 
commitment  for  substantial  expansion  of  mining  activities.  To  the 
extent  that  any  foreign  loss  was  sustained  on  a  per-country  basis 
during  the  transition  period  the  loss  is  to  be  subject  to  the  general 
loss  recapture  on  a  per-country  basis. 

The  Congress  is  also  aware  that  a  similar  problem  exists  with 
respect  to  certain  ventures  begun  in  Puerto  Rico  or  other  possessions. 
Therefore,  the  Act  applies  the  special  transition  period  developed 
for  mining  ventures  to  existing  ventures  in  Puerto  Rico  or  other 
possessions.  Thus,  a  taxpayer  may  continue  to  use  the  per-country 
limitation  for  operations  in  Puerto  Rico  for  3  additional  years,  and 
any  loss  sustained  in  those  years  will  be  subject  to  recapture,  but  on  a 
per-country  basis. 

Revenue  effect 
It  is  estimated  that  the  repeal  of  the  per-country  limitation  will  re- 
sult in  an  increase  in  budget  receipts  of  $51  million  in  fiscal  year  1977, 
$35  million  in  fiscal  year  1978  and  $45  million  in  fiscal  year  1981. 

(^)  Foreign  Joss  recapture 

Explanation  of  provisions 
Repeal  of  the  per-countrj^  limitation,  as  outlined  above,  will  prevent 
a  taxpayer  who  has  foreign  losses  from  reducing  his  U.S.  tax  on  U.S. 
source  income  if  the  taxpayer  also  has  foreign  source  income  equal  to 
or  greater  than  the  amount  of  losses.  However,  in  a  case  where  overall 
foreign  losses  exceed  foreiffn  income  in  a  given  year,  the  excess  of  the 
losses  could  still  reduce  U.S.  tax  on  domestic  source  income.  In  this 
case,  if  the  taxpayer  later  receives  income  from  abroad  on  which  he 
obtained  a  foreign  tax  credit,  the  taxpayer  has  received  the  tax  benefit 
of  having  reduced  his  U.S.  income  for  the  loss  year  while  not  paying 
a  U.S.  tax  for  ih^,  later  profitable  year.  To  reduce  the  advantage  to 
these  taxpayers,  the  Congress  has  included  a  provision  which  requires 
that  in  cases  where  a  loss  from  foreign  operations  reduces  U.S.  tax  on 
U.S.  source  income,  the  tax  benefit  derived  from  the  deduction  of  these 
losses  should,  in  effect,  be  recaptured  by  the  United  States  when  the 
company  subsequently  derives  income  from  abroad. 


240 

In  general,  the  recapture  is  accomplished  by  treating  a  portion  of 
foreign  income  which  is  subsequently  derived  as  income  from  domestic 
sources.  The  amount  of  the  foreign  income  which  is  to  be  treated  as 
income  from  domestic  sources  in  a  subsequent  year  is  limited  to  the 
lesser  of  the  amount  of  the  loss  (to  the  extent  that  the  loss  has  not  been 
recaptured  in  prior  taxable  years)  or  50  percent  of  the  foreign  taxable 
income  for  that  year,  or  such  larger  percent  as  the  taxpayer  may 
choose.  Thus,  in  any  taxable  year  the  amount  subject  to  recapture 
is  not  to  exceed  50  percent  of  the  taxpayer's  foreign  income  (before 
recharacterization)  unless  the  taxpayer  chooses  to  have  a  greater  per- 
centage of  his  foreign  income  so  recharacterized.  Since  the  amount 
that  is  recaptured  represents  a  loss  which  in  the  previous  taxable 
year  reduced  the  U.S.  tax  on  income  from  U.S.  sources,  the  recaptured 
amoimt  is  to  be  treated  as  income  from  sources  within  the  United 
States. 

For  the  purposes  of  this  recapture  provision  the  Act  defines  the 
term  "overall  foreign  loss"  to  mean  the  amount  by  which  the  taxpayer's 
(or  in  the  case  of  an  affiliated  group  filing  a  consolidated  return,  the 
group's)  gross  income  from  sources  without  the  United  States  is  ex- 
ceeded by  the  sum  of  the  expenses,  losses,  and  other  deductions  prop- 
erly apportioned  or  allocated  to  foreign  sources  and  a  ratable  part  of 
any  expenses  losses  or  other  deductions  which  cannot  definitely  be 
allocated  to  some  item  or  class  of  gross  income  (under  sec.  862(b) 
of  the  Code) .  If  no  overall  foreign  loss  has  been  sustained  in  the  case  of 
an  affiliated  group  of  corporations  filing  consolidated  returns,  then  no 
loss  is  subject  to  recapture  even  if  a  member  of  the  group  had  a 
loss  and  the  member  is  subsequently  sold  or  otherwise  leaves  the 
group  (e.g.,  a  section  936  election  is  made  with  respect  to  the  member). 
In  computing  the  amount  of  the  foreign  loss,  the  net  operat- 
ing loss  deduction  (under  sec.  172(a))  and  any  capital  loss  carry- 
back and  carryover  to  that  year  (under  sec.  1212  of  the  Code)  are 
not  to  be  taken  into  account.  In  addition,  foreign  expropriation  losses 
(as  defined  in  sec.  172(k)  (1)  of  the  Code)  or  a  loss  which  arises  from 
fire,  storm,  shipwreck,  or  other  casualty,  or  from  theft  (unless  the 
loss  is  compensated  for  by  insurance  or  otherwise)  are  not  subject 
to  tlie  recapture  provision.  A  taxpayer  is  to  be  treated  as  sustaining 
a  foreign  loss  whether  or  not  he  claims  a  foreign  tax  credit  for  the 
year  of  the  loss. 

The  Act  also  provides  for  the  recapture  of  a  loss  where  property 
which  w^as  used  in  a  trade  or  business,  and  which  was  used  predomi- 
nantly outside  of  the  ITnited  States,  is  disposed  of  prior  to  the  time  the 
loss  hns  been  recaptured  under  the  rules  discussed  above.  These  rules  are 
to  apply  regardless  o^^  whether  gain  would  otherwise  be  recognized.  In 
cases  Avhere  srain  would  otherwise  not  be  recofrnized,  the  taxpaver  is 
to  be  treated  as  having  received  gain  which  is  to  be  reco^-ni/ed  in  the 
year  the  taxpayer  disposes  of  the  property.  The  grain  is  to  be  the  excess 
of  the  fair  market  value  of  the  prone rty  disponed  of  over  the  taxpayer's 
adinsted  basis  in  the  pronertv.  Of  course,  the  crain  to  be  recoirnized 
under  this  provision  is  to  be  limited  to  the  amount  of  the  foreign  losses 
not  vet  recaT^tured.  In  the  case  of  a  recapture  resulting  from  the  dis- 
position of  the  property,  100  percent  of  the  gain  (to  the  extent  of  losses 
not  previously  recaptured)  is  recaptured.  In  such  a  case  the  50-percent 


241 

of  gain  limit  is  not  applied,  and  the  amount  (if  any)  to  be  recaptured 
in  future  years  is  reduced  by  the  full  amount  of  the  gain. 

For  purposes  of  the  recapture  provisions,  the  term  "disposition"  m- 
cludes  a  sale,  exchange,  distribution,  or  gift  of  property  whether  or 
not  gain  or  loss  would  otherwise  be  recognized. 

If  income  is  recognized  solely  because  of  this  disposition  rule,  such 
income  receives  the  same  characterization  that  it  would  be  given 
had  the  <^axpayer  actually  sold  or  exchanged  the  property.  In  such 
cases,  the  Secretary  of  the  Treasury  is  given  the  authority  to  prescribe 
appropriate  regulations  to  provide  for  any  necessary  adjustments  to 
the  basis  of  the  property  to  reflect  any  taxable  income  so  recognized. 
However,  a  disposition  for  this  purpose  only  includes  a  transfer  of 
property  which  is  a  material  factor  in  the  realization  of  taxable  in- 
come by  the  taxpayer.  A  disposition  for  this  purpose  does  not  include 
a  transfer  of  property  to  a  domestic  corporation  in  a  distribution  or 
transfer  which  has  carryover  attributes  (sec.  381(a)).  Property  is  to 
be  treated  as  a  material  factor  in  the  realization  of  income  not  only 
if  it  is  or  was  a  material  factor  in  the  production  of  income,  but  also 
if  it  would  be  in  the  future. 

In  determining  whether  the  predominant  use  of  any  property  has 
been  without  the  United  States,  the  use  of  the  asset  during  the  3  years 
immediately  prior  to  the  disposition  (or  during  the  entire  period  of 
use  of  the  property,  if  less)  is  to  be  taken  into  account. 

E-ffective  date 

The  loss  recapture  provisions  apply  to  losses  sustained  in  taxable 
years  beginning  after  December  31,  1975,  with  two  exceptions.  Since 
the  new  recapture  provisions  apply  to  all  losses  (oil-related  and  other- 
wise), the  recapture  of  foreign  oil-related  losses  is  to  be  accomplished 
under  the  general  recapture  provisions  of  section  904.  However,  under 
the  special  limitation  for  foreign  oil-related  income,  a  separate  recap- 
ture computation  and  reduction  of  the  foreign  tax  credit  limitation 
is  made  with  respect  to  the  recapture  of  foreign  oil-related  losses  and 
other  losses.  Foreign  oil-related  losses  which  were  subject  to  recapture 
under  the  provisions  of  section  907(f)  which  have  not  yet  been  recap- 
tured are  to  be  recaptured  under  the  new  recapture  provisions. 

The  first  exception  applies  to  loss  from  a  debt  obligation  of  a  foreign 
government.  In  the  case  of  a  loss  from  the  disposition  of  a  bond,  note, 
or  other  evidence  of  indebtedness  issued  before  May  14,  1976,  by  a 
foreign  government  or  instrumentality  thereof  for  property  located 
in  that  country  or  stock  or  indebtedness  of  a  corporation  incorporated 
in  such  country,  the  loss  recapture  provision  does  not  apply.  This  pro- 
vision is  intended  to  provide  relief  where  foreign  subsidiaries  of 
domestic  corporations  incur  losses  because  they  w^ere  forced,  under  the 
threat  of  expropriation,  to  exchange  their  stock  or  assets  for  long-term 
debt  obligations  of  a  foreign  government  which  yield  very  low  interest. 

The  second  exception  applies  to  cases  where  a  loss  sustained  in  1976 
is  from  an  investment  which  became  substantially  worthless  prior  to 
the  effective  date.  The  loss  may  be  with  respect  to  stock  or  indebtedness 
(including  guarantees)  of  a  corporation  in  which  the  taxpayer  owned 
at  least  10  percent  of  the  voting  stock.  The  termination  may  be  by 
reason  of  sale,  liquidation  or  abandonment  of  a  single  corporation  or 


242 

a  group  of  corporations  which  are  operated  in  the  same  line  of  busi- 
ness. To  take  into  account  more  than  one  corporation  in  computing  the 
5-year  tests,  tlie  taxpayer  must  terminate  its  operations  by  January  1, 
1977,  in  all  of  the  corporations  in  the  group.  This  exception  applies 
where  a  corporation  has  suffered  an  operating  loss  in  three  out  of  the 
five  years  preceding  the  5^ear  in  which  the  loss  was  sustained,  has 
sustairicd  an  overall  loss  for  those  five  years,  and  the  termination 
takes  place  before  January  1, 1977. 

In  some  cases,  a  corporation  mav  want  to  continue  an  investment 
beyond  1976  in  an  attempt  to  try  to  make  the  investment  profitable, 
although  it  may  ultimately  fail'in  that  endeavor.  The  Act  provides 
that  if  a  loss  would  qualify  for  the  exception  to  recapture  but  for  the 
fact  that  the  investment  is  not  terminated  in  1976,  if  the  investment 
is  terminated  before  January  1, 1979,  there  is  to  be  no  recapture  of  the 
loss  to  the  extent  there  was  on  December  31, 1975,  a  deficit  in  earnings 
and  profits. 

Revenue  effect 
It  is  estimated  that  the  loss  recapture  provisions  will  result  in  an 
increase  in  budget  receipts  of  $2  million  in  fiscal  vear  1977,  $8  million 
in  fiscal  year  1978  and  $28  million  in  fiscal  year  1981. 

6.  Dividends  from  less-developed  country  corporations 

Prior  law 
Under  prior  law,  the  amount  of  a  dividend  from  a  less-developed 
country  corporation  included  in  income  by  the  recipient  domestic  cor- 
poration was  not  increased  (i.e.,  grossed  up)  by  the  amount  of  taxes 
which  the  domestic  corporation  receiving  the  dividend  was  deemed  to 
have  paid  to  the  foreign  erovernment.  Instead,  the  amount  of  taxes  was 
reduced  by  the  ratio  of  the  foreign  taxes  paid  by  the  less-developed 
country  corporation  to  its  pretax  profits. 

Reasons  for  change 
The  failure  to  gross-up  the  dividend  by  tlie  amount  of  the  foreign 
taxes  that  were  deemed  paid  resulted,  in  effect,  in  a  double  allowance 
for  foreign  taxes.  The  problem  arose  from  the  fact  that  the  amount  paid 
in  foreign  taxes  not  only  was  allowed  as  a  credit  in  computing  the  I".S. 
tax  of  the  corporation  receiving  the  dividend,  but  also  was  allowed  as 
a  deduction  (since  the  dividends  could  only  be  paid  out  of  income  re- 
maining after  payment  of  the  foreign  tax).  The  result  was  that  the 
combined  foreign  and  U.S.  tax  paid  bv  the  domestic  corporation  was 
less  than  48  percent  of  the  taxpayer's  income  in  cases  where  the  for- 
eign tax  rate  of  the  less-developed  country  corporation  was  lower 
than  the  48  percent  U.S.  corporate  tax  rate  (but  above  zero).^  In 

"For  example,  assume  that  a  foreign  country  Imposes  a  30-percent  tax  on  $1,000  of 
Income.  If  the  forelpn  corporation  earns  .$1,000  as  a  less-developed  country  corporation  In 
that  country,  a  distribution  by  that  corporation  of  the  remalnlne  $700  to  Its  U.S.  parent 
corporation  would  result  In  $700  income  to  the  U.S.  parent.  The  parent's  U.S.  tax  vould  be 
S.T.^fi  before  allowance  of  a  foreign  tax  credit.  In  calculntinir  the  foreign  tax  credit,  the 
$300  amount  of  foreign  taxes  paid  would  be  reduced  bv  .SOO/IOOO  to  $210.  The  S210  could 
then  be  credited  against  TT.S.  tax  liability  of  $,S.'?6,  leavinc  a  net  liability  of  $126.  Thus, 
the  combined  T\S.  tax  and  foreign  tax  Uahllitv  on  the  oritrlnal  $1,000  of  income  would  be 
$426  ($300  foreign  taxes  plus  $126  U.S.  tax),' not  the  $480  which  should  be  paid  at  a  48 
percent  rate. 

If  that  same  foreign  corporation  earning  $1,000  were  not  a  less-developed  country 
corporation,  the  entire  1.000  would  be  Included  In  the  parent  corporation's  Income  If  it 
received  a  dividend  of  $700  which  would  carrv  with  it  foreign  taxes  of  $300.  In  this  case, 
the  U.S.  tax  before  credit  would  be  $480.  The  entire  $300  of  foreign  taxes  would  be 
credited,  leaving  a  U.S.  tax  liability  of  $180.  The  combined  U.S.  tax  and  foreign  tax  liabil- 
ities would  be  $480. 


243 

cases  where  the  foreign  tax  rate  exceeded  48  percent,  the  dividend  did 
not  bring  with  it  all  the  foreign  taxes  that  were  paid  and  thus  the 
size  of  foreign  tax  credit  carryover  was  reduced. 

The  size  of  the  tax  diflferential  which  existed  in  the  case  of  divi- 
dends from  less-developed  country  corporations  varied  with  the  for- 
eign tax  rate,  as  can  be  seen  by  the  table  below : 

TABLE  1— RATE  DIFFERENTIAL  ENJOYED  WITH   RESPECT  TO  DIVIDENDS   FROM   LESS-DEVELOPED  COUNTRY 
CORPORATIONS  WITH  VARIOUS  SELECTED  FOREIGN  INCOME  TAX  RATES  AND  PRESENT  48  PERCENT  U.S.  RATE 


Rate 

differential 

enjoyed  by 

Income 

U.S.  tax 

Credit 

foreign 

Foreign 

available 

before 

against 

subsidiary 

Income  before  tax 

tax 

for  dividend 

credit 

U.S. tax 

U.S.  tax 

Total  tax 

(percent) 

$100 

0 

$100 

$48.00 

0 

$48.00 

$48.00 

0 

JlOO 

$10 

90 

43.10 

$9.00 

34.20 

44.20 

3.90 

JlOO 

20 

80 

38.40 

16.00 

22.40 

42.40 

5.60 

$100 .- 

24 

76 

36.48 

18.24 

18.24 

42.24 

5.76 

$100 

30 

70 

33.60 

21.00 

12.60 

42  60 

5.40 

$100 

40 

60 

28.80 

24.00 

4.80 

44.80 

3.20 

$100 

48 

52 

24.% 

24.96 

0 

48.00 

0 

$100 

55 

45 

21.50 

24.75 

•0 

55.00 

0 

*  Excess  credits  of  3.25  are  generated. 

Further,  the  tax  differential  disappeared  either  when  the  foreign 
tax  rate  equaled  or  exceeded  the  U.S.  tax  or  when  there  was  no  foreign 
tax  imposed  at  all.  The  maximum  tax  differential,  given  a  48-percent 
U.S.  tax  rate,  occurred  when  the  foreign  tax  was  half  that,  or  24  per- 
cent. The  differential  at  this  jDoint  was  5.76  percentage  points. 

The  Congress  believes  that  in  the  interest  of  uniform  tax  treatment 
between  developed  and  less-developed  country  corporations  and  among 
all  less-developed  country  corporations,  this  double  allowance  should 
be  removed.  Further,  providing  for  identical  treatment  between  all 
foreign  corporations  simplifies  the  foreign  tax  credit  computation. 

Explaiiafion  of  proviswn 
Under  the  Act,  dividends  from  less-developed  country  corporations 
are  treated  the  same  as  dividends  from  other  foreign  corporations. 
Thus,  the  amount  of  the  dividends  is  increased  by  the  amount  of  taxes 
deemed  paid  with  respect  to  that  dividend. 

Effective  date 
For  distributions  out  of  current  income,  the  provision  is  effective 
for  taxable  years  beginning  after  December  31,  1975.  However,  the 
Act  provides  that  for  distributions  made  by  less  developed  country 
corporations  in  taxable  years  beginning  after  December  31,  1975.  and 
received  by  domestic  corporations  before  Januaiy  1,  1978,  this  provi- 
sion applies  only  to  the  extent  that  the  distributions  are  made  out  of 
profits  of  the  foreign  corporation  accumulated  in  taxable  years  (of 
such  foreign  corporation)  beginning  after  December  31,  1975.  Thus, 
during  that  period,  distributions  of  a  less-developed  country  corpo- 
ration out  of  profits  accumulated  in  taxable  years  beginning  before 
January  1.  1076,  are  taxed  as  under  prior  law.  After  January  1.  1978, 
however,  the  provisions  of  this  Act  apply  to  all  distributions  regard- 
less of  the  year  in  which  the  profits  are  accumulated. 


244 

Revenue  effect 
It  is  estimated  that  this  provision  will  increase  budget  receipts  by 
$80  million  in  fiscal  year  1977  and  by  $55  million  thereafter. 

c.  Treatment  of  capital  gains 

Reasons  for  change 

The  prior  foreign  tax  credit  limitation  created  a  number  of  prob- 
lems in  the  treatment  of  capital  gains  stemming  from  the  fact  that 
capital  gains  are  taxed  dijfferently  than  ordinary  income.  In  many 
cases  the  source  of  income  derived  from  the  sale  or  exchange  of  an 
asset  is  determined  by  the  location  of  the  asset,  or,  if  the  asset  is  per- 
sonal property,  by  the  place  of  sale  (i.e.,  the  place  where  title  to  the 
property  passes) .  In  the  latter  case,  taxpayers  could  often  exercise  a 
choice  of  the  country  from  which  the  income  from  the  sale  of  personal 
property  is  to  be  derived.  It  has  thus  been  possible,  in  some  cases,  for  a 
taxpayer  to  plan  sales  of  personal  property  (including  stocks  or  se- 
curities) in  such  a  way  as  to  maximize  use  of  foreign  tax  credits  by 
arranging  that  the  sale  of  that  property  take  place  in  a  certain  country. 

Since  most  countries  (including  the  United  States)  impose  little, 
if  any,  tax  on  sales  of  personal  property  by  foreigners  if  the  sales 
are  not  connected  with  a  trade  or  business  in  that  country,  the  prior 
system  permitted  taxpayers  to  plan  sales  of  their  assets  in  such  a  way 
that  the  income  from  the  sale  resulted  in  little  or  no  additional  for- 
eign taxes  and  yet  the  amount  of  foreign  taxes  they  could  use  as  a 
credit  against  their  U.S.  tax  liability  was  increased. 

Further  prdblems  in  the  treatment  of  income  from  the  sale  or  ex- 
change of  assets  for  purposes  of  the  foreign  tax  credit  limitation  were 
presented  because  prior  law  included  no  explicit  rules  for  netting  long- 
term  and  short-term  gains  and  losses  in  cases  where  some  gains  or 
losses  are  U.S.  source  income  while  other  gains  or  losses  are  foreign 
source  income.  The  Internal  Revenue  Service  has  held  that  if  a  tax- 
payer (in  certain  circumstances)  had  losses  from  sources  within  the 
United  States  and  had  gains  from  sources  outside  the  United  States, 
the  domestic  losses  did  not  offset  the  foreign  gains  for  purposes  of 
determining  taxable  income  from  sources  without  the  TTnited  States 
in  the  limiting  fraction  of  the  per-country  or  overall  limitation  on 
foreign  tax  credits.  For  example,  if  a  taxpayer  had  long-term  gain 
from  sources  outside  the  United  States,  that  gain  would  increase  in- 
come from  sources  without  the  United  States  and  thus  would  increase 
the  amount  of  foreign  tax  credits  allowed  to  reduce  U.S.  tax  liability, 
even  tho\igh  that  gain  had  no  effect  on  the  taxpayer's  pre-credit  U.S. 
tax  liability  because  it  was  offset  by  U.S.  source  capital  losses.  The  re- 
sult is  that  in  a  case  of  foreign  gains  and  domestic  losses  the  amount  of 
foreign  tax  credits  which  could  be  used  was  increased  without  a  com- 
mensurate increase  in  U.S.  tax  liabilitv:  IT.S.  tax  on  U.S.  income  was 
reduced.  Where  foreign  losses  reduced  U.S.  gains,  the  amount  of  the 
allowable  credit  was  improperly  reduced. 

A  problem  with  the  treatment  of  capital  gains  under  the  foreign 
tax  credit  system  was  also  presented  by  the  fact  that  the  credit  limita- 
tions were  not  adjusted  to  reflect  the  lower  tax  rate  on  capital  gains 
income  received  by  corporations.^  Under  prior  law,  corporations  hav- 


■^  A  similar  problem  exists  to  a  mvioh  lesser  extent  for  canital  gains  income  of  inrtividuals 
under  the  alternntive  tax  fsecs.  1201  (b)  and  {o>).  However,  since  only  a  limited  amount 
of  Income  is  eligible  for  this  treatment  It  was  felt  unnecessary  to  deal  with  this  problem. 


245 

ing  a  net  long-term  capital  gain  in  most  instances  pay  only  a  30-percent 
rate  of  tax  on  the  gain.  But  for  purposes  of  determining  foreign  source 
and  worldwide  income  in  the  limiting  fraction  of  the  foreign  tax  credit 
limitation,  income  from  long-term  capital  gain  was  treated  the  same  as 
ordinary  income  (i.e.,  as  if  it  were  subject  to  a  48-percent  rate  of  tax).^ 
Similarly,  a  corporation  which  had  capital  gain  income  from  U.S. 
sources  and  had  foreign  source  income  that  was  not  capital  gain  did  not 
receive  a  full  credit  for  the  amount  of  U.S.  tax  attributable  to  foreign 
source  income.^ 

Finally,  in  computing  the  foreign  tax  credit  limitation,  the  numera- 
tor of  the  limiting  fraction  was  reduced  by  the  amount  of  the  net 
capital  losses  from  sources  without  the  United  States  which  were  taken 
into  account  in  computing  the  taxpayer's  entire  taxable  income  for  the 
year  (i.e.,  to  the  extent  that  they  were  deductible  as  offsets  against 
capital  gain  net  income  from  sources  within  the  United  States).  How- 
ever, no  adjustment  was  made  under  prior  law  to  account  for  the  lower 
rate  where  the  net  capital  loss  from  sources  without  the  United  States 
offset  long-term  capital  gains  from  sources  within  the  United  States, 
even  thougli  the  gains  would  have  only  been  subject  to  tax  at  a  30- 
percent  rate  if  the  foreign  loss  had  not  been  sustained.  Thus,  while  the 
foreign  source  capital  losses  reduced  long-term  capital  gains  for  pur- 
poses of  computing  taxable  income,  the  impact  on  the  computation  of 
the  foreign  tax  credit  limitation  was  for  the  foreign  source  capital 
losses  to  reduce  foreign  source  ordinary  income.  Consequently,  the 
loss  reduced  the  taxpayer's  foreign  tax  credit  limitation  by  an  amount 
greater  than  the  tax  which  would  have  been  imposed  on  the  U.S. 
source  gain  in  the  absence  of  the  loss,  and  the  taxpayer's  net  U.S.  tax 
after  the  foreign  tax  credit  was  higher  than  it  would  have  been  had  it 
not  sustained  the  loss. 

The  Congress  believes  that  adjustments  should  be  made  to  the  for- 
eign tax  credit  limitation  to  take  into  account  the  fact  that  capital  gains 
are  taxed  differently  from  ordinary  income. 

Explanation  of  provisions 

The  Act  includes  three  provisions  altering  the  treatment  of  income 
from  the  sale  of  capital  assets  for  purposes  of  computing  the  limita- 
tion on  the  foreign  tax  credit.  The  Act  establishes  specific  rules  for  de- 
termining the  extent  to  which  income  or  loss  from  the  sale  or  exchange 
of  capital  assets  from  sources  outside  the  United  States  is  to  be  in- 
cluded in  the  limiting  fraction  in  calculating  the  foreign  tax  credit 
limitation. 

The  amount  of  capital  gain  included  in  foreign  source  income  is  re- 
ferred to  as  "foreign  source  capital  gain  net  income",  defined  as  the 
lower  of  capital  gain  net  income  from  sources  without  the  United 
States  or  capital  gain  net  income.  (Capital  gain  net  income  is  the  ex- 

» For  example,  if  a  corporation  had  worldwide  income  of  $20  million,  $10  million  of 
which  was  ordinary  income  from  sources  within  the  United  States  and  $10  million  of  which 
was  income  from  the  sgile  of  a  capital  asset  from  sources  without  the  United  States,  that 
corporation  was  allowed  a  foreign  tax  credit  equal  to  one  half  (10/20)  of  its  U.S.  tax 
liability,  even  though  only  $3  million  of  the  $7.8  million  in  U.S.  tax  liability  was  attribut- 
able to  foreign  source  income.  Prior  law  thus  favored  the  taxpayer  with  foreign  source 
capital  gain  since  its  U.S.  tax  on  foreign  income  of  $10  million  was  not  treated  as  being 
$3.0  million  but  as  $3.9  million. 

"For  example.  If  such  a  taxpayer  had  $10  million  of  U.S.  source  capital  gain  and  $10 
million  of  foreign  ordinary  Income,  the  foreign  tax  credit  limitation  would  limit  the  credit 
to  $3.9  million  even  though  it  would  be  liable  for  $4.8  million  of  U.S.  tax  on  Its  foreign 
source  Income. 


234-120  O  -  77  -  17 


246 

cess  of  the  gains  from  sales  or  exchanges  of  capital  assets  over  the 
losses  from  such  sales  or  exchanges.)  Thus,  under  this  provision,  for- 
eign source  capital  gain  can  oe  used  to  increase  the  amount  of  tax 
credits  available  to  oliset  U.IS.  tax  liability  only  to  the  extent  the  for- 
eign source  capital  gain  results  in  a  foreign  source  capital  gain  nc 
income.  In  cases  where  foreign  and  net  U.kS.  losses  equal  or  exceed 
foreign  gains,  the  foreign  gains  will  not  be  taken  into  acoomit  for  pur- 
poses of  determining  the  limitation. 

The  second  adjustment  for  capital  gains  income  of  corporations 
under  the  foreign  tax  credit  limitation  provides  that  the  foreign 
source  capital  gain  net  income  taken  into  account  is  to  be  reduced  by 
three-eighths  of  foreign  source  net  capital  gain.  Foreign  source  net 
capital  gain  is  defined  as  the  lower  of  the  net  capital  gain  from  sources 
without  the  United  btates  or  net  capital  gain.  (iSet  capital  gain  is  the 
excess  of  net  long-term  capital  gain  over  net  short-term  capital  loss.) 
In  etfect  a  maximum  of  80/48ths  of  the  net  long-term  capital  gain 
from  sources  without  the  United  States  is  taken  mto  account.^**  This 
reduction  of  income  is  made  to  prevent  distortion  in  the  amount  of 
foreign  tax  credits  allowable  to  foreign  income  which  would  result  be- 
cause capital  gams  for  corporations  is  taxed  at  a  30-percent  rate 
rather  than  a  48-percent  rate.^^ 

Further  to  the  extent  that  a  net  capital  loss  from  sources  without 
the  United  States  is  taken  into  account  in  determining  capital  gain 
net  income  for  the  taxable  year  (i.e.,  to  the  extent  that  a  net  capital 
loss  from  sources  without  the  United  States  is  allowed  as  a  deduction 
in  computing  taxable  income  for  the  taxable  year  because  it  offsets 
capital  gain  net  income  from  sources  within  the  United  States) 
and  thus  reduces  the  numerator,  the  loss  is  reduced  (and  thus  the 
numerator  is  increased)  by  three-eighths  of  the  excess  of  net  capital 
gain  from  sources  within  the  United  States  over  net  capital  gain.  Since 
the  amount  of  the  deductible  net  capital  loss  from  sources  without  the 
United  States  is  not  as  such  taken  into  account  as  a  separate  element  m 
computing  the  denominator  of  the  foreign  tax  credit  limitation,  no 
adjustment  is  made  to  the  depominator  of  the  fraction  in  this 
situation.^^ 


1"  If  a  corporation  has,  for  example,  $100  of  net  long-term  capital  gain  from  sources 
without  the  United  States,  all  of  which  is  foreign  source  capital  gain  net  income,  that 
corporation  Includes  as  foreign  source  income  only  a  maximum  of  30/48ths  (or  %ths) 
thereof.  Assuming  that  all  of  the  corporation's  foreign  source  capital  gain  net  income  qual- 
ifies as  foreign  source  net  capital  gain,  the  corporation  is  permitted  only  $30  In  tax  credits 
attributable  to  the  $100  of  foreign  source  Income,  rather  than  the  $48  in  foreign  tax  credits 
which  would  be  permitted  without  the  reduction  in  capital  gain  Income.  Similarly,  a  com- 
pany which  has  $100  in  domestic  capital  gain  income  and  $100  in  foreign  source  ordinary 
Income  includes  as  U.S. -source  Income  30/48ths  of  its  U.S.  source  net  capital  gain.  Such  a 
corporation  has  a  $48  limitation  on  foreign  tax  redits  attributable  to  the  $100  of  foreign 
income  rather  than  $39  as  would  be  permitted  without  the  reduction  in  capital  gains 
income. 

"  A  similar  adjustment  is  not  needed  In  the  case  of  taxpayers  other  than  corporations 
(even  though  the  alternative  tax  might  be  used)  since  in  computing  taxable  Income  for 
purposes  of  the  foreign  tax  credit  limitation  a  deduction  Is  taken  for  long-term  capital 
gains  (sec.  1202). 

"  This  provision  may  be  Illustrated  by  the  following  example.  Assume  a  corporation  has 
a  U.S.  source  long-term  capital  gain  of  $50,  a  U.S.  short-term  capital  gain  of  $25,  a  foreign 
source  long-term  capital  gain  of  $100,  and  a  foreign  source  long-term  capital  loss  of  $200. 
The  taxpayer  also  had  U.S.  source  ordinary  income  of  $1,000  and  foreign  source  ordinary 
Income  of  $100.  Only  $75  of  the  corporation's  net  foreign  source  capital  loss  is  taken  into 
account  in  computing  its  capital  gain  net  inome  of  zero  for  the  taxable  year,  and  its  net 
capital  gain  from  U.S.  sources  of  $50  exceeds  its  worldwide  net  capital  gain  of  zero  by  $50. 
'J''ius,  the  numerator  of  the  foreign  tax  credit  limitation  is  reduced  by  $56.25  ($75  less 
than  three-eighths  of  $50).  Therefore,  the  numerator  is  $43.75  ($100  less  $56.25),  and 
the  denominator  is  $1,100.  On  the  basis  of  a  tentative  U.S.  tax  of  $52.8,  the  foreign  tax 
credit  limitation  is  $21,  and  the  U.S.  tax  after  the  credit  is  $507,  the  same  amount  of  tax 
the  corporation  would  be  liable  for  if  its  foreign  source  income,  gains  and  losses  were 
disregarded. 


247 

The  Act  also  provides  a  special  rule  which  applies  to  personal  prop- 
erty sold  outside  of  the  United  States  by  a  corporation  or  by  an  in- 
dividual (if  sold  or  exchanged  outside  of  the  countiy  of  the  individ- 
ual's residence) .  In  these  cases,  no  income  is  included  for  purposes  of 
calculating  the  numerator  of  tiie  foreign  tax  credit  limitation  from 
such  sales  or  exchanges  if  the  country  in  which  such  property  is  sold 
does  not  impose  an  income,  war  profits,  or  excess  profits  tax  at  a  rate  at 
least  equal  to  10  percent  of  the  gain  from  the  sale  or  exchange  as  com- 
puted under  U.S.  tax  rules.  This  is  accomplished  by  treating  the 
foreign  source  capital  gain  as  U.S.  source  income.  The  purpose  of  this 
rule  is  to  prevent  taxpayei  s  from  selling  their  assets  abroad  primarily 
to  utilize  any  excess  foreign  tax  credits  which  they  may  have  available 
from  other  activities.  It  was  concluded  that  if  the  foreign  government 
significantly  taxes  a  sale,  that  sale  probably  did  not  take  place  in  that 
country  purely  for  tax  purposes.  The  Congress  concluded  that  a  tax 
of  10  percent  of  the  gain  was  substantial  for  these  purposes. 

The  rules  treating  foreign  source  capital  gain  as  U.S.  source  income 
do  not  apply  in  three  situations,  even  though  no  foreign  tax  is  paid 
on  the  gain.  These  cases  involve  situations  where  the  sale  is  not  made  in 
a  country  purely  for  tax  purposes  and,  thus,  an  exception  to  the  gen- 
eral rule  should  be  made.  The  three  cases  are :  first,  in  the  case  of  a 
sale  by  an  individual,  if  the  property  is  sold  or  exchanged  within  the 
individual's  country  of  residence;  second,  in  the  case  of  a  sale  by  a 
corporation  of  stock  in  a  second  corporation,  if  the  stock  is  sold  in  a 
country  in  which  the  second  corporation  derived  more  than  50  percent 
of  its  gross  income  for  the  3-year  period  ending  with  the  close  of  the 
second  corporation's  taxable  year  immediately  preceding  the  year  dur- 
ing which  the  sale  took  place ;  and  third,  in  the  case  of  a  sale  by  a  corpo- 
ration or  an  individual  of  personal  property  (other  than  stock  in  a  cor- 
poration), if  the  property  is  sold  in  a  country  in  which  such  property 
was  used  in  a  trade  or  business  of  the  taxpayer  or  in  which  the  tax- 
payer derived  more  than  50  percent  of  its  gross  income  for  the  3-year 
period  ending  with  the  close  of  its  taxable  year  immediately  preced- 
ing the  3'^ear  during  which  the  sale  took  place. 

The  changes  in  capital  gains  income  generally  are  to  apply  both 
to  capital  assets  and  to  business  assets  if  such  assets  are  treated  as 
capital  assets  under  the  applicable  Code  provision.  The  new  rules  for 
capital  gains  are  to  be  applied  before  application  of  the  rules  dealing 
with  the  recapture  of  foreign  losses. 

Effective  dates 

These  provisions  are  to  take  effect  with  respect  to  gains  and  losses 

recognized  in  taxable  years  beginning  after  December  31, 1975,  except 

that  the  rule  which  treats  certain  foreign  source  gain  as  U.S.  source 

gain  only  applies  to  sales  or  exchanges  made  after  November  12, 1975. 

Revenue  effect 
It  is  estimated  that  the  capital  gain  provisions  will  result  in  an 
increase  in  budget  receipts  of  $14  million  in  fiscal  year  1977  and  $10 
million  thereafter. 


248 

d.  Foreign  oil  and  gas  extraction  income 

(1)  Limitation  on  oil  and  gas  extraction  income 
Reasons  for  change 
Under  prior  law,  the  amount  of  foreign  taxes  paid  with  respect  to 
foreign  oil  and  gas  extraction  income  which  under  U.S.  law  were  cred- 
itable taxes  with  respect  to  foreign  oil  and  gas  extraction  income  was 
limited  to  50  percent  of  that  income  on  an  overall  basis  for  taxable 
years  ending  after  1976.  For  purposes  of  this  limitation  "foreign  oil 
and  gas  extraction  income"  is  the  income  derived  by  the  taxpayer  from 
extraction  (by  the  taxpayer  or  any  other  person)  of  minerals  from  oil 
and  gas  wells.  Income  from  extraction  includes  the  purchase  and  sale 
of  crude  oil  by  the  taxpayer  in  cases  where  the  taxpayer  is  not  per- 
forming the  extraction  operations.  Also  it  includes  cases  where  the 
taxpayer  is  performing  extraction  services  within  the  country  for  the 
government  of  that  country  (whether  or  not  the  taxpayer  may  pur- 
chase the  oil  from  tliat  ffovernment) .  Any  extraction  tax  allowed  could 
only  be  used  to  offset  U.S.  tax  on  oil-related  income  in  that  year.  No 
carryback  or  carryforward  on  any  excess  tax  was  pennitted. 

Explanation  of  provision 

Under  the  Act,  the  limitation  on  foreign  taxes  on  foreign  oil  and 
gas  extraction  income  allowable  as  a  foreign  tax  credit  is  reduced  for 
taxable  years  ending  after  1976  to  48  percent  of  the  foreign  oil  and 
gas  extraction  income  computed  on  an  overall  basis.  The  48-percent 
figure  is  the  sum  of  the  normal  tax  rate  and  the  surtax  rate  for  the 
taxable  year  in  which  the  credit  is  claimed.  Thus,  if  either  of  these  two 
rates  should  be  increased  or  decreased,  the  48-percent  limitation  would 
also  be  changed.  Further,  a  definition  of  foreign  oil  and  gas  extraction 
taxes  is  provided  in  order  to  make  clear  that  the  term  includes  credita- 
ble taxes  paid  to  a  foreign  country  where  there  is  no  taxable  income  in 
that  country  under  U.S.  tax  accounting  rules.  The  term  "foreign  oil  and 
gas  extraction  taxes"  is  defined  to  mean  any  income,  war  profits,  and 
excess  profits  tax  paid  or  accrued  (or  deemed  to  have  been  paid  under 
sec.  902  or  960)  with  respect  to  foreign  oil  and  gas  extraction  income. 
This  determination  of  foreign  oil  and  gas  extraction  income  is  to  be 
made  without  regard  to  whether  there  was,  under  U.S.  acxM)unting 
rules,  a  loss  described  in  section  907(c)  (4)  from  oil  or  gas  extraction 
operations  in  the  taxing  country.  The  determination  also  includes  any 
tax  on  foreign  oil  and  gas  extraction  operations  which  would  be  taken 
into  account  as  a  tax  in  computing  the  foreign  tax  credit  under  section 
901  if  section  907  of  the  Code  did  not  so  limit  the  allowability  of  that 
tax  as  a  credit. 

The  Act  provides  carryback  and  carryover  rules  for  excess  foreign 
oil  and  gas  extraction  taxes.  Under  the  Act,  foreign  oil  and  gas  ex- 
traction taxes  paid  in  taxable  years  ending  after  the  date  of  enact- 
ment which  exceed  the  percentage  limitation  for  the  year  can  be  carried 
back  2  years  to  taxable  years  ending  after  December  31,  1974,  and 
can  be  carried  forward  for  5  years  in  a  manner  similar  to  the  regular 
foreign  tax  credit  rules.  The  amount  of  the  tax  which  is  entitled  to  this 
new  carryback  or  carryforward  treatment  may  not  exceed  2  percent 
of  the  foreign  oil  and  gas  extraction  income  for  the  year.  Thus, 


amounts  in  excess  of  50  percent  of  the  forei^  oil  and  gas  extraction 
income  for  the  year  are  not  allowed  as  a  creditable  tax  in  the  current 
or  carryover  year.  For  purposes  of  determining  the  amount  of  taxes 
which  may  be  carried  to  a  taxable  year  ending  in  1975,  1976,  or  1977, 
the  Act  provides  a  transition  rule  which  permits  a  carryover  of  excess 
credits  in  addition  to  the  2  percent  allowed  under  the  general  new 
carryover  rule. 

Special  rules  are  provided  which  are  designed  to  prevent  the  carry- 
over of  credits  disallowed  under  section  907  for  extraction  taxes  paid 
or  accrued  in  a  year  (the  "unused  credit  year")  to  any  year  in  which 
the  credits  could  not  be  used  because  they  would  exceed  either  the 
section  907  limitation  for  that  year  or  the  section  904  limitation  on 
oil-related  taxes  for  that  year.  Under  the  special  rules,  the  amount  of 
extraction  taxes  which  can  be  carried  to  a  year  under  section  907 
cannot  exceed  the  lesser  of  two  limits.  The  first  limit  prevents  the 
carryover  of  taxes  to  a  year  if  they  would  exceed  the  section  907 
limitation  for  the  year.  The  limit  is  the  amount  by  which  the  section 
907  limitation  for  the  year  to  which  the  taxes  are  to  be  carried  exceeds 
(i)  the  sum  of  the  extraction  taxes  actually  paid  in  that  year  plus 
(ii)  the  amount  of  extraction  taxes  carried  to  that  year  from  years 
prior  to  the  unused  credit  year.  The  second  limit  prevents  the  carry- 
over of  taxes  which  would  exceed  the  section  904  limitation  on  foreign 
oil-related  income  for  the  year  to  which  the  taxes  are  carried.  The 
limit  is  the  amount  by  which  the  section  904  limitation  exceeds  the  sum 
of  (i)  the  amount  of  foreign  oil-related  taxes  paid  or  accrued  (or 
deemed  paid  under  sec.  902  or  960)  during  the  year,  (ii)  the  amount 
of  foreign  oil-related  taxes  carried  to  that  year  under  section  904(c) 
from  years  preceding  the  unused  credit  year,  and  (iii)  amount  of  oil 
extraction  taxes  carried  to  that  year  under  section  907  from  years 
preceding  the  unused  credit  year. 

Where  a  taxpayer's  extraction  taxes  exceed  the  section  907  limita- 
tion for  a  year  and  its  oil-related  taxes  exceed  the  section  904  limita- 
tion for  the  year,  the  carryover  under  section  907  is  to  be  made  before 
the  carryover  under  section  904(c).  In  determining  the  amount  of  oil- 
related  taxes  which  can  be  carried  to  a  year  from  the  unused  credit 
year  under  section  904(c),  an  overlap  of  carryovers  to  that  year  is 
prevented  by  treating  the  extraction  taxes  carried  to  that  year  from 
the  unused  credit  year  as  actually  having  been  paid  during  that  year 
(thereby  reducing  the  amount  which  could  be  carried  to  that  year 
under  sec.  904(c)  bv  the  amount  of  extraction  taxes  carried  to  that 
year  under  sec.  907). 

Effective  dates 
The  reduction  in  the  percentage  limitation  of  the  foreign  tax  credit 
for  foreign  oil  and  gas  extraction  taxes  applies  to  taxable  years  ending 
after  December  31,  1976.  The  new  carrvover  provisions  are  to  apply 
to  taxes  paid  or  accrued  during  taxable  years  ending  after  the  date  of 
enactment  of  the  Act, 

Revenue  effect 
It  is  est 'mated  that  the  provisions  dealing  with  limitation  and 
carryover  of  foreign  oil  and  gas  extraction  taxes  will  result  in  an 
increase  in  budget  receipts  of  $23  million  in  fiscal  year  1977,  and  $50 
million  thereafter. 


250 

(2)  Foreign  oil-related  income  earned  hy  individuals 
Reasons  for  change 

As  indicated  above,  the  foreign  tax  credit  that  can  be  claimed  for 
foreign  oil  and  gas  extraction  income  is  limited  by  a  percentage  of  that 
income,  and  the  amount  of  U.S.  taxes  that  can  be  offset  by  these  taxes 
in  any  year  is  subject  to  a  separate  overall  limitation  based  on  foreign 
oil-related  income. 

Foreign  oil-related  income  includes  (in  addition  to  extraction  in- 
come) income  from  processing,  transportation,  and  distribution  activi- 
ties. These  items  are  not  included  in  foreign  oil  and  gas  extraction  in- 
come. Under  prior  law,  individuals  and  corporations  were  subject  to  the 
same  percentage  limitation.  However,  it  is  believed  that  individuals 
seldom  have  foreign  oil-related  income  which  is  not  also  included  in 
foreign  oil  and  gas  extraction  income.  In  addition,  limiting  the  amount 
of  creditable  taxes  to  the  corporate  rate  is  unfair  or  unduly  generous 
in  the  case  of  certain  individuals.  For  example,  if  an  individual  has  a 
high  effective  rate  of  tax  (in  excess  of  the  corporate  rate),  his  dis- 
allowed foreign  tax  credit  will  cause  him  to  pay  U.S.  tax  on  his 
foreign  extraction  income,  while  a  corporation  would  owe  no  U.S.  tax. 

Expla7Mtio7i  of  provision 
The  Act  limits  the  allowable  foreign  tax  credit  on  foreign  oil  and 
gas  extraction  income  to  an  amount  equal  to  the  average  U.S.  effective 
rate  of  tax  on  that  income.  Thus,  in  any  case  there  will  be  sufficient 
tax  credits  to  offset  the  U.S.  tax  on  the  foreign  oil  and  gas  extrac- 
tion income  but  no  excess  credits  to  offset  U.S.  tax  on  other  for- 
eign source  income.  The  Act  achieves  this  result  by  limiting  the  tax- 
payer to  a  separate  overall  foreign  tax  credit  limitation  for  foreign  oil 
and  gas  extraction  income. 

Effective  date 

This  provision  is  effective  for  taxable  years  ending  after  Decem- 
ber 31,  1974. 

ReveniLe  effect 

It  is  estimated  that  this  provision  will  decrease  revenues  by  less 
than  $5  million  on  an  annual  basis. 

(J)  Production-shanng  contracts 
Reasons  for  change 
A  problem  concerning  the  allowance  of  a  foreign  tax  credit  for 
payments  to  a  foreign  government  in  connection  with  mineral  extrac- 
tion arose  in  the  case  of  production-sharing  contracts.  These  arrange- 
ments between  the  foreign  government  and  oil  companies  which  are 
becoming  increasingly  popular  involve  government  ownership  of  all 
oil  and  gas  reserves.  Under  these  arrangements,  the  oil  company 
operates  as  a  contractor  furnishing  services  and  know-how.  All  man- 
agement and  control  of  production  is  retained  by  a  government- 
owned  entity  which  has  the  exclusive  right  to  explore  and  develop 
the  government's  mineral  property.  All  tangible  property  is  owned 
by  the  government-owned  entity.  Ordinarily,  the  contractor  is  com- 
pensated for  its  costs  in  the  form  of  a  share  (not  to  exceed  a  given 
percentage  each  year)  of  the  production  from  a  contract  area.  The 


251 

remainder  of  the  production  is  divided  between  the  contractor  and 
the  government-owned  entity  according  to  negotiated  percentages. 
(Any  unrecovered  costs  are  recovered  in  subsequent  years.)  The  law  of 
the  foreign  country  generally  provides  that  the  government-owned  oil 
company  is  to  pay  to  the  government  each  year  a  i)ortion  of  its  produc- 
tion share.  This  payment  is  said  to  constitute  (among  other  things)  the 
payment  of  tlie  contractor's  tax  liability  on  its  beliaif  so  that  the  con- 
tractor does  not  directly  pay  any  income  taxes  under  the  country's  gen- 
eral corporation  tax. 

The  Inteiiv;!  Revenue  Service  issued  Revenue  Ruling  76-215,  1976 
I.R.B.  No.  ii;>,  Holding  tliat  the  contractor  under  a  production-sharing 
contract  in  Indonesia  is  not  entitled  to  a  foreign  tax  credit  for  pay- 
ments made  by  the  government-owned  company  to  the  foreign  govern- 
ment. The  grounds  for  this  holding  were,  in  part,  that  since  the 
foreign  government  already  owns  all  of  the  oil  and  gas,  there  is  no 
payment  to  the  government  by  the  contractor.  Furthermore,  even  if 
a  payment  by,  or  on  behalf  of,  the  contractor  could  be  identified,  the 
IRS  views  such  a  payment  as  in  the  nature  of  a  royalty,  rather  than 
a  tax. 

In  1969,  the  Internal  Revenue  Service  issued  Revenue  Ruling  69- 
388,  1969-2  C.B.  154,  which  held  that  certain  payments  made  pur- 
suant to  a  contract  to  explore  for,  develop,  and  produce  oil  in  Indo- 
nesia are  creditable.  The  contracts  to  which  that  Ruling  applied  were 
not  production-sharing  contracts  but  the  Ruling  was  apparently  relied 
on  by  oil  companies  entering  into  production-sharing  contracts.  In 
view  of  the  fact  that  the  scope  of  the  prior  Ruling  was  not  clear,  the 
Internal  Revenue  Service  exercised  its  discretion  to  apply  Revenue 
Ruling  76-215  only  prospectively  to  claims  for  credits  for  taxes  paid 
in  taxable  years  beginning  after  June  30, 1976. 

While  tlie  Congress  takes  no  position  on  the  correctness  of  the  IRS 
ruling,  the  Congress  feels  that  oil  companies  operating  under  existing 
production-sharing  contracts  should  have  a  reasonable  time  to  re- 
negotiate their  contracts  with  the  foreign  government.  Thus,  assum- 
ing the  ruling  is  sustained,  if  challenged,  generally  the  companies 
should  continue  to  be  allow^ed  the  foreign  tax  credit  for  another  year. 
In  the  meantime,  however,  the  oil  companies  should  not  be  allowed 
to  generate  excess  foreign  tax  credits  under  the  contracts  that  can  be 
used  to  offset  tax  on  other  income. 

Explanation  of  provision 

The  Act  allows  a  limited  foreign  tax  credit  for  a  limited  period  in 
the  case  of  certain  production-sharing  contracts  to  which  Revenue  Rul- 
ing 76-215  applies.  Under  this  provision,  amounts  which  are  desig- 
nated by  a  foreign  government  under  certain  production-sharing 
contracts  as  income  taxes  are  treated  as  creditable  income,  war  profits, 
and  excess  profits  taxes  even  though  the  amounts  would  not  other- 
wise be  treated  as  creditable  taxes.  Moreover,  the  provision  only  applies 
to  taxes  not  creditable  by  reason  of  that  ruling.  Thus,  to  the  extent  that 
payments  are  treated  as  taxes,  this  provision  does  not  apply  to  those 
payments. 

However,  the  total  amount  treated  as  creditable  taxes  under  this 
provision  is  not  to  exceed  the  lesser  of  two  amounts.  The  first  amount 


252 

is  the  total  foreio:n  oil  and  gas  extraction  income  with  respect  to  pro- 
duction-sharino;  contracts  coxered  under  the  rule  multiplied  by  the 
U.S.  corporate  tax  rate  (presently  48  ])ercent)  less  the  otherwise  allow- 
able (if  any)  foreig^i  tax  credits  attributable  to  income  from  those 
contracts.  The  second  amount  is  the  total  foreign  oil  and  gas  extrac- 
tion income  multiplied  by  the  U.S.  corporate  tax  rate  (generally 
48  percent)  less  the  total  amount  of  the  otherwise  allowable  foreign 
tax  credits  (if  any)  attributable  to  the  total  foreign  oil  and  gas  extrac- 
tion income. 

The  production-sharing  contracts  covered  by  this  provision  are  those 
contracts  for  which  the  IRS  has  published  a  ruling  disallowing  for- 
eign tax  credits  for  taxes  paid  in  taxable  years  beginning  on  or  after 
June  30, 1976,  but  has  not  disallowed  claims  for  tax  credits  for  taxable 
years  beginning  before  that  date. 

Thus,  for  example,  assume  that  the  taxpayer  for  1977  derives  a 
total  of  $100  of  foreign  oil  and  gas  extraction  income;  that  $10  of 
that  amount  is  derived  from  production-sharing  contracts  to  which 
this  provision  applies ;  that  the  taxpayer  pays  a  total  of  $45  in  foreign 
taxes  on  the  foreign  extraction  income  (not  including  any  amounts 
claimed  as  taxes  under  production-sharing  contracts  to  which  this 
provision  applies)  ;  and  that  $6  of  tax  credit  was  disallowed  on  the 
income  from  the  production-sharing  contracts.  Under  these  facts,  the 
taxpayer  is  allowed  a  foreign  tax  credit  for  amounts  under  the  pro- 
duction-sharing contract  equal  to  $3,  the  lesser  of  (48  percent  of  $10) 
or  ( (48  percent  of  $100)  minus  ^5) . 

The  special  rule  applies  only  with  respect  to  production-sharing  con- 
tracts for  which  the  Internal  Revenue  Service  will  disallow  claims 
for  a  foreign  tax  credit  for  taxes  paid  in  taxable  years  beginning  on  or 
after  June  30,  1976,  but  will  not  disallow  claims  for  taxes  paid  for  tax- 
able years  beginning  on  or  after  June  30, 1976. 

Effective  date 
The  special  rule  for  production-sharing  contracts  is  to  apply  for  tax- 
able vears  beginning  on  or  after  June  30,  1976.  This  provision  will 
apply  only  to  production-sharing  contracts  entered  into  before  April  8, 
1976,  and  will  apply  only  with  respect  to  taxable  yeare  ending  before 
January  1, 1978. 

Revenuue  effect 
It  is  estimated  that  this  provision  will  decrease  budget  receipts  by 
$23  million  in  fiscal  year  1977  and  $27  million  in  fiscal  year  1978. 

e.  Third-tier  foreign  tax  credit  under  subpart  F 

Prior  law 
Under  existing  law,  when  amounts  which  are  foreign  base  company 
income  are  included  in  the  income  of  a  domestic  corporation  under 
subpart  F  with  respect  to  the  undistributed  earnings  of  a  controlled 
foreign  corporation,  a  proportionate  part  of  the  foreign  taxes  paid 
by  the  foreign  cor^wration  are  deemed  paid  by  the  domestic  corpora- 
tion, and  a  foreign  tax  credit  is  available  to  the  domestic  corporation 
with  respect  to  those  taxes.  These  rules  are  substantially  parallel  to  the 
foreign  tax  credit  rules  on  actual  distributions.  However,  this  deemed 
paid  credit  was  available  under  prior  law  for  subpart  F  income  only 


253 

if  tlie  controlled  foreign  corporation  was  a  first-tier  foreign  corpora- 
tion (which  must  be  at  least  10  percent  owned  by  a  domestic  corpora- 
tion) or  a  second-tier  foreign  corporation  (which  must  be  at  least  50 
percent  owned  by  a  first-tier  foreign  corporation). 

Reasons  for  change 

The  rules  with  respect  to  second-  and  third-tier  corporations  were  in- 
consistent with  the  foreign  tax  ciedit  rules  applicable  with  respect  to 
dividends  actually  distributed.  Actual  dividends  carry  with  them  a 
proportionate  part  of  the  foreign  taxes  paid  by  third-tier  foreign  cor- 
porations, as  well  as  first-  and  second-tier  foreign  corporations.  More- 
over, in  order  to  qualify  as  a  second-tier  corporation  with  respect  to  di- 
vidends actuall}^  distributed,  only  10  percent  of  the  stock  need  be  held 
by  a  first-tier  foreign  corporation. 
'  The  Congress  believes  that  the  foreign  tax  credit  rules  with  respect 
to  amounts  included  in  income  under  subpart  F  should  be  consistent 
with  the  rules  applicable  to  dividends  actually  distributed.  Taxpayers 
tend  to  structure  their  business  operations  in  accordance  with  the  rules 
applicable  with  respect  to  actual  distributions.  The  rules  of  subpart  F 
were  overly  harsh  when  they  denied  a  foreign  tax  credit  to  a  taxpayer 
who  would  have  been  entitled  to  a  credit  had  there  been  an  actual 
distribvition. 

When  subpart  F  was  added  in  1962,  the  rules  for  computing  the 
deemed-paid  foreign  tax  credit  with  respect  to  dividends  were  appli- 
cable only  with  respect  to  foreign  taxes  paid  by  a  first-tier  foreign 
subsidiary  (definerl  as  being  at  least  10  percent  owned  by  a  domestic 
corporation)  or  a  second-tier  foreign  subsidiary  (defined  as  being  at 
least  50 percent  owned  by  a  first-tier  foreign  corporation).  The  foreign 
tax  credit  rules  under  subpart  F  were  made  applicable  under  the  same 
circumstances  as  actual  dividends.  In  1971,  the  deemed-paid  foreign 
tax  credit  with  respect  to  dividends  actually  distributed  was  expanded 
to  apply  to  foreign  taxes  paid  by  a  larger  class  of  second-tier  corpora- 
tions and  by  third-tier  foreign  corporations.  The  Act  conforms  the 
subpart  F  foreign  tax  credit  rules  to  the  1971  change  in  the  deemed- 
paid  foreign  tax  credit  rules  for  actual  dividend  distributions. 

Exphinatlon  of  'provision. 

The  Act  makes  two  changes  to  the  rules  for  computing  a  foreign  tax 
credit  with  respect  to  amounts  included  in  income  under  subpart  F. 
First,  the  Act  provides  that  the  foreign  tax  credit  is  applical)le  with 
respect  to  foreign  taxes  paid  by  a  third-tier  foreign  corporation  whose 
undistributed  income  is  taxed  to  the  shareholder.  Second,  the  Act  lib- 
eralizes the  stock  ownership  test  applicable  to  second-tier  foreign 
corporations. 

Under  the  Act,  a  foreign  corporation  qualifies  as  a  second-tier  for- 
eign corporation  if  at  least  10  percent  of  its  voting  stock  is  owned  by  a 
first-tier  foreign  corporation,  at  least  10  percent  of  the  voting  stock  of 
which  must  be  owned  by  a  domestic  coi-poration.  A  foi-eign  corporation 
qualifies  as  a  third-tier  foreign  corporation  if  at  least  10  percent  of  its 
voting  stock  is  owned  by  a  second-tier  foreign  corporation. 

However,  with  respect  to  a  second-tier  foreign  corporation,  the  for- 
eign tax  credit  \:,  not  available  unless  the  percentage  of  voting  stock 
owned  by  the  domestic  corpoi-ation  in  the  first-tier  foreign  corpora- 
tion and  the  percentage  of  voting  stock  owned  by  the  first -tier  foreign 


254 

corporation  in  the  second-tier  foreign  corporation  when  multiplied 
together  equal  at  least  5  pei'cent.  With  respect  to  a  third-tier  foreign 
corporation,  the  foreign  tax  credit  is  not  available  unless  the  percent- 
age of  voting  stock  in  the  first-tier  foreign  corporation  owned  by  the 
domestic  corporation  and  the  percentage  of  voting  stock  in  the  second- 
tier  foreign  corporation  owned  by  the  first-tier  foreign  corporation 
and  the  percentage  of  voting  stock  in  the  third-tier  foreign  corpora- 
tion owned  by  the  second-tier  foreign  corporation  w4ien  multiplied 
together  equal  at  least  5  percent. 

E-ffective  date 
The  Act  applies  with  respect  to  earnings  and  profits  of  a  foreign 
corporation  included  in  gross  income  after  December  31,  1976. 

Revenue  effect 
This  provision  will  reduce  budget  receipts  by  $4  million  in  fiscal 
year  1977,  $10  million  in  fiscal  year  1978,  and  $10  million  in  fiscal 
year  1981. 

/.  Source  of  underwriting  income 

Prior  law 
Under  prior  law,  the  source  of  insurance  underwriting  income  was 
imclear.  Neither  the  Internal  Revenue  Code  nor  the  Income  Tax  Reg- 
ulations set  forth  a  specihc  rule  for  determining  the  source  of  insur- 
ance underwriting  income.  It  was  apparently  the  position  of  the  Inter- 
nal Revenue  Service,  how^ever,  tliat  the  source  of  such  income  was  to  be 
determined  on  the  basis  of  where  the  incidents  of  the  transaction  which 
produced  the  income  occurred.  Under  this  rule,  income  produced  from 
insurance  underwriting  contracts  negotiated  and  executed  in  the 
United  States,  regardless  of  tlie  location  of  the  insured  risks,  was  gen- 
erally deemed  to  be  from  sources  within  the  United  States.  This  rule 
apparently  applied  even  though  the  insurance  contract  was  actually 
written  by  a  foreign  company. 

Reasons  for  change 
The  prior  source  rule  applicable  to  insurance  underwriting  income 
was  vulnerable  to  artificial  manipulation  by  taxpayers.  By  simply 
changing  the  place  wdiere  a  contract  was  negotiated  and  executed,  a 
taxpayer  could  clumge  the  source  of  the  underwriting  income  produced 
by  the  contract.  The  prior  source  rule  in  some  situations  also  could 
result  ill  double  taxation.  It  is  not  uncommon  for  United  States 
corporations  doing  business  abroad  through  foreign  subsidiaries  to 
negotiate  and  execute  insurance  contracts  in  the  United  States;  which 
cover  Its  overseas  operations.  The  insurance  policies,  however,  fre- 
quently must  be  issued  in  the  foreign  jurisdiction  in  which  the  in- 
sured's risk  is  located  in  order  to  comply  with  local  insurance  laws  or 
for  other  business  reasons.  Although  the  underwriting  income  in  these 
circumstances  generally  would  be  subject  to  foreign  taxation,  the  in- 
come w^ould  be  deemed  Ignited  States  source  income,  which  in  turn 
would  reduce  the  amount  of  the  foreign  tax  credit  available  to  the 
taxpayer. 

Explanation  of  provision 
The  Act  clearly  establishes  a  source  rule  applicable  to  insurance  un- 
derwriting income  under  which  underwriting  income  derived  from 


255 

the  insurance  of  U.S.  risks  will  be  income  from  sources  within  the 
United  States.  All  othei-  underwritiufj  income  will  be  considered  in- 
come from  sources  without  the  United  States.  The  source  rule  is  not  in- 
tended to  chano-e  the  law  with  respect  to  the  determination  of  whether 
foreign  source  income  is  effectively  connected  with  the  conduct  of  a 
trade  or  business  within  the  United  States. 

Effective  date 
The  provision  applies  to  taxable  years  beginning  after  December 
31, 1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  decrease  receipts  by  less 
than  $5  million  annually. 

6.  Exclusion  From  Gross  Income  and  From  Gross  Estate  of  Port- 
folio Investments  in  the  United  States  of  Nonresident  Aliens 
and  Foreign  Corporations  (sec.  1041  of  the  Act  and  sec.  861 
of  the  Code) 

Prior  law 

Interest,  dividends  and  other  similar  types  of  income  of  a  non- 
resident alien  or  a  foreign  corporation  are  generally  subject  to  a  30- 
})ercent  tax  on  the  gross  amount  paid  ^  if  the  income  or  gain  is  not 
effectively  connected  AA'ith  the  conduct  of  a  trade  or  business  within 
the  United  States  (sees.  871(a)  and  881).^  Prior  law  provided  a 
temporary  exemption  from  the  tax  for  interest  earned  on  deposits  with 
banks,  savings  and  loan  institutions,  and  insurance  companies  (sees. 
861(a)  (1)  (A)  and  861  (c) ).  Under  prior  law  that  temporary  exemp- 
tion would  have  expired  for  interest  paid  or  credited  after  Decem- 
ber 31, 1976. 

Bank  deposits  owned  by  nonresident  aliens  are  exempt  from  Federal 
estate  tax  if  interest  on  the  deposits,  were  it  received  by  the  decedent 
at  the  time  of  his  death  (sees.  210-1  and  2105) ,  would  be  exempt  under 
the  Code  from  the  30-percent  withholding  tax. 

In  addition  to  the  exemption  from  tlie  30-percent  withholding  tax 
provided  in  the  Internal  Revenue  Code  for  interest  on  bank  deposits, 
various  income  tax  treaties  of  the  United  States  provide  for  either 
an  exemption  or  a  reduced  rate  of  tax  for  interest  paid  to  foreign 
persons  if  the  income  is  not  effectively  connected  with  the  conduct  of 
a  trade  or  business  within  the  United  States. 

Reasons  for  change 
Interest  on  bank  deposits  paid  to  nonresident  aliens  and  foreign 
corporations  has  been  exempt  from  U.S.  tax  continuously  since  1921. 
The  exemption  was  permanent  prior  to  1966.  In  the  Foreign  Investors 
Tax  Act  of  1966,  the  exemption  was  put  on  a  temporary  basis  because 
Congress  felt  there  was  some  question  Avhether  it  was  appropriate 
that  foreign  investors  should  receive  more  favorable  treatment  with 
respect  to  bank  account  interest  than  citizens  and  residents  of  the 
United  States,  but  it  wished  to  retain  the  exemption  temporarily  so 

^  This  tax  is  generally  collected  by  means  of  a  withholdinc  by  the  person  making  the 
pavpient  to  the  foreijrn  recipient  of  the  income  (sees.  1441  and  1442). 

-  If  the  interest,  dividend  or  other  similar  income  is  effectively  connected  with  a  U.S. 
trade  or  business,  that  income  is  included  in  the  normal  income  tax  return  which  must  be 
filed  for  the  business. 


256 

that  it  could  determine  whether  the  elimination  of  exemption  would 
have  a  substantial  adverse  balance  of  payments  effect. 

Congress  has  concluded  that  the  elimination  of  the  exemption  would 
result  in  a  significant  decline  in  the  substantial  deposits  by  nonresident 
aliens  and  foreign  corporations  in  banks  in  the  United  States.  Since 
a  possible  shortage  of  investment  capital  presently  exists  in  the  United 
States,  Congress  concluded  further  that  it  would  not  be  advisable  at 
this  time  to  permit  the  exemption  to  expire  at  the  end  of  1976  with 
the  resultant  outflow  of  investment  capital. 

Moreover,  it  was  decided  to  retain  the  exemption  on  a  permanent 
basis.  It  is  believed  that  the  temporary  nature  of  the  exemption  in 
recent  years  may  have  discouraged  foreign  investors  from  investing 
in  fixed  term  bank  deposits  such  as  certificates  of  deposit  where  those 
obligations  were  due  to  mature  after  the  dates  the  exemption  was  due 
to  expire.  Although  the  exemption  had  in  the  past  l)een  extended  each 
time  it  was  due  to  expire,  some  foreign  investors  (as  the  expiration 
came  near)  who  desired  to  invest  in  fixed-term  obligations  because 
they  tend  to  bear  a  relatively  high  interest  rate  apparently  felt  that 
they  could  not  take  the  risk  that  the  exemption  would  not  be  extended, 
and  thus  they  invested  their  funds  elsewhere. 

Explanation  of  proiusion 
The  Act  continues  without  any  termination  date  the  exemption  in 
prior  law  for  interest  earned  by  nonresident  aliens  and  foreign  cor- 
porations on  deposits  with  banks,  savings  and  loan  institutions,  and 
insurance  companies  where  the  interest  is  not  effectively  connected 
with  the  conduct  of  a  trade  or  business  within  the  United  States, 
The  Act  makes  the  exemption  for  interest  on  deposits  permanent  by 
eliminating  the  language  of  prior  law  which  would  have  terminated 
the  provision  for  interest  paid  or  credited  after  December  31,  1976. 

Effective  date 
The  provision  is  effective  upon  enactment. 

Revenue  effect 
It  is  estimated  that  this  provision  will  reduce  budget  receipts  by 
$55  million  in  fiscal  year  1977,  $115  million  in  fiscal  year  1978,  anil 
$145  million  in  fiscal  year  1981. 

7.  Changes  in  Ruling  Requirements  Under  Section  367  and 
Changes  in  Amounts  Treated  as  Dividends  (sec.  1042  of  the 
Act  and  sees.  367,  1248,  and  7477  of  the  Code) 

Prior  laio 
Certain  types  of  exchanges  relating  to  the  organization,  reorganiza- 
tion, and  liquidation  of  a  corporation  can  be  made  without  recognition 
of  gain  to  the  corporation  involved  or  to  its  shareholders.  lender  prior 
law,  howev^er,  when  a  foreign  corporation  was  involved  in  certain  of 
these  types  of  exchanges,  tax-free  treatment  was  not  a\ailable  unless 
prior  to  the  transaction  the  Internal  Revenue  Service  had  made  a 
determination  that  the  exchange  did  not  have  as  one  of  its  principal 
purposes  the  avoidance  of  federal  income  taxes.  Under  prior  practice 
this  determination  was  made  by  issuing  a  separate  ruling  for  each. 


257 

transaction.  The  required  deteniiination  had  to  be  obtained  before  the 
transaction  began  in  all  cases  unless  the  transaction  involved  only  a 
change  in  the  form  of  organization  of  a  second  (or  lower)  tier  foreign 
subsidiary  with  no  change  in  ownership. 

The  advance  i-uling  requirement  of  section  367  applied  to  exchanges 
involving  contributions  of  property  to  controlled  corporations  (sec. 
351),  all  tax-free  corporate  reorganizations  (sees.  154,  355,  356  and 
361),  and  liquidations  of  subsidiary  corporations  (sec.  3^2).  In  de- 
termining the  extent  to  which  gain  (but  not  loss)  was  recognized  in 
these  exchanges,  a  foreign  corporation  was  not  considered  a  corporation 
unless  it  was  established  to  the  satisfaction  of  the  Internal  Revenue 
Service  that  the  exchange  was  not  in  pur-suance  of  a  plan  having  as 
one  of  its  principal  purposes  the  avoidance  of  Federal  income  taxes. 
Since  corporate  status  is  essential  to  qualify  for  the  tax-free  organiza- 
tion, reorganization  and  liquidation  provisions,  failure  to  satisfy  the 
Commissioner  under  section  367  could  result  in  the  recognition  of  gain 
to  the  participant  corporations  and  shareholders.  Furthermore,  there 
was  no  effective  way  a  taxpayer  could  appeal  an  adverse  decision  bj^  the 
Commissioner  to  the  courts  because  the  statute  re(|uired  the  Commis- 
sioner's, not  the  court's,  satisfaction. 

In  1968,  the  Internal  Revenue  Service  issued  guidelines  (Rev.  Proc. 
68-23,  1968-1  Cum.  Bull.  821)  as  to  when  favorable  rulings  "ordi- 
narily" would  be  issued.  As  a  condition  of  obtaining  a  favorable  ruling 
with  respect  to  certain  transactions,  the  section  367  guidelines  required 
the  taxpayer  to  agree  to  include  certain  items  in  income  (the  amount 
to  be  included  was  called  the  section  367  toll  charge).  For  example,  if 
a  domestic  corporation  transferred  property  to  a  foreign  subsidiary 
(a  transaction  otherwise  accorded  tax-free  treatment  under  section 
351) ,  the  transaction  was  given  a  favorable  ruling  only  i "  the  domestic 
corporation  agreed  to  include  in  its  gross  income  for  its  taxable  year 
in  which  the  transfer  occurred  an  ajjpropriate  amount  to  i-eflect  realiza- 
tion of  income  or  gain  with  respect  to  certain  types  of  assets  {e.g.,  in- 
ventory, accounts  receivable,  and  certain  stock  or  securities)  trans- 
ferred to  the  foreign  corporation  as  part  of  the  transfer.  If  the 
transaction  involved  the  liquidation  of  a  foreign  corporation  into  a 
domestic  parent,  a  favorable  ruling  was  issued  if  the  domestic  parent 
agreed  to  include  in  its  income  as  a  dividend  for  the  taxable  vear  in 
which  the  liquidation  occurred  the  portion  of  the  accumulated  earn- 
ings and  profits  of  the  'oreign  corporation  which  were  jyroperly 
attributable  to  the  domestic  corporation's  stock  interest  in  the  foreign 
corporation.  These  two  cases  illustrate  that  the  statutory  stand- 
ard for  determining  that  a  transaction  did  not  have  as  one  of  its 
principal  purposes  tax  avoidance  had  evolved  through  administrative 
internretation  into  a  renuirement  o-enerally  that  tax-free  treatment 
would  be  permitted  only  if  the  ILS.  tax  on  accumulated  earnino-s  and 
profits  (in  the  case  of  transfers  into  the  Ignited  States  bv  a  foreijrn 
corporation)  or  the  I^.S.  tax  on  the  notential  earnin.o-s  from  liouid 
or  passive  investment  assets  (in  the  case  of  transfers  of  pronerty 
outside  the  United  States)  was  paid  or  was  preserved  for  future 
payment. 

In  addition  to  section  367,  section  1248  provided  for  the  imposition 


258 

of  a  full  U.S.  tax  on  accumulated  profits  earned  abroad  when  they 
were  repatriated  to  the  United  States  in  cases  where  gain  was  recog- 
nized on  the  sale  or  exchange  (or  liquidation)  of  stock  of  a  controlled 
foreign  corporation  held  by  a  U.S.  person  owning  10  percent  or  more 
of  the  voting  stock.  In  these  cases,  the  gain  was  included  in  the  gross 
income  of  the  U.S.  person  as  a  dividend  to  the  extent  of  the  earnings 
and  profits  of  the  foreign  corporation  attributable  to  the  period  the 
stock  was  held  by  the  U.S.  person  while  the  foreign  corporation  was 
a  controlled  foreign  corporation.  Tliis  provision  applied  to  post-1962 
accumulated  earnings. 

Reasons  for  change 

Several  pix)blems  developed  insofar  as  section  367  and  the  related 
provisions  of  section  12-18  were  concerned.  First,  the  advance  ruling 
requirement  often  resulted  in  an  undue  delay  for  taxpayers  attempting 
to  consummate  perfectly  proper  business  transactions.  Second,  a  num- 
ber of  cases  had  arisen  where  a  foreign  corporation  was  involved  in 
an  exchange  within  the  scope  of  the  section  367  guidelines  without  the 
knowledge  of  its  U.S.  shareholdei-s,  and  thus  no  request  for  prior 
approval  had  been  made.  In  a  case  of  this  type,  an  otherwise  tax-free 
transaction  became  a  taxable  transaction,  and  if  a  second  or  lower  tier 
foreign  subsidiary  was  involved,  the  U.S.  shareholders  of  the  controlled 
foreign  corporation  might  have  been  taxed  under  the  subpart  F  rules. 
This  could  have  occurred  under  the  Service's  section  367  guidelines 
despite  the  fact  that  a  favorable  ruling  would  clearly  have  been  issued 
by  the  Internal  Revenue  Service  had  it  been  requested  prior  to  the 
transaction. 

The  third  area  of  difficulty  in  the  administration  of  section  367  under 
prior  law  concerned  situations  where  the  IRS  required  a  U.S.  share- 
holder to  include  certain  amounts  in  income  as  a  toll  charge  even 
though  there  was  no  present  tax  avoidance  purpose  but,  rather,  only 
the  existence  of  a  ix)tential  for  future  tax  avoidance.  This  occurred 
under  the  section  367  guidelines  because  of  limitations  in  the  carryover 
of  attribution  rules  (sec.  381).  The  Internal  Revenue  Service  in  some 
cases  had  the  option  either  of  collecting  an  immediate  tax  or  of 
collecting  no  tax  at  all  since  in  those  cases  it  had  no  authority  to  defer 
payment  of  the  tax  until  the  time  that  the  avoidance  actually  arose, 
except  by  entering  into  closing  agreement  with  the  taxpayer. 

The  fourth  problem  concerned  the  fact  that  since  the  law  required 
the  satisfaction  of  the  Commissioner,  a  taxpayer  was  unable  to  go 
through  with  a  transaction  and  litigate  in  the  courts  the  question  of 
whether  tax  avoidance  was  one  of  the  ]nirix)ses  of  the  transaction. 
While  the  Congress  generally  approves  the  standard  applied  by  the 
IRS,  there  may  have  been  cases  where  these  standards  were  inappro- 
priate or  were  not  being  correctly  applied.  Congi-ess  believes  it  is  fair 
to  permit  taxpayers  to  litigate  these  questions  in  the  courts. 

The  Congress  further  believes  that  the  interpretation  of  the  rules 
governing  exchanges  described  in  section  367  should  not  be  done  in  in- 
dividual rulings  but  should  be  provided  by  clear  and  certain  regula- 
tions. "\Miile  it  is  recognized  tliat  the  prior  rules  were  necessarily 
highly  technical  and  largely  procedural  and  while  it  is  essential  to  pro- 


259 

tect  against  tax  avoidance  in  transfers  to  foreign  corporations  and 
upon  the  repatriation  of  previously  untaxed  foreign  earnings,  unneces- 
sary barriers  to  justifiable  and  legitimate  business  transactions  shoiild 
be  avoided.  The  Congress  believes  that  U.S.  taxpayers  participating 
in  certain  types  of  transactions  involving  foreign  corporations  should 
he  able  to  determine  the  tax  effects  of  the  transaction  from  the  statute 
and  accompanying  regulations  rather  than  being  required  to  apply  to 
the  Internal  Revenue  Service  for  a  determination  in  advance  of  the 
transaction.  Only  in  those  types  of  transactions  where  the  amount  of 
tax,  if  any,  which  must  be  paid  to  protect  against  tax  avoidance  can 
only  be  determined  by  judging  the  specific  facts  of  the  case  should 
the  taxpayer  be  required  to  obtain  a  determination  from  the  Internal 
Revenue  Service.  Moreover,  in  cases  where  such  a  ruling  is  to  be 
required,  taxpayers  should  be  permitted  to  obtain  the  ruling  within 
some  limited  time  after  the  transaction  has  begun. 

A  problem  also  existed  with  the  provision  which  imposes  a  tax 
at  ordinary  income  rates  to  the  extent  of  post-1962  accumulated  earn- 
ings and  profits  upon  certain  sales  or  exchanges  of  stock  in  a  controlled 
foreign  corporation  (sec.  1248).  In  some  situations  other  than  those 
covered  by  section  367,  a  domestic  corporation  is  entitled  to  nonrecog- 
nition  of  any  gain  if  it  sells,  exchanges,  or  distributes  its  property. 
When  transactions  coming  within  the  scope  of  these  non recognition 
provisions  involve  the  sale  or  distribution  of  stock  in  a  controlled  for- 
eign corporation,  section  1248  did  not  apply  since  that  provision 
applied  only  when  gain  was  recognized.  Thus,  any  ordinary  income  tax 
on  the  repatriation  of  accumulated  earnings  and  profits  of  the  con- 
trolled foreign  corporation  was  lost.  For  example,  a  U.S.  parent  cor- 
poration was  able  to  avoid  ordinary  income  tax  on  foreign  earnings 
if  it  sold  the  stock  in  a  controlled  foreign  subsidiary  as  part  of  a  plan 
of  complete  liquidation  (pursuant  to  sec.  337).  The  U.S.  corporation 
was  entitled  to  nonrecognition  of  gain  (or  loss)  on  the  sale  or  exchange 
of  the  stock  and  was  not  requii-ed  to  recognize  any  gain  when  it  dis- 
tributed its  property  (including  the  sales  proceeds)  to  its  shareholders 
in  complete  liquidation.  The  shareholders  would  pay  a  capital  gains 
tax  on  the  difference  between  the  value  of  the  property  received  in 
liquidation  and  their  basis  in  the  stock  of  the  liquidating  corporation, 
but  no  ordinary  income  tax  was  paid  on  the  foreign  earnings. 

A  similar  problem  was  involved,  for  example,  if  a  U.S.  corporation 
distributed  stock  in  a  controlled  foreign  corporation  as  a  dividend. 
The  distributing  corporation  would  not  recognize  gain  on  the  distribu- 
tion and  the  distributee  shareholders  (if  they  were  individuals)  would 
acquire  a  fair  market  value  basis  in  tlie  distributed  stock  and  would 
not  be  treated  as  holdinc:  the  stock  for  the  period  it  was  held  by  the  cor- 
poration (sec.  1223).  Thus,  although  the  shareholders  would  be  taxed 
on  the  dividend  out  of  the  domestic  corporation's  earnings,  there  was 
no  corporate  tax  on  the  earnings  of  the  foreip-n  corporation. 

The  Congress  believed  that  the  availability  of  nonrecoo-nition 
treatment  for  distributions  or  exchanges  of  stock  of  controlled  foreign 
corporations  in  situations  not  covered  under  section  367  or  1248  de- 
tracted substantially  from  the  principle  of  taxing  accuinulated  earn- 
ings and  profits  of  foreign  corporations  upon  repatriation.  In  Con- 


260 

gress's  view,  nonrecognition  should  not  be  available  to  the  selling  or 
distributing  corporation  but,  rather,  it  should  be  required  to  include 
in  income,  as  a  dividend,  its  share  of  post-1962  foreign  earnings  and 
profits. 

Explanation  of  provisions 

The  Act  approaches  the  problems  outlined  above  first  by  amending 
section  367  to  establish  separate  rules  for  two  different  groups  of  trans- 
actions: (i)  transfers  of  property  from  the  United  States,  and  (ii) 
other  transfers  (this  latter  group  including  transfers  into  the  United 
States  and  those  which  are  exclusively  foreign).  Transactions  in  the 
first  group  generally  include  those  transactions  where  the  statutory 
aim  is  to  prevent  the  removal  of  appreciated  assets  or  inventory  from 
U.S.  tax  jurisdiction  prior  to  their  sale,  while  transactions  in  the  second 
group  include  those  where  the  statutory  purpose  in  most  cases  is  to 
prepare  for  taxation  the  accumulated  profits  of  controlled  foreign 
corporations. 

Transfers  from  the  United  States. — With  respect  to  the  first  group 
(sec.  367(a)),  it  is  provided  that  if  in  connection  with  an  exchange 
described  in  section  332,  351,  354,  355,  356,  or  361,  there  is  a  trans- 
fer of  property  (other  than  stock  or  securities  of  a  foreign  corpora- 
tion which  is  a  party  to  the  exchange)  by  a  U.S.  person  to  a  foreign 
corporation,  the  foreign  corporation  will  not  be  considered  a  corpora- 
tion (for  purposes  of  determining  gain)  unless,  pursuant  to  a  request 
filed  not  later  than  the  close  of  the  183rd  day  after  the  beginning  of 
the  transfer,  the  taxpayer  establishes  to  the  satisfaction  of  the  Inter- 
nal Revenue  Service  that  the  exchange  did  not  ha^•e  as  one  of  its 
principal  purposes  the  avoidance  of  Federal  income  taxes.  The  term 
"party  to  the  exchange"  as  used  in  this  provision  includes  a  party  to 
the  reorganization  (as  defined  in  sec.  368(b))  and  the  transferor  and 
transferee  in  an  exchange  other  than  a  reorganization.  Types  of  "out- 
bound" transfers  falling  within  this  categor}'  include  exchanges  involv- 
ing transfers  of  property  to  a  foreign  corporation,  the  liquidation  of  a 
U.S.  subsidiary  into  a  foreign  parent,  the  acquisition  of  a  U.S.  corpo- 
ration's assets  by  a  foreign  corporation  in  a  qualified  reorganization 
and  the  acquisition  of  stock  in  a  U.S.  corporation  by  a  foreign  cor- 
poration in  a  type  "B"  reorganization.^  Exchanges  where  the  only 
transfer  of  property  out  of  the  United  States  is  stock  of  a  foreign 
corporation  which  is  a  party  to  the  exchange  are  treated  as  transfers 
into  the  T'nited  States,  since  the  princi]^al  concern  in  that  case  is  the 
avoidance  of  taxation  on  the  accumulated  earnings  of  the  foreign 
corporation.  The  rules  for  outbound  transactions  apply  only  to  trans- 
fers of  property  by  U.S.  persons;  thev  do  not  apply  to  transfers 
which  are  between  two  foreign  corporations  or  between  a  foreign  cor- 
poration and  a  foreign  individual. 

The  Act  thus  provides  that  for  transfers  of  property  out  of  the 
United  States  the  requirement  of  an  advance  ruling  is  replaced  by  a 
I'equirement  that  the  taxpayer  file  a  request  for  clearance  with  the 


1  Also  Included  as  "outbou'Hl"  transfers  are  transfers  of  assets  from  one  domestic 
corporation  to  another  in  a  "C"  reorganization  where  the  acquirlnfr  corporation  is  con- 
trolled hv  foreigners  who  were  not  In  control  of  the  acquired  corporation  before  the 
reorganization. 


261 

Internal  Revenue  Service  within  183  days  after  the  beginning  of  the 
transfer.  Even  this  post-transaction  clearance  from  the  Internal  Rev- 
enue Service  may  not  be  required  in  certain  clearcut  situations  involv- 
ing outbound  transfers  where  significant  tax  avoidance  possibilities  do 
not  exist  or  where  the  amount  of  any  section  367  toll  charge  can  be 
ascertained  without  a  ruling  request.  The  Act  provides  that  the  Secre- 
tary is  to  designate  by  regulations  those  transactions  which  for  these 
reasons  do  not  require  the  filing  of  a  ruling  request.  For  transactions 
designated  by  the  regulations,  taxpayers  may  go  ahead  with  the  trans- 
action without  a  ruling  but  are  subject  to  any  section  367  toll  charge 
prescribed  by  the  regulations.  For  example,  if  a  section  351  transfer  to 
a  foreign  corporation  involves  only  the  transfer  of  cash  and  inventory 
property,  the  Secretary  may  by  regulations  designate  the  transaction 
as  one  which  does  not  require  the  filing  of  a  request,  although  the 
regulations  would  require  the  inventory  to  be  taken  into  income. 

The  Act  provides  a  special  rule  dealing  with  the  situation  where 
there  are  a  number  of  transfers  which  are  treated  iby  the 
Secretary  as  part  of  the  same  exchange.  In  general,  if  there  is  an  or- 
ganization, reorganization,  or  liquidation  involving  a  transfer  or 
transfers  of  property  by  a  U.S.  person  to  a  foreign  corporation,  non- 
recognition  of  gain  will  be  permitted  if  a  request  for  a  nding  that  a 
tax  avoidance  purpose  is  not  present  is  filed  within  183  days  after 
the  beginning  of  the  transfer.  Under  this  rule,  the  taxpayer  may  re- 
quest a  nding  not  later  than  the  183rd  day  after  the  beginning  of  any 
transfer  which  is  part  of  the  exchange,  whether  or  not  a  ruling  has 
been  requested  with  respect  to  prior  transfers  which  are  part  of  the 
exchange.  If  the  Secretary  detemtiines  that  the  entire  exchange  does 
not  involve  a  tax  avoidance  purpose,  nonrecognition  of  gain  will  be 
permitted  for  that  transfer  and  any  subsequent  transfers.  Nonrecogni- 
tion will  be  provided  with  respect  to  any  transfer  which  is  part  of 
the  exchange  but  which  begins  more  than  183  days  before  the  ruling 
request  is  made  if  the  Secretary  determines  that  tax  avoidance  will 
not  result  if  the  earlier  transfer  is  provided  nonrecognition  treat- 
ment and  if  a  ruling  was  obtained  for  the  earlier  transfer.  If  no  ruling 
was  obtained  for  the  earlier  transfer,  nonrecognition  treatment  will 
not  be  accorded  the  earlier  transfer  if  a  ruling  is  required  for  that 
transfer  for  there  to  be  nonrecognition.  However,  failure  of  the  tax- 
payer to  apply  for  a  ruling  with  respect  to  an  earlier  transfer  will 
not  automatically  result  in  taxable  treatment  of  the  earlier  transfer 
because  the  Secretary  may  require  nonrecognition  treatment  of  the 
earlier  transfer  in  those  situations  he  deems  appropriate  even  in  the 
absence  of  a  ruling. 

Tax  Court  review. — In  the  case  of  an  actual  controversy  involving 
a  determination  or  a  failure  to  make  a  determination  by  the  Secretary 
as  to  whether  a  plan  has  as  one  of  its  principal  purposes  the  avoidance 
of  Federal  income  taxes,  the  Act  provides  that  a  taxpayer  may  liti- 
•gate  the  determination  in  the  Tax  Court.  The  Act  ffenerallv  follows  the 
declaratorv  judgment  procedures  which  were  added  to  the  tax  law  in 
the  recently  enacted  pension  reform  act.  In  addition,  the  Tax  Court  is 
to  review  any  terms  and  conditions  which  the  Secretary  seeks  to  im- 
pose upon  a  taxpayer  in  makin.qr  the  determination  that  the  exchange 
is  not  in  pursuance  of  a  plan  having  as  one  of  its  principal  purposes  the 
avoidance  of  income  taxes. 


234-120   O  -  77  -  18 


262 

The  Tax  Court  is  to  review  whether  the  Secretary's  determination 
as  to  tax  avoidance  is  reasonable  and  whether  the  conditions  imposed 
in  making  the  determinations  are  reasonable  conditions  in  order  to 
prevent  the  avoidance  of  income  tax.  If  the  Tax  Court  finds  that  the 
Secretary's  terms  and  conditions  are  not  reasonable,  then  the  Tax 
Court  is  to  make  a  declaration  as  to  the  terms  and  conditions  which 
it  finds  to  be  reasonable  in  order  to  prevent  the  avoidance  of  income 
taxes. 

A  request  for  a  declaratory  judgment  under  these  proceedings  can 
only  be  filed  by  a  petitioner  who  is  a  transferor  or  transferee  of  stock, 
securities  or  property  in  an  exchange  where  money  or  other  property 
is  being  transferred  from  the  United  States  (sec.  367(a)(1)).  In 
addition,  no  proceeding  may  begin  unless  the  exchange  with  respect 
to  which  the  declaration  is  being  sought  has  begun.  It  is  not  necessary 
for  this  purpose  that  the  full  exchange  has  been  completed.  In  addi- 
tion, this  requirement  will  be  satisfied  although  the  taxpayer  has 
transferred  assets  conditioned  upon  a  stipulation  that,  if  there  is  a 
failure  to  obtain  fi'om  the  Internal  Revenue  Service  a  determination 
that  the  transaction  does  not  have  as  one  of  its  principal  purposes  the 
avoidance  of  Federal  income  taxes,  the  transaction  will  not  be  com- 
pletely consummated  and,  to  the  extent  possible,  the  assets  transferred 
will  be  returned. 

Any  such  declaration  is  to  have  the  force  and  effect  of  a  final  judg- 
ment or  decree  and  is  to  be  reviewable  as  such.  The  court  is  to  base 
its  determination  upon  the  reasons  provided  by  the  Internal  Revenue 
Service  in  its  notice  to  the  party  making  the  request  for  a  determina- 
tion, or  upon  any  new  matter  which  the  Service  may  wish  to  intro- 
duce at  the  time  of  the  trial.  The  Tax  Court  judgment,  however,  is 
to  be  based  upon  a  redetermination  of  the  Internal  Revenue  Service's 
determination.  The  burden  of  proof  rules  are  to  be  developed  by  the 
Tax  Court  under  its  rule-making  powers.  Under  the  existing  Tax 
Court  rules  the  taxpayer  has  the  burden  of  proof  as  to  matters  in  the 
notice  of  deficiency.  As  to  matters  raised  by  the  Service  at  the  time 
of  the  Tax  Court  hearing,  the  Service  has  the  burden.  It  is  expected 
that  rules  similar  to  these  will  be  adopted  by  the  Tax  Court. 

The  judgment  of  the  Tax  Court,  in  a  declaratory  judgment  proceed- 
ing is  to  be  binding  upon  the  parties  to  the  case  based  upon  the  facts 
as  presented  to  the  court,  in  the  case  for  the  year  or  years  involved. 
This,  of  course,  does  not  foreclose  action  (within  the  limits  of  the  legal 
d'>ctrines  of  estoppel  and  stare  decisis)  if  an  examination  of  the  facts 
of  the  exchange  indicates  that  they  differ  from  those  stated  in  the 
ruling.  It  is  anticipated  that  the  normal  rules  of  the  Federal  courts 
as  they  relate  to  declaratory  judgment  procedure  will  apply. 
^  For  a  petitioner  to  receive  a  declaratoi-y  judgment  from  the  Tax 
Court  under  this  provision,  he  must  demonstrate  to  the  court  that  he 
has  exhausted  all  administrative  remedies  which  are  available  to  him 
within  the  Internal  Revenue  Service.  Thus,  he  must  demonstrate  that 
he  has  made  a  request  to  the  Internal  Revenue  Service  for  a  deter- 
mmation  and  that  the  Internal  Revenue  Service  has  either  failed  to 
act,  or  has  acted  adversely  to  him,  and  that  he  has  appealed  any 
adverse  determination.  To  exhaust  his  administrative  remedies  a  party 


263 

must  satisfy  all  procedural  requirements  of  the  Service.  For  example, 
the  Service  may  decline  to  make  a  determination  if  a  petitioner  fails 
to  supply  the  Service  with  the  necessary  information  on  which  to  make 
a  determination. 

A  petitioner  is  not  to  be  deemed  to  have  exhausted  his  administra- 
tive remedies  in  cases  where  there  is  a  failure  by  the  Internal  Revenue 
Service  to  make  a  determination  before  the  expiration  of  270  days 
after  the  request  for  such  a  determination  is  made.  Once,  this  270- 
day  period  has  elapsed,  a  petitioner  who  has  exhausted  his  remedies 
may  bring  an  action  even  though  there  has  been  no  notice  of  determina- 
tion from  the  Internal  Revenue  Service. 

No  petition  to  the  Tax  Court  may  be  filed  after  90  days  from  the 
date  on  which  the  Internal  Revenue  Service  sends  by  certified  or  reg- 
istered mail  notice  to  a  person  of  its  determination  (including  refusals 
to  make  determinations)  as  to  whether  tliere  is  a  tax  avoidance  purpose 
in  an  exchange.  Such  notice  is  to  be  treated  by  the  taxpayer  as  exhaus- 
tion of  administrative  remedies.  This  90-day  period  does  not  begin  to 
run  until  the  Secretaiy  sends  the  taxpayer  the  required  notice. 

Tax  Court  Cwmnissioners. — In  order  to  provide  the  court  with 
flexibility  in  carrying  out  this  provision,  the  Act  authorizes  the  Chief 
Judge  of  the  Tax  Court  to  assign  the  Commissioners  of  the  Tax  Court 
to  hear  and  make  determinations  with  respect  to  petitions  for  a  declar- 
atory judgment,  subject  to  such  conditions  and  review  as  the  court 
may  provide.  Congress  does  not  intend  that  this  be  constiiied  as  indi- 
cating that  all  of  these  proceedings  should  be  heard  by  commissionei-s 
and  decisions  entered  by  them  rather  than  by  the  judges  of  the  court. 
Instead,  it  is  intended  to  provide  more  flexibility  to  the  Tax  Court  in 
the  use  of  commissioners  in  these  types  of  cases.  It  is  anticipated,  for 
example,  that  if  the  volume  of  these  cases  should  be  large,  the  Tax 
Court  will  expedite  the  resolution  of  these  cases  by  authorizing  com- 
missioners to  hear  and  enter  decisions  in  cases  where  similar  issues 
have  already  been  heard  and  decided  by  the  judges  of  the  court  or  in 
other  cases  where,  in  the  discretion  of  the  court,  it  is  appropriate  for 
the  commissioners  to  hear  and  decide  cases. 

These  procedures  apply  with  respect  to  proceedings  filed  with  the 
Tax  Court  after  the  date  of  the  enactment  of  the  Act,  but  only  with 
respect  to  transfers  beginning  after  October  9.  1975. 

Other  transfers. — The  Act  establishes  separate  treatment  under  sec- 
tion 367(b)  for  a  second  group  of  transfers  which  consists  of  exchanges 
described  in  sections  332,  351,  354,  355.  356,  and  361  that  are  not  treated 
as  transfers  out  of  the  ITnited  States  (under  section  367(a) )  under  the 
rules  described  above.  With  respect  to  these  other  transactions,  a  rul- 
ing is  not  required.  Instead,  a  foreign  corporation  will  not  be  treated 
as  a  corporation  to  the  extent  that  the  Secretary  of  the  TreasuiT  pro- 
vides in  regulations  that  are  necessar}-^  or  approj^riate  to  prevent  the 
avoidance  of  Federal  income  taxes.  These  regulations  are  to  be  subject 
to  nonnal  court  review  as  to  whether  the  regulations  are  necessar\^  or 
appropriate  for  the  prevention  of  avoidance  of  Federal  income  taxes. 
Thus,  a  taxpayer  may  challenge  a  projwsed  deficiency  with  respect  to 
an  exchange  dealt  with  in  the  regulations  by  arguing  in  the  courts  that 
the  regulations,  as  applied  in  the  taxpayers  case,  are  not  necessary  or 


264 

appropriate  to  prevent  the  avoidance  of  Federal  income  taxes.  If  the 
court  should  agree  with  the  taxpayer,  it  is  to  apply  the  balance  of  the 
regulations  to  the  extent  appropriate. 

Transfers  covered  in  these  regulations  are  to  include  transfers  con- 
stituting a  repatriation  of  foreign  earnings.  Also  included  are  trans- 
fers that  involve  solely  foreign  corporations  and  shareholders  (and 
involve  a  U.S.  tax  liability  of  U.S.  shareholders  only  to  the  extent 
of  determining  the  amount  of  any  deemed  distribution  under  the  sub- 
part F  rules).  It  is  anticipated  that  in  this  latter  group  of  exchanges, 
the  regulations  will  not  provide  for  any  immediate  U.S.  tax  liability 
but  will  mai'  tain  the  potential  tax  liability  of  the  U.S.  shareliolder. 

It  is  intended  that  the  regulations  promulgated  wdth  respect  to  this 
group  of  transactions  will  enable  taxpayers  to  determine  the  extent 
(if  any)  to  which  there  will  be  any  immediate  U.S.  tax  liability  re- 
sulting from  any  transaction.  The  Act  provides  (sec.  367(b)  (2^ )  that 
the  regulations  promulgated  with  respect  to  this  group  will  include 
(but  shall  not  be  limited  to) regulations  dealing  with  the  sale  or  ex- 
cliange  of  stock  or  securities  in  a  foreign  corporation  by  a  U.S.  person, 
including  regulations  providing  the  circumstances  under  which  (i) 
gain  is  recognized  currently  or  is  included  in  income  as  a  dividend,  or 
both,  or  (ii)  gain  or  other  amounts  may  be  deferred  for  inclusion  in 
the  gross  income  of  a  shareholder  (or  his  successor  in  interest)  at  a 
later  date.  The  regulations  may  also  provide  the  extent  to  which  ad- 
justments are  to  be  made  to  the  earnings  and  profits  of  any  corporation, 
the  basis  of  any  stock  or  securities,  and  the  basis  of  any  assets. 

Examples  of  transfers  into  the  United  States  which  are  to  be  treated 
within  this  group  (sec.  367(b)(1))  include:  (i)  the  liquidation  of 
a  foreign  corporation  into  a  domestic  parent ;  (ii)  the  acquisition  of 
assets  of  a  foreign  corporation  by  a  domestic  corporation  in  a  type 
"C"  or  "D"  reorganization;  and  (iii)  the  acquisition  of  stock  in  a 
foreign  corporation  by  a  domestic  corporation  in  a  type  "B"  reorgani- 
zation. With  respect  to  transfers  which  exclusively  involve  foreign 
parties  (i.e.,  where  no  U.S.  persons  are  parties  to  the  exchange) ,  exam- 
ples of  situations  coming  within  section  367(b)(1)  include:  (i)  the 
acquisition  of  stock  of  a  controlled  foreign  corporation  by  another 
foreign  corporation;  (ii)  the  acquisition  of  stock  of  a  controlled  for- 
eign corporation  by  another  foreign  corporation  which  is  controlled  by 
the  same  U.S.  shareholders  as  the  acquired  corporation;  (iii)  the  ac- 
quisition of  the  assets  of  a  controlled  foreign  corporation  by  another 
foreign  corporation;  (iv)  the  mere  recapitalization  of  a  foreign 
corporation  (type  "E"  reorganization)  ;  and  (v)  a  transfer  of  property 
by  one  controlled  foreign  corporation  to  its  foreign  subsidiary.  For 
these  exclusively  foreign  transactions,  it  is  anticipated  that  regulations 
will  provide  for  no  immediate  U.S.  tax  liability. 

The  Secretary's  authority  to  prescril)e  regulations  relating  to  the 
sale  or  exchange  of  stock  in  a  foreign  corporation  includes  authority 
to  establish  rules  pursuant  to  which  an  exchange  of  stock  in  a  second 
tier  foreign  con^oration  for  other  stock  in  a  similar  foreign  corpora- 
tion will  result  in  a  deferral  of  the  toll  charge  w^hich  otherwise  would 
be  imposed  based  on  accumulated  earnings  and  profits.  This  deferral 
could  be  accomplished  by  designating  the  stock  received  as  stock  with 


265 

a  deferred  tax  potential  in  a  mpnner  similar  to  section  1248  without 
reference  to  the  December  31,  1962,  date;  the  amount  includable  as 
foreign  source  dividend  income  upon  the  subsequent  disposition  of  the 
stock  in  question  results  in  dividend  income  only  to  the  extent  of  the 
gain  realized  on  the  subsequent  sale  or  exchange.  In  addition,  if  a 
second  tier  foreign  subsidiary  is  liquidated  into  a  first  tier  foreign 
subsidiary,  the  regulations  may  provide  that  the  tax  which  would 
otherwise  be  due  in  the  absence  of  a  ruling "  is  deferred  until  the 
disposition  of  the  stock  in  the  fii-st  tier  foreign  subsidiary. 

Transfers  treated  as  exchanges. — A  distribution  of  stock  or  securities 
(under  section  355)  is  treatecl  as  an  exchange  whether  or  not  it  other- 
wise would  be  an  exchange.  Also,  a  transfer  of  property  to  a  foreign 
corporation  in  the  form  of  a  contribution  of  capital  by  one  or  more 
persons  having  (after  application  of  the  ownership  attribution  rules 
of  section  318)  at  least  80  percent  of  the  total  combined  voting  power 
of  all  classes  of  stock  entitled  to  vote  is  treated  as  an  exchange  of  the 
property  contributed  to  the  corporation  in  return  for  the  equivalent 
value  of  stock  of  the  corporation. 

Traiisitional  rules. — The  changes  made  to  section  367  generally 
apply  to  transfers  within  the  meaning  of  section  367,  beginning  after 
October  9,  1975.  However,  in  order  to  permit  the  Internal  Revenue 
Service  sufficient  time  to  develop  the  regulations  required  for  transfers 
into  the  United  States  and  between  foreign  corporations,  the  Act 
establishes  a  transition  rule  requiring  that  these  regulations  need  not 
be  effective  until  January  1,  1978.  In  the  intervening  period  transac- 
tions which  would  otherwise  be  covered  by  those  regulations  are 
covered  by  the  rules  applicable  generally  to  transfers  out  of  the  United 
States,  and  thus  a  ruling  will  be  required.  Moreover,  in  the  case  of  any 
exchange  (as  described  in  section  367  as  in  effect  on  December  31, 
1974),  in  any  taxable  year  beginning  after  1962  and  before  1976,  Avhich 
does  not  involve  the  transfer  of  property  to  or  from  a  IT.S.  person,  a 
taxpayer  has  for  purjwses  of  section  367  until  183  days  after  the  date 
of  the  enactment  of  this  Act  to  make  a  request  to  the  Secretary  for 
a  finding  that  such  exchange  was  not  in  pursuance  of  a  plan  having 
as  one  of  its  principal  purposes  the  avoidance  of  Federal  inconie  taxes 
so  that  for  purposes  of  that  section  a  foreign  corporation  is  to  be 
treated  as  a  foreign  corporation. 

Sales  or  exchanges  givii^g  rise  to  dividends. — In  addition  to  the 
above  changes  in  section  367,  the  Act  amends  the  provision  which 
requires  that  recognized  gain  on  the  sale  or  exchange  of  stock  in  a 
foreign  corporation  l)e  taxed  as  a  dividend  to  the  extent  of  earnings 
and  profits  of  the  foreign  corporation.  The  Act  applies  this  provision 
to  situations  where  gain  is  not  recognized  under  the  provisions  of  sec- 
tions 311,  336,  and  337.  The  Act  provides  (in  a  new  sec.  1248(f)) 
that  if  a  domestic  corporation  which  meets  the  stock  ownership  re- 
quirements of  section  1248(a)  (2)  with  respect  to  a  foreign  corporation 
distributes,  sells,  or  exclianges  the  stock  of  the  foreign  corporation 
in  a  transaction  to  which  section  311,  336,  or  337  applies,  then,  not- 
withstanding any  other  j^rovision,  the  domestic  cornoration  is  to  in- 
clude in  gross  income  as  a  dividend  an  amount  equal  to  the  excess  of 
the  fair  market  value  of  the  stock  of  the  foreign  corporation  over  its 


«  See  Rev.  Rul.  64-157,  1964—1  (Part  1)  Cum.  Bull.  139. 


266 

basis  to  the  extent  of  the  eurninos  and  profits  of  the  foreign  corpora- 
tion which  were  accunuihited  after  1962  and  during  the  period  the 
stock  was  held  by  the  domestic  corporation  while  the  foreign  corpora- 
tion was  a  controlled  foreign  corporation.  For  this  purpose  earnings 
and  profits  excluded  from  the  dividend  treatment  (of  sec.  1248 (a)) 
are  not  taken  into  account.  Thus,  earnings  and  prohts  of  a  less  devel- 
ojjed  couiiti-y  corporation  (to  the  extent  provided  in  sec.  1248  (d)  (3) ) 
are  not  taken  into  account. 

If,  however,  the  domestic  corporation  distributes  the  stock  of  a  for- 
eign corporation  to  a  shareholder  which  is  a  domestic  corporation  the 
rule  stated  above  generally  does  not  apply  since  the  basis  of  the  prop- 
erty received  is  the  lesser  of  fair  market  value  or  adjusted  basis  to  the 
distributing  corporation.  In  this  type  of  situation,  the  corporate  dis- 
tributee does  not  receive  a  stepped  up  basis  as  a  result  of  the  distribu- 
tion. Since  the  potential  for  the  future  application  of  section  1248 
still  exists,  it  is  not  necessary  to  overiide  the  nonrecognition  provi- 
sions which  otherwise  apply  to  corporate  distributions.  Consequently, 
the  Act  provides  that  the  distributing  corporation  need  not  include 
nny  amounts  in  income  if  the  distribution  is  to  a  domestic  coi'poration 
(i)  which  is  treated  as  holding  the  stock  for  the  period  the  stock  was 
held  by  distributing  corporation  (sec.  1228)  :  and  (ii)  which, 
immediate!}^  after  the  distribution,  satisfies  the  stock  ownership  re- 
quirements of  section  1248(a)(2)  with  respect  to  the  foreign  cor- 
poration. 

The  above  rules  also  do  not  apply  to  certain  section  837  liquida- 
tions of  domestic  corj^orations  where,  under  prior  law,  gain  Avas  sub- 
ject to  tax  as  ordinary  income  to  the  shareholders  of  that  corporation 
under  the  provisions  of  section  1248(e)  dealing  with  domestic  corpo- 
rations formed  or  availed  of  to  hold  stock  of  a  foi-eigii  corporation. 
This  exception  applies  if  (1)  all  the  stock  of  a  domestic  corporation  is 
owned  by  United  States  persons  who  have  been  10  percent  sharehold- 
ers of  the  domestic  corpoi-ation  throughout  the  entire  period  that  the 
stock  of  the  foreign  corporation  was  held  by  the  domestic  corporation, 
and  (2)  the  jirovisions  of  section  124S(a)  treating  an  amount  equal  to 
the  earnings  of  the  foreign  corporation  as  a  dividend  apply  by  reason 
of  section  1248(e)  (1)  to  any  liquidation  or  distribution  from  the  do- 
mestic corporation  and  applied  to  all  other  transactions  relating  to  the 
stock  of  the  domestic  corporation  during  the  period  that  the  domestic 
corporation  held  the  stock  of  the  foreign  corporation. 

Also  the  rules  for  taxing  the  sale  of  a  partnership  Intercast  (under 
sec.  751)  are  modified  so  that  to  the  extent  any  gain  from  the  sale  is 
attributable  to  stock  in  a  controlled  foreign  corporation,  that  gain  is 
to  be  treated  as  ordinai-y  income  (in  the  same  manner  as  gain  attribut- 
able to  section  1245  property  and  section  1250  property  is  taxed  as 
ordinary  income) . 

Effective  date 
The  modifications  to  section  867  and  to  section  1248  and  related  pro- 
visions apply  to  transfers  beginning  after  October  9, 1975,  and  to  sales, 
exchanges,  and  distributions  taking  place  after  that  date. 

Revenue  ejfect 
It  is  not  expected  that  these  })rovisions  will  have  any  significant 
impact  on  the  revenues. 


267 

8.  Contiguous  Country  Branches  of  Domestic  Insurance  Com- 
panies (sec.  1043  of  the  bill  and  sec.  819A  of  the  Code) 

Prior  lm.0 
Under  prior  law,  a  domestic  life  insurance  company  was  subject 
to  tax  on  its  worldwide  taxable  income.  If  the  company  paid  foreign 
income  taxes  on  its  income  from,  foreign  sources  it  was  allowed  a 
foreign  tax  credit  against  its  otherwise  payable  U.S.  tax  on  foreign 
source  income. 

Reasons  for  change 

Since  the  beginning  of  this  century,  U.S.  mutual  life  insurance 
companies  have  been  engaged  in  the  life  insurance  business  in  Canada. 
Under  prior  law,  the  tax  imposed  by  the  United  States  on  the  opera- 
tions of  Canadian  branches  of  U.S.  mutual  life  insurance  companies 
generally  exceeded  the  tax  imposed  by  the  Dominion  of  Canada  and 
its  pro\  inces. 

The  income  of  the  companies  from  their  Canadian  operations  is 
derived  generally  by  the  issuance  of  policies  insuring  Canadian  risks 
and  the  investment  income  from  the  policyholder  reserves  on  the 
Canadian  risks  and  any  surplus.  Quite  often  the  investments  of  the 
Canadian  branch  is  in  Canadian  securities.  A  separate  branch  account 
is  maintained  by  the  life  insurance  companies  under  which  the  various 
income,  expense,  asset,  reserve  and  other  items  that  relate  to  Canadian 
policyholders  are  segregated  on  the  books  of  the  company.  The  sepa- 
rate branch  accounting  system  is  used  for  purposes  of  establishing 
premiums  and  policyholder  dividend  rates  based  upon  the  separate 
mortality  and  earnings  experience  of  the  Canadian  branch. 

The  income  earned  by  the  Canadian  branch  inures  solely  to  the 
benefit  of  these  Canadian  policyholders  and  is  reflected  either  by  divi- 
dends paid  to  them  or  increases  in  the  size  of  the  reserves  and  surplus 
with  respect  to  Canadian  policyholders.  Thus,  the  additional  cost 
resulting  because  U.S.  tax  liability  exceeded  Canadian  income  tax 
liability  on  the  Canadian  branch  profits  fell  primarily  upon  the 
Canadian  policyholders,  since  it  reduced  the  reser\^es  and  surplus 
available  to  the  Canadian  policyholders.  This  additional  cost  made  it 
more  difficult  to  issue  mutual  life  insurance  policies  in  Canada. 

Further,  under  prior  law  the  sale  of  pension  contracts  in  Canada 
had  been  almost  precluded  by  uncertainty  as  to  whether  reserves  for 
Canadian  pension  contracts  qualified  for  the  exclusion  from  gross 
income  which  reserves  for  qualified  plans  in  the  XTnited  States  may 
obtain. 

In  contrast,  Canada,  which  generally  also  taxes  Canadian  com- 
panies on  their  worldwide  taxable  income,  does  not  tax  Canadian  life 
insurance  companies  on  their  foreign  source  income  except  when  the 
profits  are  repatriated. 

As  a  general  rule,  profits  of  a  U.S.  company  although  earned  from 
sources  outside  the  United  States  should  be  subiect  to  U.S.  tax  when 
earned  since  those  profits  are  available  for  distribution  to  tlie  share- 
holders of  the  compauA^  or  are  nvailable  to  the  company  to  be  used 
within  or  without  the  United  States  for  new  investments.  However, 
the  profits  derived  by  a  Canadian  branch  of  a  I'^^.S.  mutual  life  insur- 
ance company  are  not  generally  available  for  use  other  than  as  re- 


268 

serves  and  surplus  for  the  Canadian  policyholders  and  may  not  be 
used  to  provide  insurance  for  the  U.S.  policyholders.  This  unique  fea- 
ture of  mutuality,  in  which  the  earnings  are  restricted  to  benefit  the 
Canadian  policyholders,  distinguishes  the  branch  operations  of  a  mu- 
tual life  insurance  company  from  the  branch  operations  of  other  busi- 
nesses. For  this  reason  Congress  believes  it  is  appropriate  to  view 
the  Canadian  operation  as  a  separate  entity  in  eifect  owned  by  the 
Canadian  policyholders.  Accordingly,  Congress  concluded  that  it  was 
desirable  to  provide  that  the  profits  of  the  Canadian  branch  of  a  U.S. 
mutual  life  insurance  company  are  not  to  be  subject  to  U.S.  taxation 
except  in  the  rare  situation  where  profits  are  somehow  repatriated 
to  the  United  States  for  the  benefit  of  the  non-Canadian  operations 
or  are  derived  from  sources  within  the  United  States. 

Congress  concluded  tliat  it  would  also  ba  desirable  to  provide  a 
special  rule  in  the  case  of  stock  life  insurance  companies  operating 
in  Canada  or  Mexico.  While  it  is  easier  for  a  stock  life  insurance  com- 
pany to  operate  through  a  subsidiary  organized  under  foreign  law 
than  it  is  for  a  mutual  company,  ])roblems  would  be  encountered  in 
transferring  an  existing  business  to  a  foreign  subsidiary  since  such 
a  transfer  would  require  the  satisfaction  of  the  Secretary  that  one 
of  its  purposes  was  not  the  avoidance  of  Federal  income  taxes.  Since 
the  Act  contains  special  rules  for  deemed  transfers  in  the  case  of 
mutual  life  insurance  companies,  (^ongress  felt  it  was  appropriate  to 
provide  similar  rules  in  the  case  of  actual  transfers  by  stock  com- 
panies to  a  contiguous  country  subsidiary. 

Explanation  of  proi'isions 

Mutual  companies. — The  Act  establishes  a  special  system  of  taxation 
for  branches  of  U.S.  mutual  life  insurance  companies  which  are  oper- 
ated in  a  contiguous  country  (i.e.,  Canada  or  Mexico) .  To  be  eligible  for 
this  S|)ecial  treatment  a  mutual  life  insurance  company  must  make  an 
election  with  respect  to  a  contiguous  country  life  insui'ance  branch. 

If  a  proper  election  is  made,  there  is  excluded  from  each  item  in- 
volved in  the  determination  of  life  insurance  company  taxable  income 
the  items  separately  accounted  for  in  a  separate  contiguous  country 
branch  account  which  the  mutual  life  insurance  company  is  required 
to  establish  and  maintain  under  the  Act.  The  branch  account  must  be 
esfablished  by  the  end  of  the  first  taxable  year  to  which  the  election 
applies  and  is  to  include  the  various  items  of  income,  exclusion,  de- 
duction, asset  reserve,  liability,  and  surplus  properly  attributable  to 
life  insurance  contracts  issued  by  the  contiguous  country  branch.  The 
separate  accounting  is  to  be  made  in  accordance  with  the  method  regu- 
larly employed  by  the  company,  if  the  method  clearly  reflects  income 
derived  from,  and  other  items  attributable  to,  the  life  insurance  con- 
tracts issued  by  the  contiguous  country  branch,  and  in  all  other  cases  in 
accordance  with  regulations  issued  by  the  Secretary.  Once  a  method 
of  branch  accoimting  is  established,  it  must  be  applied  consistently  and 
may  not  be  changed.  HoAvever,  the  taxpayer  may  initially  choose  in  his 
return  for  the  first  taxable  year  to  which  it  applies  the  system  of 
branch  accounting  which  properly  reflects  the  results  of  operations  of 
the  branch.  It  is  expected  that  the  regulations  will  provide  that  a  sys- 
tem properly  reflects  income  if  it  provides  for  an  allocation  or  designa- 


269 

tion  of  assets  to  the  contiguous  country  branch  at  the  time  that  they 
are  acquired.  This  requirement  is  satisfied  if  the  allocation  or  designa- 
tion is  made  on  a  periodic  basis  (either  monthly  or  weekly).  Once  an 
asset  is  designated  or  allocated  as  a  branch  asset  it  must  retain  that 
character  so  long  as  it  is  held.  All  income,  expense,  gain  or  loss  con- 
nected with  a  branch  asset  must  be  accounted  for  in  the  branch  ac- 
count. Also,  new  assets  acquired  by  the  company  must  be  credited  to 
the  branch  account  to  the  extent  attributable  to  reserves  and  surplus  in 
the  branch  account. 

For  purposes  of  this  provision,  a  branch  is  a  contiguous  country 
life  insurance  branch  if  it  satisfies  three  conditions.  First,  it  must  issue 
insurance  contracts  insuring  risks  in  connection  with  the  lives  or  health 
of  residents  of  a  country  which  is  contiguous  to  the  United  States  (i.e., 
Canada  or  Mexico) .  For  this  purpose  an  insurance  contract  means  any 
life,  health,  accident,  or  annuity  contract  or  reinsurance  contract  with 
respect  to  these  contracts  or  any  other  type  of  contract  relating  to 
these  contracts.  Second,  the  branch  must  have  its  principal  place  of 
business  in  the  contiguous  country  for  which  it  insures  risks.  Third, 
the  branch,  if  it  were  a  separate  domestic  corporation,  must  be  able  to 
qualify  as  a  separate  mutual  life  insurance  company. 

The  Act  provides  that  an  election  to  establish  a  separate  contiguous 
country  branch  is  to  be  treated  as  a  taxable  disposition  for  purposes 
of  recognizing  any  gain  by  the  domestic  company.  If  the  aggregate 
fair  market  value  of  all  the  invested  assets  and  tangible  property 
which  is  separately  accounted  for  by  the  company  in  the  branch 
account  exceeds  the  aggregate  adjusted  basis  of  those  assets  (for  pur- 
poses of  determining  gain),  then  the  company  is  to  be  treated  as  hav- 
ing sold  those  assets  on  the  first  day  of  the  first  taxable  year  for  which 
the  election  is  in  effect  at  the  fair  market  value  on  that  day.  The  net 
gain  on  the  deemed  sale  of  these  assets  is  to  be  recognized  notwith- 
standing any  other  provision  of  the  Code.  The  assets  taken  into  ac- 
count for  this  determination  include  all  of  the  invested  assets  (such 
as  stock  and  secur'ties)  ar»d  all  tangible  property  (such  as  land,  build- 
ijigs,  and  equipment)  which  are  separately  accounted  for  in  the  branch 
account.  However,  goodwill,  since  it  is  an  intangible  asset,  is  not  taken 
into  account. 

While  Congress  does  not  believe  that  any  of  the  profits  of  the  con- 
tiguous countrv  branch  can  be  accumulated  for  the  benefit  of  the  U.S. 
policyholders  (since  the  branch  is  treated  as  operating  as  a  mutual 
life  insurance  company  and  insures  risk  for  policyholders  only  in  a 
contiguous  country  and  thus  any  profits  would  be  accumulated  for 
the  benefit  of  the  contiguous  country  policyholders),  the  Act  never- 
theless, in  order  to  provide  assurance  on  this  point,  provides  rules  for 
the  taxation  of  the  contiguous  country  branch  income  if  it  is  ever  re- 
patriated. First,  payments,  transfers,  reimbursements,  credits,  or  al- 
lowances which  are  made  from  a  separate  contigiious  country  branch 
account  to  one  or  more  accounts  of  the  domestic  company  as  reim- 
bursements for  costs  (e.g.,  home  office  services)  incurred  for  or  with 
respect  to  the  insurance  (including  reinsurance)  of  risks  accounted 
for  in  the  separate  branch  account  are  to  be  taken  into  account  by  the 
domestic  company  in  the  same  manner  as  if  the  payment,  transfer, 
reimbursement,  credit,  or  allowance  were  received  from  a  separate 
per-son.  For  this  purpose  the  rules  in  the  Internal  Revenue  Code  (sec. 


270 

48'2)  dealing  with  reiinbureeinent  of  costs  between  related  pai-ties  are 
to  apply  and  the  domestic  company  is  to  establish  procedures  for  bill- 
ing the  branch  at  cost.  Reimbursements  under  this  provision  are  not 
treated  as  repatriation  of  income. 

If  amounts  are  directly  or  indirectly  transferred  or  credited  from  a 
contiguous  country  branch  account  to  one  or  more  other  'accounts  of 
the  domestic  company  they  are  to  be  added  to  the  life  insurance  com- 
pany taxable  income  of  the  domestic  company  except  to  the  extent  the 
transfers  are  I'eimbursements  for  home  office  services.  The  amount 
which  is  to  be  added  to  life  insiii-ance  company  taxable  income  is  not 
to  exceed  the  amount  by  which  the  aggregate  decrease  in  life  insur- 
ance company  taxable  income  for  the  taxable  year  and  for  all  prior 
taxable  years  resulting  solely  from  the  application  of  these  exclusion 
provisions  with  respect  to  the  contiguous  counti\v  branch  exceeds  the 
amount  of  additions  to  life  insurance  company  taxable  income  with 
respect  to  that  branch  wdiich  were  treated  as  a  repatriation  of  income 
for  all  prior  taxable  yeai'S. 

The  Act  provides  that  no  foreign  tax  credit  (under  sees.  901  or 
902)  is  to  be  allowed  with  i-espect  to  income  excluded  from  life  insur- 
ance coinpany  taxable  income  by  reason  of  it  being  accounted  for  in  a 
contiguous  country  life  insurance  branch.  In  addition,  no  deduction  is 
to  be  allowed  for  these  amounts.  If  amounts  are  treated  as  repatriated 
from  a  contiguous  country  life  insurance  branch,  they  are  to  be  treated 
for  purposes  of  the  foreign  tax  credit  provisions  (sees.  78  and  902) 
as  if  they  were  paid  as  a  dividend  from  a  foreign  subsidiary.  Thus,  the 
gross-up  provisions  of  section  78  are  to  apply.  For  purposes  of  taxa- 
tion of  any  income  from  U.S.  sources  which  is  earned  by  the  contig- 
uous country  life  insurance  branch,  the  branch  is  treated  as  a  for- 
eign corporation  and  is  subject  to  tax  under  the  provisions  of  sections 
881,  882  and  1442.  Thus,  if  it  derives  fixed  or  deteruiinable  annual  or 
periodic  income  from  the  United  States  it  is  subject  to  the  ^^■ithhold- 
ing  taxes  which  apply  to  foreign  corporations.  For  this  purpose  a 
Canadian  branch  is  to  be  entitled  to  any  treaty  benefits  which  it  would 
be  entitled  to  if  it  were  a  Canadian  subsidiary  of  a  U.S.  corporation. 

The  election  provided  by  this  provision  may  be  made  for  any  tax- 
able year  beginning  after  December  31, 1975,  Once  an  election  is  made, 
it  is  to  remain  in  effect  for  all  subsequent  years  except  that  it  may  be 
revoked  with  the  consent  of  the  Secretary.  An  election,  however,  may 
not  be  made  later  than  the  time  jirescribecl  by  law  for  filing  the  return 
(including  extensions  thereof)  for  the  taxable  year  with  respect  to 
which  the  election  ig  made.  Elections  and  any  revocations  are  to  be 
made  in  a  manner  prescribed  by  the  Secretary. 

Transfer  hy  stock  companies. — Under  the  Act,  a  domestic  stock  life 
insurance  company  which  has  a  contiguous  counti-y  life  insurance 
branch  may  elect  to  transfer  the  assets  of  that  branch  to  a  foreign 
corporation  organized  under  the  laws  of  that  contiguous  country  with- 
out the  application  of  section  367  or  1491.  Thus,  the  excise  tax  under 
section  1491  is  not  to  be  imposed  on  tlie  transfer,  nor  is  the  Commis- 
sioner's approval  of  tlie  transfei-  required  under  section  367. 

The  insurance  contracts  which  may  be  transferred  to  the  subsidiary 
include  only  those  of  the  types  issued  by  a  mutual  life  insurance  com- 
pany. For  this  purpose  an  insurance  contract  means  a  life,  health,  acci- 


271 

dent  or  annuity  contract  or  reinsurance  contract  with  respect  to  these 
contracts  and  other  types  of  contracts  relating  to  such  contracts.  Con- 
tracts are  to  be  considered  as  similar  to  those  issued  by  a  mutual  life 
insurance  company  if  they  provide  to  the  policyholder  a  reduction  in 
premiums  similar  to  the  mutual  life  insurance  company's  dividend 
or  retrospective  rate  credit. 

The  Act  provides  for  the  taxation  of  the  net  gain  on  the  transfer. 
To  the  extent  that  the  aggregate  fair  market  value  of  all  the  invested 
assets  in  tangible  property  which  are  separately  accounted  for  in  the 
contiguous  country  life  insurance  branch  exceeds  the  aggregate  ad- 
justed basis  of  all  of  these  assets  for  purposes  of  determining  gain,  the 
domestic  life  insurance  company  is  to  be  treated  as  having  sold  all  of 
the  assets  on  the  first  day  of  the  first  taxable  year  for  which  the  elec- 
tion is  in  effect.  The  sale  will  be  deemed  to  have  been  at  the  fair  market 
value  on  that  first  day,  and  notwithstanding  any  other  provision  of 
Chapter  1  (e.g.,  sec.  351) ,  the  net  gain  is  to  be  recognized  to  the  domes- 
tic life  insurance  company  on  the  deemed  sale.  If  less  than  all  of  the 
invested  assets  and  tangible  property  of  the  contiguous  country  life 
insurance  branch  of  the  domestic  company  are  transferred,  the  domes- 
tic company  will  recognize  only  that  part  of  the  net  gain  which  is 
proportional  to  the  total  net  gain  as  the  value  of  the  transferred  assets 
is  to  the  value  of  all  such  assets. 

This  provision  also  provides  that  the  stock  of  the  subsidiary  for 
purposes  of  determining  the  income  tax  of  the  domestic  stock  life 
insurance  company  is  to  be  given  the  same  treatment  as  is  accorded  the 
assets  of  a  contiguous  country  branch  of  a  mutual  company  under  the 
mutual  company  provision.  Similarly,  any  dividends  paid  by  the  sub- 
sidiary to  the  domestic  life  insurance  company  will  be  added  to  its  life 
insurance  company  taxable  income. 

Effective  date 
The  provisions  of  this  section  apply  to  taxable  years  beginning  after 
December  31,  1975. 

Revenue  effect 
It  is  estimated  that  the  mutual  and  stock  companj^  provisions  will 
result  in  a  decrease  in  budget  receipts  of  $12  million  in  fiscal  year  1977 
and  of  $8  million  thereafter. 

9.  Transitional  Rule  for  Bond,  Etc.,  Losses  of  Foreign  Banks  (sec. 
1044  of  the  Act  and  sec.  582(c)  of  the  Code) 

Prior  law 

The  Tax  Reform  Act  of  1969  (Public  Law  91-172)  eliminated  the 
preferential  treatment  accorded  to  certain  financial  institutions  for 
transactions  involving  corporate  and  government  bonds  and  other 
evidences  of  indebtedness.  Previous  to  that  these  financial  institutions 
were  allowed  to  treat  net  gains  from  these  transactions  as  capital  gains 
and  to  deduct  the  losses  as  ordinary  losses.  The  1969  Act  (sec.  433, 
amending  sec.  582  of  the  Code)  provided  parallel  treatment  to  gains 
and  losses  pertaining  to  these  transactions  by  treating  net  gains  as 
ordinary  income  and  by  continuing  the  treatment  of  net  losses  as  ordi- 
nary losses.  The  ordinary  income  and  loss  treatment  provided  under  the 
1969  Act  was  also  applied  to  corporations  which  would  be  considered 
banks  except  for  the  fact  that  they  are  foreign  corporations.  Previous 


272 

to  the  1969  Act,  these  corporations  had  treated  the  above-described 
transactions  as  resulting  in  either  capital  gains  or  capital  losses. 

Reasom  for  change 
Some  of  the  corporations  which  would  be  considered  banks  except 
for  the  fact  that  they  are  foreign  corporations  had  capital  loss  carrj'- 
overs  predating  the  1969  Act.  However,  any  post-1969  gains  realized 
by  these  corporations  resulting  from  the  sale  or  exchange  of  a  bond, 
debenture,  note,  or  other  evidence  of  indebtedness  were  accorded  ordi- 
nary income  treatment.  Thus,  these  corporations  were  left  with  cap- 
ital loss  carryforwards  which,  under  prior  law,  could  not  be  applied 
against  any  gains  resulting  from  the  same  type  of  transactions  which 
had  previously  generated  such  losses. 

Explanation  of  provision 
The  Act  provides  a  special  transitional  rule  for  corporations  which 
would  bp  banks  except  for  the  fact  that  they  are  foreign  corporations. 
Under  the  Act,  net  gains  (if  any)  for  a  taxable  year  on  sales  or  ex- 
changes of  bonds,  debentures,  notes,  or  other  evidences  of  indebtedness 
are  considered  as  gains  from  the  sale  or  exchange  of  capital  assets  to 
the  extent  that  such  gains  do  not  exceed  the  portion  of  any  capital  loss 
carryover  to  the  taxable  year  where  such  capital  loss  is  attributable  to 
the  same  tvpes  of  sales  or  exchanges  for  taxable  years  beginning  before 
July  12, 1969.  In  addition,  the  Act  provides  that  the  refund  or  credit  of 
any  overpayment  as  a  result  of  its  application  is  not  precluded  by  the 
operation  of  any  law  or  rule  of  law  (other  than  section  7122,  relating 
to  compromises)  so  long  as  the  claim  for  credit  or  refund  is  filed 
within  one  year  after  the  date  of  the  enactment  of  the  Act. 

Effective  date 
The  provision  applies  to  taxable  years  beginning  after  July  11, 1969. 

Revermie  effect 
The  revenue  loss  for  fiscal  1977  is  estimated  to  be  less  than  $5  million. 

10.  Tax  Treatment  of  Corporations  Conducting  Trade  or  Busi- 
ness in  Possessions  of  the  United  States  (sec.  1051  of  the  Act 
and  sees.  33,  931,  and  936  of  the  Code) 

Prior  law 

ITnder  prior  law,  corporations  operating  a  trade  or  business  in  a 
possession  of  the  United  States  were  entitled  to  exclude  from  gross 
income  all  income  from  sources  without  the  ITnited  States,  including 
foreign  source  income  earned  outside  of  the  possession  in  which  they 
conducted  business  operations,  if  they  met  two  conditions.  First,  80 
percent  or  more  of  the  gross  income  of  the  coi-poration  for  the  -i-year 
period  immediately  preceding  the  close  of  the  taxable  vear  had  to  be 
derived  from  sources  within  a  possession  of  the  Ignited  States.  Second, 
50  percent  of  the  gross  income  of  the  corporation  for  the  same  .'Vyear 
period  had  to  be  derived  from  the  active  conduct  of  a  trade  or  business 
within  a  possession  of  the  ITnited  States. 

Any  dividends  from  a  corporation  which  satisfied  these  require- 
ments were  not  eligible  for  the  intercorporate  dividends  received  de- 
duction (sec.  216(a)  (2)  (B)).  In  addition,  since  corporations  meeting 
the  requirements  of  section  931  were  domestic  corporations,  no  gain  or 
loss  was  recognized  by  a  parent  corporation  if  it  liquidated  a  posses- 
sions corporation   (under  sec.  332).  Corporations  satisfying  the  re- 


273 

quirements  of  a  posspssions  corporation  and  receiving  some  benefit 
from  the  exclusion  of  income  were  not  entitled  to  l>e  included  in  the 
consolidated  return  of  an  affiliated  group  of  corporations  (sec.  1504  (b) 

(4)). 

The  exclusion  of  possession  income  applied  to  corporations  conduct- 
ing business  operations  in  the  Commonwealth  of  Puerto  Rico  and  all 
possessions  of  the  United  States  except  the  Virgin  Islands.  The  exclu- 
sion also  applied  to  business  operations  of  U.S.  citizens  in  possessions 
other  than  Puerto  Rico,  the  Virgin  Islands,  and  Guam. 

Reasons  for  change 

The  special  exemption  provided  (under  sec.  931)  in  conjunction  with 
investment  incentive  programs  established  by  possessions  of  the  United 
States,  especially  the  Commonwealth  of  Puerto  Rico,  have  been  used 
as  an  inducement  to  U.S.  corporate  investment  in  active  trades  and 
businesses  in  Puerto  Rico  and  the  possessions.  Under  these  invest- 
ment programs  little  or  no  tax  is  paid  to  the  possession  for  a  period  as 
long  as  10  to  15  years.  Under  prior  law  no  tax  was  paid  to  the  United 
States  as  long  as  no  dividends  were  paid  to  the  parent  corporation. 

Because  no  current  U.S.  tax  was  imposed  on  the  earnings  if  they 
were  not  repatriated,  the  amount  of  income  which  accumulated  over 
the  years  from  these  business  activities  could  be  substantial.  The 
amounts  allowed  to  accumulate  were  often  beyond  what  could  be  prof- 
itably invested  within  the  possession  where  the  business  was  con- 
ducted. As  a  result,  corporations  generally  invested  this  income  in  other 
possessions  or  in  foreign  countries  either  directly  or  through  posses- 
sions banks  or  other  financial  institutions.  In  this  way  possessions  cor- 
porations not  only  avoided  U.S.  tax  on  their  earnings  from  businesses 
conducted  in  a  possession,  but  also  avoided  U.S.  tax  on  the  income 
obtained  from  reinvesting  their  business  earnings  abroad. 

After  studving  the  problem,  Congress  concluded  that  it  is  inappro- 
priate to  disturb  the  existing  relationship  between  the  possessions  in- 
vestment incentives  and  the  U.S.  tax  laws  because  of  the  important  role 
it  is  l-)elieved  they  play  in  keeping  investment  in  the  possessions  com- 
petitive with  investment  in  neighboring  countries.  The  U.S.  Govern- 
ment imposes  upon  the  possessions  various  requirements,  such  as  mini- 
mum wage  requirements  ^  and  requirements  to  use  U.S.  flag  ships  in 
transporting  goods  between  the  United  States  and  various  posses- 
sions,2  which  substantially  incroase  the  labor,  transportation  and 
other  costs  of  establishing  business  operations  in  Puerto  Rico.  Thus, 
without  significant  local  tax  incentives  that  are  not  nullified  by  U.S. 
taxes,  the  possessions  would  find  it  quite  difficult  to  attract  investments 
by  TT.S.  corporations. 

However,  investing  the  business  earnings  of  these  possessions  cor- 
porations outside  of  the  possession  where  the  business  is  being  con- 
ducted does  not  contribute  significantly  to  the  economv  of  that  posses- 
sion either  by  creating  new  iobs  or  by  providing  canital  to  others  to 
acquire  new  plant  and  equipment.  Accordingly,  while  Congress  be- 
lieves it  is  appropriate  to  continue  to  exempt  trade  or  business  income 
derived  in  a  posses^sion  and  investment  income  earned  in  that  posses- 
sion, it  does  not  believe  it  is  appropriate  to  provide  a  tax  exemption  for 
income  from  investments  outside  of  the  possession. 

i2fl  TT.S.C.   206-208. 
3  46  U.S.C.  883. 


274 

In  addition,  Congress  recognized  that  the  provision  of  prior  law 
denying  a  dividends  received  deduction  to  tnc  U.S.  ]iarent  corporation 
forced  a  possessions  corporation  to  invest  its  income  abroad  until  it 
was  liquidated  (usually  upon  the  termination  of  the  local  tax  exemp- 
tion) when  it  could  be  returned  to  the  United  States  tax  free.  These 
accumulated  business  profits  were  thus  not  available  for  investment 
within  the  United  States,  and  the  income  produced  was  (under  prior 
law)  not  subject  to  U.S.  tax.  Congress  believed  that  while  it  is  appro- 
priate to  tax  the  foreign  source  investment  income  from  possession 
business  earnings,  possessions  corporations  should  at  the  same  time  be 
given  the  alternative  of  returning  the  business  income  to  the  United 
States  prior  to  liquidation  without  paying  U.S.  tax.  Permitting  tax- 
free  repatriation  of  the  accumulated  earnings  only  upon  the  liquidation 
of  the  possessions  corporation,  while  taxing  the  foreign  source  invest- 
ment income  derived  from  the  accumulated  earnings,  would  lessen  to 
a  significant  extent  the  tax  incentive  of  making  the  initial  investment. 

To  accomplish  these  two  major  changes,  the  Act  revises  prior  law  to 
provide  for  a  more  efficient  system  for  exemption  of  possessions  cor- 
porations. Under  the  Act,  these  corporations  aj-e  generally  to  be  taxed 
on  worldwide  income  in  a  manner  similar  to  that  applicable  to  any 
other  U.S.  corporation,  but  a  full  credit  is  to  be  given  for  the  U.S.  tax 
on  the  business  and  qualified  investment  income  from  possessions  re- 
gardless of  whether  or  not  any  tax  is  paid  to  the  government  of  the 
possession.  The  effect  of  this  revised  treatment  is  to  exempt  from  tax 
the  income  from  business  activities  and  qualified  investments  in  the 
possessions,  to  allow  a  dividends  received  deduction  for  dividends  from 
a  possessions  corporation  to  its  U.S.  parent  corjioration,  and  to  tax 
currentlv  all  other  foreign  source  income  of  possessions  corporations 
(with  allowance  for  the  usual  foreign  tax  credit  for  foreign  taxes  paid 
with  respect  to  that  other  income).  Congress  believes  that  this  revised 
treatment  will  assist  the  U.S.  possessions  in  obtaining  employment- 
producing  investments  by  U.S.  corporations,  while  at  the  same  time 
encouraging  those  corporations  to  bring  back  to  the  United  States  the 
earnings  from  these  investments  to  the  extent  they  cannot  be  reinvested 
productively  in  the  possession. 

A  second  set  of  difficulties  under  prior  law  resulted  from  the  rela- 
tionship of  the  possessions  corporation  provisions  to  the  provisions 
relating  to  the  filinsr  of  consolidated  tax  returns.  Domestic  corpoi-a- 
tions  which  are  affiliated  (i.e.,  generally  where  there  is  a  common 
ownership  of  80  percent  or  more  of  their  stock)  usually  file  a  consoli- 
dated tax  return.  Among  the  l>enefits  of  a  consolidated  return  is  the 
opportunity  to  offset  the  losses  of  one  cor))oration  against  the  income 
of  other  corporations.  A  corpoi-ation  which  was  entitled  to  the  Ijenefits 
of  the  special  possessions  corporation  exclusion  could  not  participate 
in  the  filing  of  a  consolidated  return.  Plowever,  the  courts  detemiined 
that  possessions  corporations  could  join  in  filing  consolidated  retui-ns 
in  years  in  which  they  incur  losses.''  As  a  result,  these  corporations 

3  The  Internal  Revenue  Service  had  taken  the  po.sition  that  a  corporation  whicli  meets 
both  of  the  gross  income  tests  of  the  possession  corporation  exclusion  provision  may  not 
file  a  consolidnted  return  in  years  In  which  that  corporation  incurred  a  loss.  However,  the 
Tax  Court  In  Burke  Concrete  Accesftorien,  Inc.,  56  T.C.  5RS  (1971),  held  that  the  posses- 
sion corporation  was  properly  includable  in  the  consolidated  return  in  these  years  since  it 
could  not  be  entitled  to  any  benefit  from  the  exclusion  jtrovision  where  it  had  a  loss  year. 
The  Internal  Revenue  Service  reversed  its  position  in  ligbt  of  this  decision  (Rev.  Kul. 
73-498.  1973-2  C.B.  316). 


275 

could  in  effect  gain  a  double  benefit.  Not  only  was  the  possessions  and 
other  foreign  source  income  of  these  corporations  excluded  from  U.S. 
taxable  income,  but  losses  of  possessions  corporations  could,  by  filing 
a  consolidated  return,  reduce  U.S.  tax  on  the  U.S.  income  of  related 
corporations  in  the  consolidated  group.  Congress  believes  that  it  is 
appropriate  to  allow  the  losses  of  a  possession  corporation  to  reduce 
U.S.  tax  on  other  income  by  filing  a  consolidated  return  only  in  the 
case  of  initial  or  start-up  losses  of  possessions  corporation  just  be- 
ginning its  possession  operations.  Moi  ?over,  even  in  the  case  of  start- 
up losses  which  offset  U.S.  source  income  Congress  believes  that  these 
losses  should  be  recaptured  if  in  a  later  year  foreign  source  income  is 
derived. 

Explanation  of  provisions 

Accordingly,  the  Act  provides  that  a  possessions  corporation  must 
make  an  election  to  obtain  the  benefits  of  possessions  corporation  status 
and  that  after  this  election  the  corporation  is  ineligible  to  join  in 
filing  a  consolidated  return  for  a  period  of  10  years.*  Once  the  election 
is  made  the  losses  of  the  possessions  corporation  cannot  offset  the  in- 
come of  other  related  corporations. 

The  Act  achieves  the  results  described  above  by  adding  a  new  provi- 
sion (sec.  936  of  the  Code)  for  the  tax  treatment  of  U.S.  corporations 
operating  in  Puerto  Rico  and  pos.sessions  of  the  United  States,  other 
than  the  Virgin  Islands.  The  provision  of  prior  law  (sec.  931  of  the 
(.We)  is  retained  for  citizens  with  business  operations  in  possessions 
of  the  United  States,  other  than  the  Virgin  Islands,  Guam,  and  Puerto 
Rico.  The  new  provision  establishes  a  new  tax  credit  for  certain  in- 
come of  possessions  corporations.  This  tax  credit  (called  the  section 
936  credit)  is  given  in  lieu  of  the  ordinary  foreign  tax  credit  (pro- 
vided in  sec.  901  of  the  Code) . 

The  Act  provides  that  any  domestic  corporation  which  elects  to  be 
a  section  936  corporation  can  receive  the  section  936  tax  credit  if  it 
satisfies  two  conditions.  First,  80  percrnt  or  more  of  its  gross  income 
for  the  3-year  period  immediately  pr-^ceding  the  close  of  the  taxable 
year  must  be  from  sources  within  a  possession  (or  possessions).  Sec- 
ond, 50  percent  or  more  of  its  gross  income  must  be  derived  from  the 
active  conduct  of  a  trade  or  business  within  a  possession  (or 
possessions). 

The  amount  of  the  credit  allowed  under  this  provision  is  to  equal 
the  portion  of  the  U.S.  tax  on  the  domestic  corporation  attributable 
to  taxable  income  from  sources  without  the  United  States  from  the 
active  conduct  of  a  trade  or  business  within  a  possession  of  the  United 
States  and  from  qualified  possession  source  investment  income.  In 
determining  the  amount  of  tax  attributable  to  the  income  fiom  the 
active  conduct  of  a  possession  trade  or  business  or  from  qualified  pos- 
session investment  income,  losses  from  other  sources  are  to  be  taken 
into  account.  For  example,  if  a  corporation  has  an  overall  loss  from 
foreign  sources  (not  taking  into  account  income  qualifying  for  the 
section  936  tax  credit) ,  these  losses  reduce  income  from  U.S.  sources 

*  Unlike  the  act  of  incorporating  a  branch  in  a  foreign  jurisdiction,  the  malting  of  a 
section  936  election  does  by  itself  cause  a  recapture  of  an  earlier  loss. 


276 

and  income  qualifying  for  the  section  936  credit  proportionately  for 
purposes  of  determining  the  tax  on  the  taxable  income  from  which  the 
section  936  credit  is  allowed. 

Qualified  possession  source  investment  income  includes  only  income 
from  sources  within  a  possession  in  which  the  possessions  corporation 
actively  conducts  a  trade  or  business  (whether  or  not  sucli  business 
produces  taxable  income  in  that  taxable  year).  It  is  intended  that 
interest  paid  by  one  possessions  corporation  to  a  secoiid  unrelated 
possessions  corporation  operating  in  the  same  possession  is  to  be 
treated  as  qualified  possessions  source  investment  income.  Further, 
the  taxpayer  must  establish  to  the  satisfaction  of  the  Secretary  that 
the  funds  invested  were  derived  from  the  active  conduct  of  a  trade 
or  business  within  that  same  possession  and  were  actually  invested 
in  assets  in  that  possession.  It  is  intended  that  income  from  sources 
within  the  possession  attributable  to  reinvestments  of  qualified  pos- 
session source  investment  income  is  also  to  be  treated  as  qualified  pos- 
sessions source  investment  income.  Funds  placed  with  an  intermediary 
(such  as  a  bank  located  in  the  possession)  are  to  be  treated  as  invested 
in  that  possession  only  if  it  can  be  shown  that  the  intermediary  did  not 
reinvest  the  funds  outside  the  possession.  The  special  treatment  for 
qualified  i:>ossessions  source  investment  income  is  provided  so  that  the 
possessions  do  not  lose  a  significant  source  of  capital  which  they 
pi'esently  have  available  to  them  for  the  financing  of  government  de- 
velopment programs  and  private  investment. 

To  avoid  a  double  credit  against  U.S.  taxes  if  a  coi-poration  is  eligi- 
ble for  the  section  936  credit,  any  actual  taxes  paid  to  a  foreign  country 
(because  it  has  different  source  rules)  or  a  possession  with  respect  to 
the  gross  income  taken  into  account  for  the  credit  are  not  treated  as  a 
creditable  tax  (under  sec.  901  of  the  Code),  and  no  deduction  is  to  be 
allowed  with  respect  to  that  tax.  Thus,  the  section  936  credit  replaces 
entirely  any  section  901  foreign  tax  credit  and  any  deduction  for  taxes 
paid  which  otherwise  would  be  allowed  with  respect  to  the  income 
taken  into  account. 

Since  the  new  section  936  tax  credit  is  separate  from  the  tax  credit 
permitted  under  section  901,  the  limitation  under  section  904  of  the 
Code  is  not  to  apply  to  income  subject  to  a  section  936  credit,  and  such 
income  is  not  to  be  taken  into  account  in  computing  the  limitation  on 
the  amount  of  allowable  tax  credits  (under  sec.  904  of  the  Code).^ 

The  credit  provided  for  under  section  936  is  generally  to  be  allowed 
against  taxes  imposed  by  chapter  1  of  the  Internal  Revenue  Code. 
However,  the  credit  is  not  to  be  taken  against  any  minimum  tax  for 
tax  preferences  (sec.  56  of  the  Code),  any  tax  on  accumulated  earn- 
ings (sec.  531  of  the  Code),  taxes  relating  to  recoveries  of  foreign 
expropriation  losses  (sec.  1351  of  the  Code),  or  the  personal  holding 
company  tax  (sec.  541  of  the  Code).  In  computing  the  amount  of  U.S. 
tax  paid  by  the  corporation  which  is  attributable  to  possessions  active 
trade  or  business  and  qualified  investment  income,  taxes  paid  relating 
to  the  items  described  above  are  not  taken  into  account. 


"Thus,  the  numerator  and  denominator  of  the  limitinp;  fraction  fprorided  in  see.  904) 
are  to  he  calculated  without  regard  to  the  taxable  income  for  which  a  credit  is  permitted 
under  section  936. 


277 

In  order  to  receive  the  benefits  of  the  section  936  tax  credit,  a  corpo- 
ration must  make  an  election  at  the  time  and  in  the  manner  as  the 
Secretary  prescribes  by  regulations.  Once  the  election  is  made,  the 
domestic  corporation  cannot  join  in  a  consolidated  return  with  other 
related  taxpayers.  The  election  is  to  remain  in  effect  for  nine  taxable 
years  after  the  first  year  for  which  the  election  was  effective  and  for 
which  the  domestic  corporation  satisfied  the  80  percent  possession 
source  income  and  50  percent  active  trade  or  business  income  require- 
ments. However,  the  election  may  be  revoked  before  the  expiration  of 
the  10-year  period  with  the  consent  of  the  Secretaiy.  It  is  contem- 
plated that  consent  will  be  given  only  in  cases  of  substantial  hardship 
where  no  tax  avoidance  can  result  from  the  revocation  of  the  election. 
In  determining  whether  there  would  be  substantial  hardship,  the  Sec- 
retary is  to  take  into  account  changes  in  business  conditions.  The  elec- 
tion shall  remain  in  effect  after  the  10-year  period  unless  such  domestic 
corporation  revokes  such  election.  After  a  revocation  the  domestic 
corporation  may  again  make  the  election  for  a  10-year  period  in  any 
taxable  year  in  which  it  satisfies  the  80  percent  possession  source  income 
and  50  percent  active  trade  or  business  tests. 

The  Act  retains  existing  law  by  providing  that  any  gross  income 
actually  received  by  a  possessions  corporation  within  the  United 
States,  whether  or  not  that  income  is  derived  from  sources  within  or 
without  the  United  States,  is  not  taken  into  account  as  income  for 
which  a  section  936  tax  credit  may  be  allowed.  However,  this  income 
may  be  eligible  for  a  section  901  tax  credit  if  any  foreign  taxes  were 
paid  on  that  income. 

Finally,  the  Act  provides  for  a  dividends-received  deduction  (sec. 
246(a)(1)  of  the  Code)  for  dividends  received  from  corporations 
eligible  for  the  section  936  tax  credit.  Thus,  corporations  which  other- 
wise would  qualify  for  the  100-percent  dividends-received  deduction 
if  an  election  (under  sec.  936)  were  not  in  effect  are  to  receive  that 
deduction  for  dividends  from  a  possessions  corporation.  Also,  corpora- 
tions eligible  for  the  85-percent  dividends-received  deduction  are  to 
receive  that  deduction  with  respect  to  dividends  fronl  possessions  cor- 
porations. The  amount  of  any  income  received  as  a  dividend  from  a 
possessions  corporation  is  to  be  domestic  or  foreign  source  income 
as  determined  under  existing  rules  of  the  Code  (sec.  861),  and  is  to 
be  included  in  the  computation  of  the  limitation  on  the  section  901 
foreign  tax  credit  (sec.  904  of  the  Code) . 

"  Since  the  100-percent  dividends-received  deduction  totally  elimi- 
nates any  U.S.  tax  on  dividends  paid  by  a  possessions  corporation, 
and  the  85  percent  dividends-received  deduction  (after  the  allocation 
of  expenses)  will  in  many  cases  eliminate  any  U.S.  tax  on  the  diiadend, 
the  Act  adds  a  provision  disallowing  a'credit  or  a  deduction  for  any 
income  taxes  paid  to  a  possession  or  foreign  country  with  respect  to  the 
repatriation  of  earnings.  Further,  the  disallowance  provision  applies 
in  the  case  of  a  tax-free  liquidation  of  a  possessions  corporation. 

It  is  the  understanding  of  Congress  that  the  Department  of  the 
Treasury  is  to  review  the  operations  of  section  936  corporations  in 
order  to  apprise  Congress  of  the  effects  of  the  changes  made  by  the  Act. 
The  Treasury  is  to  submit  an  annual  report  to  the  Congress  setting 
forth  an  analysis  of  the  operation  and  effect  of  the  possessions  corpo- 


234-120  O  -  77 


278 

ration  system  of  taxation.  Among  other  things,  the  report  is  to  in- 
clude an  analysis  of  the  revenue  effects  to  the  provision  as  well  as  the 
effects  on  inevstment  and  employment  in  the  j)ossessions.  These  reports, 
which  are  to  begin  with  a  report  for  calendar  year  1976,  are  to  be  sub- 
mitted to  the  Congress  within  18  months  following  the  close  of  each 
calendar  year. 

Effective  dates 

The  provisions  of  the  Act  establishing  a  new  section  936  tax  credit 
for  certain  possessions  income  apply  to  taxable  years  of  possessions 
corporations  beginning  after  December  31,  1975.  The  new  rules  on  the 
dividends-received  deduction  apply  to  dividends  paid  in  taxable  years 
of  possessions  corporations  beginning  after  that  date  regardless  of 
when  the  earnings  out  of  which  the  dividends  were  paid  were 
accumulated. 

Although  these  provisions  generally  apply  to  taxable  years  of  pos- 
sessions corporations  beginning  after  December  31,  1975,  the  Act 
continues  to  exempt  foreign  source  income  derived  from  sources  out- 
side the  possession  by  treating  the  investment  income  as  qualified 
possession  source  investment  income  if  the  taxpayer  can  establish  to 
the  satisfaction  of  the  Secretary  that  the  income  was  earned  before 
October  1, 1976,  whether  or  not  the  invested  funds  were  initally  derived 
from  the  possessions  business.  Similarly,  funds  which  are  properly 
reinvested  in  the  possession  will  produce  qualified  possession  source 
investment  income  provided  those  funds  had  been  derived  initially 
from  a  trade  or  business  conducted  by  the  corporation  in  that  posses- 
sion. In  addition,  the  foreign  tax  credit  is  allowed  for  taxes  paid  with 
respect  to  liquidations  occurring  before  January  1,  1979,  to  the  extent 
the  taxes  are  attributable  to  amounts  earned  before  January  1,  1976. 

Revenue  effect 
It  is  estimated  that  these  provisions  will  result  in  an  increase  budget 
receipts  of  $6  million  in  fiscal  year  1977  and  of  $10  million  thereafter. 

11.  Western  Hemisphere  Trade  Corporations  (sec.  1052  of  the  Act 
and  sees.  921  and  922  of  the  Code) 

Prior  law 

Under  prior  law,  certain  domestic  corporations  called  "Western 
Hemisphere  Trade  Corporations"  ( WHTCs)  were  entitled  to  a  deduc- 
tion which  could  reduce  their  applicable  corporate  income  tax  rate  by 
as  much  as  14  percentage  points  below  the  applicable  rate  for  other 
domestic  corporations.^ 

A  domestic  corporation  had  to  meet  three  basic  requirements  to 
qualify  as  a  WHTC.  First,  all  of  its  business  (other  than  incidental 
purchases)  had  to  be  conducted  in  countries  in  North,  Central  or  South 
America  or  in  the  West  Indies.  Second,  the  corporation  had  to  derive 
at  least  95  percent  of  its  gross  income  for  the  3-year  period  immedi- 
ately preceding  the  close  of  the  taxable  year  from  sources  outside  the 
United  States.  Third,  at  least  90  percent  of  the  corporation's  income 
for  the  above  period  had  to  be  derived  from  the  active  conduct  of  a 


^The  deduction  (sec.  922  of  the  Code)  was  equal  to  taxable  income  multiplied  by  14  over 
the  normal  tax  and  surtax  rates. 


279 

trade  or  business.  The  above  requirements  were  intended  to  insure  that 
the  corporation  was  engaged  in  an  active  trade  or  business  outside  the 
United  States,  but  within  the  Western  Hemisphere. 

Reasons  for  change 

The  WHTC  provisions  were  originally  enacted  in  1942  during  a 
period  of  high  U.S.  wartime  taxes  and  generally  low  taxes  in  other 
Western  Hemisphere  countries.  The  provision  was  aimed  at  insuring 
that  domestic  corporations  did  not  operate  at  a  disadvantage  in  com- 
peting with  foreign  corporations  within  the  Western  Hemisphere. 
While  not  explicitly  stated,  it  appears  that  the  goal  was  to  retain  U.S. 
ownership  of  foreign  investments,  which  if  placed  in  a  foreign  cor- 
poration, might  end  up  being  owned  by  foreign  interests. 

Congress  believes  general  tax  equity  requires  that  income  derived 
from  all  foreign  sources  be  taxed  at  the  same  rate.  To  the  extent  that 
incentives  are  needed  for  the  export  of  U.S.  manufactured  goods 
Congress  believes  that  the  Domestic  International  Sale  Corporation 
(DISC)  provisions  are  a  more  appropriate  incentive.  Further,  because 
the  taxes  imposed  by  other  Western  Hemisphere  countries  have  been 
substantially  increased  since  the  original  enactment  of  the  provision, 
many  companies  which  qualified  as  WHTCs  received  little  or  no  bene- 
fit from  the  deduction.  Thus,  in  many  instances  i\\B  WHTC  deduction 
merely  added  to  the  complexity  of  preparing  an  income  tax  return 
without  providing  significant  tax  benefits. 

The  preferential  rate  granted  to  WHTCs  also  encouraged  U.S. 
manufacturers  to  set  the  price  on  sales  of  goods  to  related  WHTCs 
so  as  to  maximize  the  income  derived  by  the  WHTCs  since  this  in- 
come was  taxed  at  the  lower  WHTC  rate.  These  pricing  practices  have 
been  the  source  of  many  controversies  between  taxpayers  and  the  In- 
ternal Revenue  Service.  Finally,  the  broad  interpretation  given  to 
the  WHTC  provisions  by  the  Internal  Revenue  Service  enabled  cor- 
porations to  obtain  the  benefits  of  the  WHTC  provisions  for  goods 
manufactured  outside  the  Western  Hemisphere  by  causing  the  title  to 
the  goods  sold  to  the  WHTC  to  be  passed  within  the  Western  Hemis- 
phere. In  such  a  situation  Congress  believes  it  is  inappropriate  to  give 
special  tax  relief. 

Explan/aMon  of  provision 
The  Act  repeals  the  WHTC  provisions  for  taxable  years  beginning 
after  December  31,  1979.  However,  corporations  which  qualifj'  for 
WHTC  treatment  are  provided  a  transitional  period  in  which  they 
can  adjust  their  operations  to  the  repeal  of  the  provisions.  During 
this  transitional  period  the  14-percent  tax  reduction  {i.e.,  the  numera- 
tor in  the  14/48ths  fraction)  is  gradually  phased  out  beginning  in 
1976.  I^^nder  the  phaseout  rules  the  percentage  rate  reduction  is  re- 
duced to  11  percent  in  1976,  8  percent  in  1977,  5  percent  in  1978  and  2 
percent  in  1979.  Corporations  which  presently  do  not  qualify  for 
WHTC  treatment  are  able  to  qualify  and  receive  the  remaining  benefits 
of  the  treatment  during  the  transitional  period.  Thus,  during  the 
phaseout  period  no  distinction  is  to  be  made  between  corporations 
qualifvin.""  for  WHTC  treatment  in  1975  and  other  corporations  which 
first  qualify  during  the  phaseout  period.  It  is  anticipated  by  the  Con- 
gress that  in  appropriate  situations  the  modifications  made  by  the  Act 
to  section  367  will  make  it  easier  for  certain  WHTCs  to  adjust  to  the 


280 

repeal  of  the  WHTC  provisions  by  reincorporating  in  a  foreign  coun- 
try where  they  are  doing  business  in  order  to  retain  tax  advantages 
provided  by  the  tax  laws  of  foreign  governments. 

Effective  date 
The  provision  phasing  out  WHTC  treatment  applies  to  taxable  years 
begimiing  after  December  31,  1975. 

Revenue  effect 
This  provision  will  increase  budget  receipts  by  $19  million  in  fiscal 
year  1977,  $25  million  in  fiscal  year  1978,  and  $50  million  in  fiscal  year 
1981. 

12.  China  Trade  Act  Corporations  (sec.  1053  of  the  Act  and  sees. 
941  to  943  of  the  Code) 

Prior  law 

Under  prior  law,  China  Trade  Act  Corporations  ("CTA  corpora- 
tions") and  their  shareholders  were  entitled  to  special  tax  benefits. 
Under  those  provisions,  a  CTA  corporation  was  subject  to  the  same  tax 
rates  as  any  other  domestic  corporation,  but,  upon  meeting  certain  re- 
quirements, was  allowed  a  special  deduction  which  could  completely 
eliminate  any  income  subject  to  tax  (sec.  941) } 

The  special  deduction  was  allowed  against  taxable  income  derived 
from  sources  within  Formosa  and  Hong  Kong  in  the  proportion  which 
the  par  value  of  stock  held  by  residents  of  Formosa,  Hong  Kong,  the 
United  States,  or  by  individual  citizens  of  the  United  States,  wherever 
resident,  bore  to  the  i3ar  value  of  all  outstanding  stock.  Thus,  where 
all  the  shareholders  of  the  CTA  corporation  were  either  U.S.  citizens 
or  residents  of  Hong  Kong,  Formosa,  or  the  United  States,  and  all  of 
the  corporation's  income  was  derived  from  sources  within  Hong  Kong 
and  Formosa,  the  special  deduction  equaled  and  thereby  eliminated 
the  taxable  income  of  the  corporation. 

The  special  deduction  was  limited  by  a  requirement  that  a  dividend 
be  paid  in  an  amount  at  least  equal  to  the  amount  of  Federal  tax  that 
would  have  been  due  were  it  not  for  the  special  deduction.  The  "special 
dividend"  had  to  be  paid  to  stockholders  who,  on  the  last  day  of  the 
taxable  j^ear,  were  resident  in  Formosa,  Hong  Kong,  or  were  either 
residents  or  citizens  of  the  United  States.^  The  special  dividend  de- 
duction enabled  the  CTA  corporation  to  operate  free  of  tax. 

In  addition  to  the  favorable  tax  treatment  at  the  corporate  level, 
special  benefits  were  accorded  to  the  shareholders  of  a  CTA  corpora- 
tion. Dividends  paid  by  a  CTA  corporation  to  shareholders  who  re- 
sided in  Hong  Kong  or  Formosa  were  not  includable  in  the  gross 
income  of  the  shareholrler  (sec.  943) .  This  applied  to  all  dividends  paid 
to  Hong  Kong  or  Formosa  resident  shareholders,  regardless  of 
whether  they  were  regular  or  special  dividends. 


'The  CTA  corporation  was  not  entitled  to  the  forelcrn  tax  crerllt  (sec.  942),  but  was  en- 
titled to  the  deduction  of  all  foreign  taxes  paid  with  respect  to  taxable  income  derived 
from  sources  within  Hong  Kong  or  Formosa  ^sec.  164). 

2  For  example,  if  the  taxable  Income  before  the  special  deduction  was  $100,000,  the 
special  dividend  would  have  to  equal  at  least  $41,500  (22  percent  of  the  first  $25,000  olus 
4S  percent  of  the  remaining  $75,000).  In  this  example,  upon  payment  of  the  special  dividend 
of  $41,500,  the  CTA  corporation  deriving  all  of  its  taxable  income  from  sources  within 
Hong  Kong  and  Formosa  ($100,000)  would  be  entitled  to  a  special  deduction  in  an  amount 
equal  to  its  taxable  income,  i.e.,  $100,000. 


281 

Reasons  for  change 

The  combination  of  benefits  granted  to  CTA  corporations  and  their 
shareholders  was  unprecedented.^  Both  the  corporation  and  its  share- 
holders could  operate  free  of  any  U.S.  tax  liability. 

As  originally  enacted,  the  Chma  Trade  Act  was  intended  to  apply 
to  mainland  China,  including  Manchuria,  Tibet,  Mongolia,  and  any 
territory  leased  by  China  to  any  foreign  government,  the  Crown 
Colony  of  Hong  Kong,  and  the  Province  of  Macao.  However,  since 
the  earlj^  1950's  the  provisions  have  only  applied  to  business  trans- 
actions by  CTA  corporations  in  Hong  Kong  and  Formosa. 

Since  the  enactment  of  the  China  Trade  Act  of  1922,  Sino-U.S. 
trade  has  changed  dramatically.  In  1922,  China  was  considered  an 
unequal  trade  partner — a  market  which  Western  companies  competed 
for  under  rules  that  were  laid  down  by  their  own  governments,  not 
by  the  Chinese  Government.  Prior  to  the  Communist  occupation  of 
the  China  mainland  in  1949,  approximately  250  companies  were  con- 
ducting business  there  under  the  China  Trade  Act.  At  the  time  the 
Act  w^as  enacted,  this  situation  no  longer  existed,  trade  being  restricted 
to  Hong  Kong  and  Formosa ;  nor  was  it  likely  to  exist  in  the  foresee- 
able future.  At  that  time  there  were  only  three  active  CTA  corpora- 
tions, which  reportedly  accounted  for  a  rather  negligible  amount  of 
trade. 

Thus,  the  original  purpose  of  the  China  Trade  Act,  that  of  expand- 
ing trade  with  China,  was  no  longer  being  served  by  the  very  favorable 
tax  advantages  it  provided.  Moreover,  there  were  innumerable  U.S. 
companies  currently  trading  in  Hong  Kong  and  Formosa  without  the 
extensive  tax  benefits  provided  by  the  China  Trade  Act. 

The  tax  advantages  enjoyed  by  a  CTA  corporation,  and  particu- 
larly its  shareholders,  were  almost  without  parallel.  While  there  are 
cases  where  U.S.  tax  is  not  owing  with  respect  to  corporate  income 
derived  by  a  foreign  subsidiary  involved  in  an  active  trade  or  business 
abroad,  dividend  payments  received  from  such  corporations  by  U.S. 
shareholders  are  subject  to  U.S.  taxation.  There  was  no  longer  any 
justification  for  exempting  CTA  corporation  dividends  paid  to  its 
Hong  Kong  and  Formosa  resident  shareholders  who  were  U.S.  citizens. 

Explanation  of  provision 
The  Act  provides  for  a  phaseout  over  a  3-year  period  of  the  provi- 
sions permitting  special  tax  treatment  for  CTA  corporations  and 
their  shareholders.  Thus,  the  special  deduction  allowable  under  section 
941  (a)  and  the  dividend  exclusion  under  section  943  will  be  reduced  by 
one- third  for  taxable  years  beginning  in  1976,  by  two-thirds  for  tax- 
able years  beginning  in  1977,  and  repealed  for  taxable  years  begin- 
ning *in  1978.* 


3  For  example,  If  in  a  plven  year,  a  CTA  corporation,  whose  shareholders  were  U.S. 
citizens  residing  In  Hong  Kong  or  Formosa,  had  $500,000  of  taxable  income  and  paid  a 
special  dividend  of  at  least  $233,500  to  Its  shareholders,  neither  the  corporation  nor  Its 
shareholders  would  incur  any  U.S.  tax  liability,  whereas  a  domestic  corporation  and  Its 
shareholders  in  this  situation  (assuming  marginal  tax  brackets  of  50  percent  for  the  share- 
holders) would  incur  respective  U.S.  tax  liabilities  of  $233,500  and  $116,750.  The  tax 
savings  to  the  CTA  corporation  and  its  shareholders  in  the  above  example  would  be 
$350,250.  If  the  balance  of  the  earnings  of  the  CTA  corporation  were  paid  out,  the  tax 
savings  would  be  even  greater. 

*  For  example.  If  the  taxable  Inrome  before  the  special  deduction  of  a  CTA  corporation 
was  $100,000  and  the  special  dividend  was  $41,500.  the  special  deduction  for  the  corpo- 
ration and  the  amount  of  dividend  excludlble  from  income  for  taxable  years  beginning 
in  1976  would  be  S66.667  and  $13,S33.  respectively.  For  taxable  years  beginning  in  1977. 
the  amounts  would  be  $33,333  and  $27,667.  For  taxable  years  beginning  in  1978  and 
subsequent  years,  the  CTA  provisions  are  repealed  and  no  special  deduction  nor  dividend 
exclusion  would  be  available. 


282 

Effective  date 
The  provision  phasing  out  China  Trade  Act  corporations  applies  to 
taxable  years  beginning  after  December  31, 1975. 

Revenue  effect 
This  provision  is  expected  to  increase  receipts  by  less  than  $5  mil- 
lion per  year. 

13.  Denial  of  Certain  Tax  Benefits  for  Cooperation  With  or  Par- 
ticipation in  an  International  Boycott  (sees.  1061-1064,  1066 
and  1067  of  the  Act  and  sees.  908, 952, 995  and  999  of  the  Code) 

Prior  law 

U.S.  taxpayers  operating  abroad  receive  a  number  of  bene- 
fits or  incentives  which  enable  them  to  compete  with  foreign- 
owned  businesses  or  to  increase  the  export  of  U.S.-made  goods.  The 
three  major  tax  provisions  which  are  significant  in  connection  with 
overseas  operations  are  (1)  the  foreign  tax  credit  for  foreign  taxes 
paid,  (2)  the  deferral  of  earnings  of  foreign  subsidiaries,  and  (3)  the 
deferral  of  earnings  of  Domestic  International  Sales  Corporations. 

Prior  law  contained  no  tax  provisions  dealing  with  international 
boycotts  and  thus  taxpayers  were  entitled  to  receive  these  tax  benefits 
with  respect  to  operations  in  connection  with  which  they  agreed  to 
participate  in  an  international  boycott. 

Reasons  foi'  change 

Congress  is  concerned  that  U.S.  businesses  have  been  prevented 
from  freely  operating  in  international  markets  by  the  threat  of  eco- 
nomic sanctions  by  certain  foreign  countries  or  their  nationals  or  com- 
panies. Unless  the  U.S.  businesses  agree  to  participate  in  or  cooperate 
witli  certain  foreign  countries  in  an  international  boycott,  they  are 
denied  the  opportunity  to  conduct  business  with  a  country.  Congress 
believes  that  it  is  particularly  unfair  to  tliose  taxpayers  who  refuse  to 
participate  in  the  boycott,  when  the  taxpayer  who  does  participate  in 
the  boycott  is  a  recipient  of  tax  benefits  by  reason  of  the  participation. 
Congress  believes  that  many  taxpayers  would  not  participate  in  an 
international  boycott  if  the  taxpayer  and  the  foreign  countries  were 
made  aware  that  tax  benefits  were  not  available  to  a  taxpayer  who 
participates  in  a  boycott. 

Congress  believes  that  these  three  tax  benefits  referred  to  above  in 
connection  Avith  overseas  operations  should  not  be  made  available  with 
respect  to  operations  in  connection  with  which  there  has  been  an 
agreement  to  participate  in  or  cooperate  with  an  international  boycott. 

Explanation  of  provision 

The  Act  denies  to  any  person  who  agrees  to  participate  in  or  coop- 
erate with  any  international  boycott  the  benefits  of  the  foreign  tax 
credit,  deferral  of  earnings  of  foreign  subsidiaries,  and  DISC  to  the 
extent  these  tax  benefits  are  attributable  to  operations  of  that  person 
(or  its  affiliates)  in  connection  with  which  there  was  an  agreement  to 
participate  in  or  cooperate  with  an  international  boycott. 

The  benefits  of  deferral  and  DISC  are  denied  to  the  taxpayer  by 
requiring  a  deemed  distribution  of  earnings  to  the  shareholders  of  the 
DISC  or  controlled  foreign  corporation.  The  benefits  of  the  foreign 


283 

tax  credit  are  denied  to  the  taxpayer  Tdj  reducing  the  otherwise  allow- 
able foreign  tax  credit  to  which  the  taxpayer  would  be  entitled  under 
section  901,  902,  and  960  of  the  Code,  after  applying  the  limitation,  if 
applicable,  of  section  907.  AVliere  a  foreign  corporation  has  agreed  to 
participate  in  or  cooperate  with  the  boycott,  the  otherwise  allowable 
indirect  foreign  tax  credits  to  which  the  United  States  shareholders 
would  be  entitled  (under  sec.  902  or  960)  are  reduced  under  the  Act  re- 
gardless of  whether  the  foreign  corporation  is  a  controlled  foreign 
corporation  (i.e.,  more  than  50  percent  of  its  stock  owned  by  U.S. 
shareholders).  Taxes  which  are  denied  the  foreign  tax  credit  under 
this  provision  are  not  entitled  to  be  carried  back  or  forward  as  foreign 
tax  credits  but  may  be  eligible  to  be  deducted  in  computing  taxable 
income.  Of  course,  if  so  deducted,  the  rules  of  sections  861  and  862  will 
apply  with  respect  to  the  deduction. 

The  loss  of  deferral  benefits  is  accomplished  under  the  Act  by  treat- 
ing as  subpart  F  income  the  earnings  attributable  to  boycott  partici- 
pation. Thus,  deferral  benefits  are  only  lost  with  respect  to  earnings 
of  controlled  foreign  corporations.  Each  U.S.  shareholder  of  the  con- 
trolled foreign  corporation  (that  is,  each  U.S.  person  owning,  or 
treated  under  the  applicable  attribution  rules  as  owning,  at  least  10 
percent  of  its  stock)  is  currently  to  include  in  income  under  the  sub- 
part F  provisions  its  pro  rata  portion  of  the  earnings  of  the  controlled 
foreign  corporation  attributable  to  boycott  participation,  whether  or 
not  the  shareholder  and  the  controUecl  foreign  corporation  are  mem- 
bers of  the  same  controlled  group. 

The  denial  of  DISC  benefits  is  accomplished  by  treating  as  a  deemed 
distribution  by  a  DISC  to  its  shareholders  the  earnings  of  the  DISC 
attributable  to  the  boycott  participation.  The  deemed  distribution 
is  similar  to  the  other  deemed  distributions  from  a  DISC  to  its  share- 
holders. Thus,  the  amount  deemed  distributed  is,  for  purposes  of  com- 
puting the  DISC  earnings  and  profits,  treated  as  being  part  of  the 
previously  taxed  income  account. 

A  person  participates  in  or  cooperates  with  an  international  boycott 
if  the  person  agrees,  as  a  condition  of  doing  business  directly  or  in- 
directly within  a  country  or  with  the  government,  a  company,  or  a 
national  of  a  countiy  (1)  to  refrain  from  doing  business  with  or  in  a 
country  which  is  the  object  of  an  international  boycott  or  with  the  gov- 
ernment, companies,  or  nationals  of  that  country;  (2)  to  refrain  from 
doing  business  with  any  U.S.  person  engaged  in  trade  within  another 
country  which  is  the  object  of  an  international  boycott  or  with  the 
government,  companies,  or  nationals  of  that  country;  (3)  to  refrain 
from  doing  business  with  any  company  whose  ownership  or  manage- 
ment is  made  up,  all  or  in  part,  of  indiv'iduals  of  a  particular  national- 
ity, race,  or  religion,  oi-  to  remove  (or  refrain  from  selecting)  corpo- 
rate directors  who  are  individuals  of  a  particular  nationality,  race,  or 
religion  :  (4)  to  refrain  from  emplorinn-  individuals  of  a  particular  na- 
tionality, race,  or  religion;  or  (5)  to  rrfraiii  from  shipping  or  insuring 
products  on  a  carrier  owned,  leased,  or  operated  by  a  person  who  does 
not  participate  in  or  cooperate  with  an  international  bovcott.  While  it 
is  anticipated  that  in  most  cases  a  third  country  will  be  the  object  of  an 
international  boycott,  it  is  possible  that  the  United  States  may  be  the 
object  of  an  international  boycott.  The  agreement  maj^  be  with  respect 


284 

to  any  type  of  business  (including  manufacturing,  banking,  and  service 
businesses). 

llie  Act  permits  a  person  to  agree  to  comply  with  certain  laws  with- 
out being  treated  as  agreeing  to  participate  in  or  cooperate  with  an  in- 
ternational boycott.  A  person  may  agree  to  meet  requirements  imposed 
by  a  foreign  country  with  respect  to  an  international  boycott  if  a  U.S. 
law,  executive  order,  or  regulation  sanctions  that  participation  or  co- 
operation. Secondly,  the  person  may  agree  to  comply  with  a  prohibition 
on  the  importation  of  goods  produced  in  whole  or  in  part  in  any  boy- 
cotted country  or  to  comply  with  a  prohibition  imposed  by  a  country 
on  the  exportation  of  products  obtained  in  that  country  to  any  boy- 
cotted country,  'i'he  person  however,  may  not  agree  to  refrain  from 
importing  or  exporting  to  or  from  a  particular  country  products  which 
are,  or  wnich  contain  components  wnich  are,  made  by  a  company  on  a 
boycott  list. 

A  pei-son  is  not  considered  as  having  participated  in  or  cooperated 
^yith  an  international  boycott  unless  he  has  agreed  to  such  participa- 
tion or  cooperation.  The  agreement  need  not  be  in  writing ;  there  may 
be  an  implied  agreement.  However,  an  agreement  will  not  be  inferred 
from  the  mere  fact  that  any  country  is  exercising  its  sovereign  rights. 
Thus,  a  person  is  not  considered  to  have  agreed  to  participate  in  or 
cooperate  with  an  international  boycott  merely  by  reason  of  the  in- 
ability of  the  person  to  obtain  an  export  or  import  license  from  a 
sovereign  country  for  specific  goods.  Similarly,  a  person's  inability, 
under  the  laws  or  administrative  practices  of  a  country,  to  bring 
certain  personnel  into  that  country,  to  bring  certain  ships  into  the 
waters  of  that  country,  to  provide  certain  services  in  that  country,  or 
to  import  or  export  certain  products  to  or  from  a  country,  is  not  to  be 
considered  to  constitute  an  agreement  to  participate  in  or  cooperate 
with  an  international  boycott.  Further,  the  signing  (at  the  time  of 
import)  of  a  certification  as  to  content,  which  is  required  to  obtain  an 
import  license,  does  not  by  itself  constitute  an  agreement  by  the  per- 
son. However,  this  will  not  permit  the  making  of  an  agreement  not  to 
import  certain  goods  into  the  country.  In  addition,  a  course  of  conduct 
of  complying  with  sovereign  law  may,  along  with  other  factors,  be 
evidence  of  an  agreement. 

If  a  person  or  a  member  of  the  controlled  group  (within  the  mean- 
ing of  section  993(a)  (3) )  which  includes  that  person  has  participated 
in  or  cooperated  with  an  international  boycott  in  a  country,  that  person 
or  group  is  presumed  to  have  participated  in  or  cooperated  with  that 
boycott  with  respect  to  all  operations  in  all  countries  which  require  of 
the  person  (or  of  other  persons,  whether  or  not  related  to  that  pereon) 
participation  in  or  cooperation  with  that  international  boycott.  How- 
ever, the  taxpayer  may  establish  that  he  has,  or  related  persons  have, 
conducted  clearly  separate  and  identifiable  operations  in  that  country 
or  another  country  with  respect  to  which  there  is  no  cooperation  with 
or  participation  in  that  boycott.  Where  the  person  involved  is  a  for- 
eign corporation,  its  United  States  shareholders  (within  the  meaning 
of  section  951(b)  of  the  Code)  may  establish  that  it  has  conducted 
clearly  separate  and  identifiable  operations  with  respect  to  which  there 
has  been  no  participation  in  or  cooperation  with  the  boycott. 


285 

Where  there  are  not  continuous  business  activities  within  a  country, 
separate  and  identifiable  operations  may  include  separate  export  or 
import  transactions.  Where  there  are  continuous  business  activities 
within  a  country,  each  separate  business  activity  (taking  into  account 
basic  differences  in  the  types  of  any  products  sold  or  services  offered, 
clear  separation  of  the  management  of  the  activities,  and  so  forth) 
may  represent  a  separate  and  identifiable  operation.  If  the  taxpayer  is 
able  to  establish  separate  and  identifiable  operations,  he  may  then 
establish  that  with  respect  to  certain  operations  there  was  no  partici- 
pation in  or  cooperation  with  that  international  boycott.  The  burden 
of  proof  will  be  upon  the  taxpayer  to  establish  that  an  operation  is 
separate  and  identifiable  and  that  there  was  no  participation  in  or 
cooperation  with  an  international  boycott  in  connection  with  that 
operation. 

In  addition,  the  Act  contains  a  special  rule  extending  the  presump- 
tion of  participation  to  related  persons  in  certain  limited  situations 
where  the  related  persons  are  not  members  of  the  same  controlled 
group  (under  sec.  993),  The  rule  provides  that  if  a  person  (e.g..  an 
individual  or  a  corporation)  controls  a  corporation,  (i)  participation 
in  or  cooperation  with  an  international  boycott  by  the  corporation  is 
presumed  to  be  participation  in  or  cooperation  with  the  boycott  by  that 
person  (and  thus  by  all  members  of  the  controlled  group  including 
that  person),  and  (2)  participation  or  cooperation  by  the  person  is 
presumed  to  be  participation  or  cooperation  by  the  controlled  cor]:)ora- 
tion  (and  thus  by  all  members  of  the  controlled  group  including  that 
corporation).  Control  for  this  purpose  has  the  same  meaning  as  it  does 
in  Code  section  304(c)  ;  that  is,  a  person  is  considered  to  control  a  cor- 
poration if,  after  application  of  the  appropriate  attribution  of  stock 
ownership  rules,  the  person  owns  at  least  50  percent  of  stock  of  the  cor- 
poration. Thus,  the  presumption  applies  in  the  case  of  noncorporate 
shareholders  owning  at  least  50  percent  of  a  corporation's  stock,  or 
corporate  shareholders  owning  only  50  percent  of  a  corporation's  stock, 
even  though  in  both  cases  the  shareholders  are  not  members  of  the  same 
controlled  group  as  the  corporations  in  which  they  own  the  stock  in- 
terest. As  above,  however,  the  taxpayer  may  rebut  the  presumption 
by  establishing  clearly  separate  and  identifiable  operations  with  re- 
spect to  which  there  was  no  boycott  participation. 

In  addition,  the  Act  provides  a  proration  formula  for  computing  the 
amount  of  tax  benefits  which  are  related  to  an  international  boycott, 
and  thus  are  denied  to  the  taxpayer.  This  formula,  it  is  anticipated, 
will  be  used  by  taxpayers  who  are  unable  to  separate  their  tax  benefits 
between  boycott  and  nonboycott  operations.  Under  this  formula,  the 
reduction  of  the  tax  benefits  allowed  to  the  taxpaj-er  are  determined 
by  multiplying  the  otherwise  allowable  tax  benefits  by  a  fraction. 
Generally,  the  numerator  of  the  fraction  reflects  the  worldwide  opera- 
tions of  the  taxpayer  (or.  in  the  case  of  a  controlled  group  within  the 
meaning  of  sec.  993(a)  (3)  which  includes  that  taxpayer,  of  the  group) 
in  countries  associated  in  carrying  out  the  international  boycott  (exclu- 
sive of  those  operations  for  which  the  presumption  of  participation 
or  cooperation  has  been  rebutted).  The  denominator  reflects  the  world- 
wide foreign  operations  of  the  taxpayer  (or  the  group).  The  factors 
to  be  taken  into  account  in  computing  the  fraction  are  to  be  determined 


286 

in  accordance  with  the  regulations  prescribed  by  the  Secretary.  It  is 
anticipated  that  the  regulations  will  reflect  the  nature  of  the  boycott 
activity  carried  on  by  the  taxpayer  (or  group)  and  will  take  into 
account  such  factors  as  purchases,  sales,  payroll  or  other  items  which 
may  be  relevant.  Unless  the  taxpayer  establishes  to  the  contrary,  all 
operations  of  the  taxpayer  (or  group)  in  connection  with  countries 
which  require  participation  in  or  cooperation  with  the  boycott  are  to 
be  reflected  in  the  numerator  of  the  fraction. 

A  U.S.  taxpayer  is  to  take  into  account  the  operations  of  all  mem- 
bers of  the  same  controlled  group  to  which  it  belongs  in  computing  its 
international  boycott  factor.  However,  if  the  taxpayer  is  a  share- 
holder of  a  person  who  is  not  a  member  of  a  controlled  group  with  the 
U.S.  taxpayer,  and  that  person  has  agreed  to  cooperate  with  or  par- 
ticipate in  an  international  boycott,  the  U.S.  taxpayer  is  to  compute 
separately  the  international  boycott  factor  with  respect  to  that  person 
(and  any  corporation  controlled  by  that  person)  for  purposes  of 
determining  the  DISC  benefits,  deferral  of  earnings  of  a  foreign 
subsidiary  or  deemed  paid  foreign  tax  credit,  the  benefits  of  which  are 
denied  to  that  U.S.  taxpayer. 

The  proration  formula  is  not  to  apply  if  instead  the  taxpayer,  with 
respect  to  the  operations  which  are  related  to  participation  in  or  co- 
operation with  an  international  boycott,  clearly  demonstrates  the 
amount  of  the  foreign  taxes  and  earnings  which  are  allocable  to  the 
boycott  operations.  Those  taxpayers  who  are  not  able  clearly  to  ac- 
count separately  for  the  foreign  taxes  and  earnings  which  are  allocable 
to  boycott  operations  must  apply  the  proration  formula  in  computing 
the  amount  of  tax  benefits  which  are  denied  to  them.  Of  course,  all 
operations  of  the  person  in  countries  which  require  participation  in 
or  cooperation  with  that  boycott  are  presumed  to  be  boycott  operations 
unless  the  taxpayer  establishes  to  the  contrary. 

It  is  expected  that  the  provisions  of  the  Act  will  be  administered 
in  the  normal  course  of  a  tax  audit.  However,  if  a  person,  or  a  member 
of  a  controlled  group  (within  the  meaning  of  section  993(a)(3)) 
which  includes  that  person,  has  operations  in  or  related  to  a  country 
(or  with  the  government,  a  company,  or  a  national  of  a  country) 
which  is  on  a  list  (maintained  by  the  Secretary  of  the  Treasury)  of 
countries  requiring  participation  in  or  cooperation  with  an  inter- 
national boycott,  or  in  any  other  country  which  the  person  (or  if  the 
person  is  a  foreign  corporation,  any  United  States  shareholder  of  the 
corporation)  knows  or  has  reason  to  know  requires  boycott  participa- 
tion or  cooperation,  that  person  or  shareholder  must  report  those  oper- 
ations to  the  Secretary  of  the  Treasury.  In  the  case  of  these  operations 
of  a  foreign  subsidiary,  however,  the  report  is  to  be  made  by  its  United 
States  shareholders. 

The  taxpayer  is  to  include  in  the  report  the  identity  of  any  country 
in  connection  with  which  the  taxpayer  has  participated  in  or  cooper- 
ated with  (or  has  been  requested  to  participate  in)  an  international 
boycott  as  a  condition  of  doing  business  in  that  country  (or  with  such 
government,  company  or  national).  The  report  should  also  indicate 
the  nature  of  any  operations  in  connection  with  such  countries.  A  tax- 
payer will  also  be  expected  to  disclose  in  the  report  any  country  where 
the  taxpayer  has  been  requested  to  participate  in  such  a  manner  which 


287 

could  be  interpreted  as  an  official  request  of  that  country.  This  is  not 
to  say  that  the  request  must  be  made  directly  by  a  government  official 
or  representative. 

The  Secretary  of  the  Treasury  is  to  publish  the  list,  which  is  to  be 
updated  periodically,  of  those  countries  which  may  require  participa- 
tion in  or  cooperation  with  an  international  boycott.  The  initial  list 
must  be  published  Avithin  30  days  after  date  of  enactment.  However, 
the  absence  of  a  countiy  from  the  list  does  not  mean  that  the  country 
is  not  a  country  which  requires  participation  in  or  cooperation  with 
an  international  boycott. 

The  willful  failure  to  make  a  report  will  subject  the  taxpayer  to  a 
fine  of  not  more  than  $25,000  or  imprisonment  for  not  more  than  one 
year,  or  both.  A  failure  to  make  a  report  will  not  be  a  willful  failure 
if  the  taxpayer  had  no  knowledge  of  a  boycott  operation  unless  the 
taxpayer's  failure  to  have  knowledge  is  so  negligent  as  to  constitute  a 
reckless  disregard  of  the  requirements  of  the  law. 

The  initial  determination  of  participation  in  or  cooperation  with 
any  international  boycott  is  to  be  made  by  the  taxpayer,  who  will  be 
expected  on  his  return  to  reduce  the  amount  of  the  foreign  tax  credit, 
deferral  benefits,  or  DISC  benefits  to  the  extent  necessary  to  reflect  the 
participation  in  or  cooperation  with  an  international  boycott.  The  tax- 
payer is  to  show  how  any  reduction  is  made.  However,  it  is  expected 
that  the  returns  and  the  determinations  by  the  taxpayer  will  be  audited 
and  the  accuracy  of  the  taxpayer's  determinations  will  be  verified 
in  the  usual  course  of  such  an  audit.  While  this  verification  will  be 
done  in  the  usual  course  of  a  tax  audit,  it  is  anticipated  that  the  IRS 
will  develop  a  group  of  experts  who  are  knowledgeable  in  audit 
aspects  of  determining  whether  a  taxpayer  is  involved  in  an  inter- 
national boycott. 

The  Act  also  establishes  a  determination  procedure  so  that  tax- 
payers conducting  business  with  foreign  countries  will  be  able  to 
obtain  a  determination  from  the  Secretary  of  the  Treasury  as  to 
whether  their  operations  constitute  an  international  boycott  agree- 
ment. While  the  determination  procedure  may  rely  upon  the  audit 
expertise  of  the  IRS,  it  is  anticipated  that  this  procedure  will  be  dele- 
gated to  Treasury  officials.  The  determination  request  may  be  filed 
by  the  taxpayer  before  he  has  computed  and  filed  his  tax  return,  or 
at  any  time  during  the  course  of  an  audit  of  a  tax  return  in  which 
the  question  is  raised  as  to  whether  the  taxpayer  has  agreed  to  par- 
ticipate in  or  cooperate  with  an  international  boycott.  To  obtain  a 
determination  from  the  Secretary,  the  taxpayer  will  be  required  to 
make  available  all  factual  materials  which  may  be  relevant  to  the 
Secretary's  determination.  If  the  request  for  a  determination  is  made 
before  the  particular  operation  is  commenced  or  before  the  close  of 
the  taxable  year,  the  Secretary  may  defer  making  the  determination 
until  the  close  of  the  taxable  year. 

If  the  Secretary  does  determine  that  a  person  has  agreed  to  partici- 
pate in  or  cooperate  with  an  international  boycott,  there  will  be  a 
presumption  that  the  participation  or  cooperation  of  the  person 
relates  to  all  of  the  operations  of  the  taxpayer  in  all  of  the  boycott 
countries  involved.  However,  the  taxpayer  will  be  entitled  to  rebut 
this  presumption  by  demonstrating  that  certain  operations  are  clearly 


288 

separate  and  identifiable  and  are  not  connected  with  an  international 
boycott  agreement.  An  adverse  determination  by  the  Secretary  will 
be  reflected  by  the  taxpayer  either  directly  in  his  return  or  by  normal 
deficiency  procedures  of  the  Internal  Revenue  Service.  Thus,  a 
determination  by  the  Secretary  that  a  person  has  agreed  to  participate 
in  or  cooperate  with  an  international  boycott  will  be  reviewable  by  the 
courts  in  the  same  manner  as  the  usual  tax  controversy. 

In  order  to  assess  the  effectiveness  of  this  legislation  in  discouraging 
participation  in  or  cooperation  with  international  boycotts,  the  Act 
requires  the  Secretary  to  report  annually  to  the  taxwriting  commit- 
tees the  number  of  boycott  reports  filed  with  the  IRS  and  the  percent- 
age which  indicated  that  there  had  been  participation  in  an  interna- 
tional boycott.  Further,  the  report  to  the  committees  should  contain 
a  detailed  description  of  the  results  of  the  audits  of  these  taxpayers  in 
connection  with  boycott  operations,  the  changes  made  by  the  IRS  on 
unreported  boycott  activities,  and  such  other  information  which  would 
be  useful  or  helpful  in  evaluating  the  administration  of  these  provi- 
sions. The  report  should  also  indicate  to  the  extent  possible  the  tax 
benefits  which  are  claimed  for  operations  in  each  boycott  country ;  the 
benefits  claimed  by  taxpayers  in  those  countries  and  the  benefits  denied 
by  application  of  these  provisions ;  and  the  extent  that  benefits  denied 
were  attributable  to  boycott  agreements  determined  by  reason  of  an 
Internal  Revenue  audit.  The  report  must  be  in  such  a  form  that  it  can- 
not, directly  or  indirectly,  be  associated  with  or  otherwise  identify  a 
particular  taxpayer. 

Effective  date 
The  international  boycott  provisions  apply  to  any  participation  in 
or  cooperation  with  an  international  boycott  made  more  than  30  days 
after  the  date  of  enactment  (October  4, 1976) .  However,  in  the  case  of 
operations  which  are  carried  out  in  accordance  with  the  terms  of  a 
binding  contract  entered  into  before  September  2,  1976,  the  interna- 
tional boycott  provisions  apply  to  participation  or  cooperation  after 
December  31,  1977. 

Revenue  e-ffect 
It  is  estimated  that  the  international  boycott  provisions  will  increase 
budget  receipts  by  $32  million  in  fiscal  year  1978,  and  by  5tJ70  million 
in  fiscal  year  1981. 

14.  Denial  of  Certain  Tax  Benefits  Attributable  to  Bribe-Pro- 
duced Income  (sees.  1065  and  1066  of  the  Act  and  sees.  952, 
964(a),  and  995(b)  (1)  of  the  Code) 

Prior  laio 
Under  prior  law,  illegal  payments  to  government  officials  were  not 
deductible,  but  the  denial  of  tlie  deduction  for  bribes  had  little  impact 
on  bribes  paid  by  foreign  subsidiaries  or  DISCs. 

Reasons  for  change 
Prior  law  in  many  cases  provided  more  favorable  tax  treatment  for 
illegal  payments  made  by  a  foreign  subsidiary  of  a  U.S.  corporation 
than  by  its  parent.  Further,  the  Congress  is  concerned  over  the  re- 
cent revelations  that  disclosed  the  practice  of  using  foreign  bribes 


289 

as  a  means  of  doing  business  overseas.  The  Congress  believes  that 
illegal  payments  made  out  of  funds  entitled  to  tax  deferral  should 
cause  the  termination  of  the  tax  deferral. 

Explanation  of  provisions 

The  Act  subjects  to  current  taxation  as  a  deemed  dividend  an 
amount  equal  to  the  amount  of  any  illegal  bribes,  kickbacks,  or  other 
payments  (within  the  meaning  of  section  162(c))  paid  by  or  on  be- 
half of  a  DISC  or  a  controlled  foreign  corporation  (a  foreign  corpo- 
ration more  than  50  percent  of  the  stock  of  which  is  owned  by  United 
States  shareholders)  directly  or  indirectly  to  an  official  or  employee 
of  any  government  (or  of  any  agency  or  instrumentality  of  any  gov- 
ernment). Illegal  payments  include  payments  which  are  unlawful  un- 
der the  laws  of  the  United  States  or,  if  made  to  an  official  or  employee 
of  a  foreign  government,  payments  which  would  be  unlawful  under 
the  laws  of  the  United  States  if  such  laws  were  applicable. 

In  the  case  of  a  controlled  foreign  corporation,  the  deemed  dividend 
is  accomplished  by  treating  an  amount  equal  to  the  bribe  as  subpart 
F  income  includible  in  the  income  of  the  subsidiary's  United  States 
shareholders  in  the  same  manner  as  other  subpart  F  income.  In  the 
case  of  a  DISC,  the  deemed  dividend  is  made  under  the  same  rules 
which  are  applicable  to  other  deemed  distributions  required  during 
qualified  years  (e.g.,  deemed  distributions  of  interest  on  producer's 
loans) . 

In  addition,  the  earnings  and  profits  of  any  foreign  subsidiary 
which  has  made  an  illegal  payment  are  not  to  be  reduced  by  the 
amount  paid. 

Effective  date 
The  provisions  dealing  with  the  making  of  illegal  payments  by 
foreign  corporations  apply  to  payments  made  after  November  3, 1976. 

Revenue  effect 
It  is  estimated  that  these  provisions  will  increase  budget  receipts 
by  less  than  $5  million  on  an  annual  basis. 


J.  DOMESTIC  INTERNATIONAL  SALES  CORPORATIONS 
(Sec.  1101  of  the  Act  and  Sees.  991-997  of  the  Code) 

Prior  law 

The  tax  law  provides  for  a  system  of  tax  deferral  for  corporations 
known  as  Domestic  International  Sales  Corporations,  or  "DISCs", 
and  tlieir  shareholders.  Under  this  tax  system,  the  profits  of  a  DISC  are 
not  taxed  to  the  DISC  but  are  taxed  to  the  shareholders  of  the  DISC 
when  distributed  to  them.  However,  each  year  a  DISC  is  deemed  to 
have  distributed  income  representing  50  percent  of  its  profits,  thereby 
subjecting  that  income  to  current  taxation  in  the  shareholders'  hands. 
In  this  way,  imder  the  prior  rules,  the  tax  deferral  which  was  available 
under  the  DISC  provisions  was  limited  to  50  percent  of  the  export  in- 
come of  the  DISC. 

To  qualify  as  a  DISC,  at  least  95  percent  of  the  corporation's  assets 
must  be  export-related  and  at  least  95  percent  of  a  corporation's  gross 
income  must  arise  from  export  sale  or  lease  transactions  and  other 
export-related  activities  (i.e.,  qualified  export  receipts).  Qualified  ex- 
port receipts  include  receipts  from  the  sale  of  export  property,  which 
generally  means  property  such  as  inventory  manufactured  or  pro- 
duced in  the  United  States  and  held  for  sale  for  direct  use,  consump- 
tion or  disposition  outside  the  United  States  (or  to  an  unrelated  DISC 
for  such  a  purpose).  The  President  has  the  authority  to  exclude  from 
export  property  any  property  which  he  determines  (by  Executive 
order)  to  be  in  short  supply.  However,  energy  resources,  such  as  oil 
and  gas  and  depletable  minerals,  are  automatically  denied  DISC  bene- 
fits under  the  Tax  Reduction  Act  of  1975.  That  Act  also  eliminated 
DISC  benefits  for  products  the  export  of  which  is  prohibited  or 
curtailed  under  the  Export  Administration  Act  of  1969  by  reason  of 
scarcity. 

If  a  DISC  fails  to  meet  the  qualifications  for  any  reason  (including 
legislation  excluding  the  corporation's  products  from  export  prop- 
erty), the  DISC  provisions  provide  for  an  automatic  recapture  of  the 
DISC  benefits  received  in  previous  years.  LTnder  prior  law,  this  re- 
capture was  spread  out  over  the  number  of  years  for  which  the  corpo- 
ration was  qualified  as  a  DISC  but  could  not  exceed  10  years.  In  addi- 
tion, the  DISC  provisions  provide  for  recapture  of  the  DISC  benefits 
if  the  stock  of  the  DISC  is  sold  or  exchanged. 

Reasons  for  change 
Congress  has  examined  the  DISC  provisions  at  great  length  and 
has  concluded  that  the  legislation  has  had  a  beneficial  impact  on 
U.S.  exports.  Since  1971.  when  DISC  was  enacted,  exports  have  in- 
creased from  $43  billion  to  $107  billion  for  1975.  It  is  clear  that  much 
of  this  increase  has  resulted  from  the  devaluation  of  the  dollar  which 
took  place  in  that  period.  Nonetheless,  Congress  has  concluded  that 
a  significant  portion  of  the  increase  in  exports  which  has  taken  place 

(290) 


291 

resulted  from  the  DISC  legislation.  This  increase  in  exports,  Congress 
concluded,  provides  jobs  for  U.S.  workers  and  helps  the  U.S.  balance 
of  payments. 

However,  Congress  also  recognized  that  questions  have  been  raised 
as  to  the  revenue  cost  of  the  DISC  program.  In  1975,  the  program 
is  estimated  to  have  cost  nearly  $1.3  billion  and  it  is  estimated  that  in 
1976  the  amount  would  have  been  $1.4  billion.  Furthermore,  Congress 
believed  that  the  DISC  legislation  was  made  less  efficient  because  the 
benefits  applied  to  all  exports  of  a  company,  regardless  of  whether 
or  not  a  company's  products  would  be  sold  in  similar  amounts  without 
export  incentive  and  regardless  of  whether  or  not  the  company  was 
increasing  or  decreasing  its  exports. 

Given  these  considerations,  Congress  concluded  that  the  DISC  pro- 
gram could  become  more  efficient  and  less  costly  while  still  providing 
the  same  incentive  for  increased  exports  and  jobs  by  granting  DISC 
benefits  only  to  the  extent  that  a  company  increases  its  exports  over 
a  base  period  amount  and  by  reducing  DISC  benefits  for  certain 
products  and  commodities. 

Explanation  of  provisions 

Incremental  computation  of  DISC  henefts. — Under  the  Act,  the 
tax  deferral  benefits  provided  to  a  DISC  and  its  shareholders  are  to 
be  computed  on  an  incremental  basis.  However,  the  basic  structure 
of  the  DISC  provisions  of  prior  law  are  continued.  DISCs  continue 
not  to  be  taxable  entities  themselves,  but  certain  amounts  of  the  taxable 
income  of  the  DISCs  are  deemed  distributed  to  the  shareholders  of  the 
DISCs  and  taxed  to  them.  Furthermore,  the  requirements  for  qualify- 
ing as  a  DISC  are  to  remain  the  same,  as  are  the  intercompany  pricing 
rules  and  most  of  the  technical  provisions  of  the  DISC  provisions. 

Deemed  distribution. — The  Act  provides  for  the  incremental  com- 
putation of  DISC  benefits  by  adding  a  new  category  of  deemed 
distribution  from  a  DISC  to  its  shareholders.  The  amount  of  this 
new  deemed  distribution  is  the  adjusted  taxable  income  for  the  cur- 
rent taxable  year  which  is  attributable  to  adjusted  base  period  export 
gross  receipts  (i.e.,  the  nonincremental  portion  of  the  current  year's 
export  receipts). 

Adjusted  taxable  income  is  the  taxable  income  of  the  DISC  in  the 
current  year  reduced  by  producer's  loan  interest  and  gain  on  the  sale 
of  certain  property  of  the  DISC.  These  amounts  are  deemed  distribu- 
tions from  a  DISC  to  its  shareholders  under  prior  law.  The  amount 
of  the  new  deemed  distribution  is  that  portion  of  the  current  year's 
adjusted  taxable  income  which  is  attributable  to  the  current  year's 
export  gross  receipts  not  in  excess  of  the  adjusted  base  period  export 
gross  receipts.  For  example,  if  adjusted  base  period  export  gross 
receipts  were  $100  and  the  current  year's  export  gross  receipts  were 
$300,  one-third  of  the  adjusted  taxable  income  of  the  DISC  in  the 
current  year  would  be  treated  as  attributable  to  adjusted  base  period 
export  gross  receipts  and  thus  would  be  a  deemed  distribution  for 
the  current  year. 

The  deemed  distribution  is  computed  by  takinsr  the  ratio  of  "adjusted 
base  period  export  gross  receipts"  of  the  DISC  to  the  export  gross 
receipts  for  the  current  year  and  multiplying  it  by  the  adjusted  tax- 


292 

able  income  of  the  DISC  for  the  current  year.  Adjusted  base  period 
export  gross  receipts  are  defined  as  67  percent  of  the  average  of  the 
disc's  export  gross  receipts  during  a  moving  4-year  base  period. 
Thus,  this  nonincremental  dividend  is  computed  as  follows: 

67  percent  of  the  average  base 
DISC  income  for  current       s^  period  export  gross  receipts 

y^^^  Export  gross  receipts 

for  current  year 

The  nonincremental  dividend  is  to  be  deemed  distributed  to  the 
shareholder  prior  to  the  computation  of  the  deemed  distribution  (pro- 
vided under  prior  law)  equal  to  one-half  of  the  taxable  income  of 
the  DISC.  That  is,  adjusted  taxable  income  attributable  to  adjusted 
base  period  export  gross  receipts  is  to  be  deemed  distributed  first,  and 
then  one-half  of  remaining  taxable  income  of  the  DISC  is  to  be  deemed 
distributed.  For  example,  if  a  DISC  had  taxable  income  of  $100  and 
taxable  income  attributable  to  the  adjusted  base  period  export  gross 
receipts  of  $30,  the  deemed  distributions  for  the  year  would  be  $65 
($30+ 1/2  ($100- $30) ).  Thus,  a  deferral  of  tax  would  be  permitted  on 
$35. 

Export  gross  receipts. — The  term  "export  gross  receipts"  includes 
those  receipts  which  are  received  in  the  ordinary  course  of  the  export 
trade  or  business  of  the  DISC  in  which  the  DISC  derives  its  income 
(see  sec.  993(a) ).  For  this  reason,  the  term  includes  income  from  the 
sale,  exchange,  or  rental  (and  related  subsidiary  services)  of  export 
property  (as  defined  in  sec.  993(c))  for  consumption  outside  of  the 
United  States;  engineering  and  architectural  services  for  projects  out- 
side the  United  States;  and  the  performance  of  managerial  services 
for  a  DISC  which  relate  to  the  sale,  exchange,  rental  or  other  dis- 
position of  export  property.  However,  the  term  does  not  include  gross 
receipts  from  the  sale,  exchange  or  other  disposition  of  qualified  export 
assets  (under  sec.  993(b) )  other  than  export  property  (i.e.,  assets  such 
as  warehouses  and  packaging  machines  which  generally  are  used  in 
the  export  business  but  uhich  are  not  sold  in  the  ordinary  course  of 
business) ;  dividends  or  deemed  distributions  (under  subpart  F)  from 
a  related  foreign  export  corporation  (as  defined  in  sec.  993(e)) ;  and 
interest  on  any  obligation  (such  as  Export-Import  Bank  obligations) 
which  is  a  qualified  export  asset. 

Base  period  years. — Under  the  Act,  the  base  period  for  taxable  years 
beginning  in  1976,  1977,  1978.  and  1979  is  composed  of  the  DISC'S 
taxable  years  beginning  in  1972, 1973, 1974,  and  1975.  In  taxable  years 
beginning  in  1980  and  later  years,  the  base  period  becomes  a  4-year 
moving  base  period.  The  base  period  is  to  move  forward  1  year  for 
each  year  beyond  1979,  so  that  the  base  period  years  for  any  year  are 
the  taxable  years  beginning  in  the  4th,  5th,  6th,  and  7th  calendar  years 
preceding  such  calendar  year.  For  example,  for  1980,  the  base  period 
years  are  1973, 1974,  1975,  and  1976,  and  for  1981,  the  base  period  years 
are  1974, 1975, 1976,  and  1977. 

The  average  export  gross  receipts  for  the  base  period  is  the  sum  of 
the  export  gross  receipts  for  tlie  4  base  period  years  divided  by  4.  If 
the  taxpayer  did  not  haAe  a  DISC  in  any  year  wliich  would  be  in- 
cluded in  the  base  period  for  the  current  year,  the  taxpayer  is  to  cal- 


293 

culate  base  period  export  gross  receipts  by  attributing  a  zero  amount 
of  export  gross  receipts  to  that  base  period  year.  For  example,  in  the 
case  of  a  DISC  which  was  not  in  existence  in  1973  and  1974,  but  had 
$25  of  export  gross  receipts  in  1975,  and  $35  in  1976,  the  base  period 
export  gross  receipts  of  the  DISC  for  taxable  year  1980  would 
be  ($0  +  $04-$25  +  $35)  divided  by  4  or  $15.  Sixty-seven  percent  of  this 
average,  or  roughly  $10,  would  be  the  adjusted  base  period  export  gross 
receipts  of  the  DISC. 

Because  base  period  years  in  which  a  DISC  was  not  in  existence  are 
included  as  zero  base  period  years  under  these  provisions,  DISCs  be- 
ginning operation  in  1976  have  no  base  period  export  gross  receipts  for 
4  full  years  (until  1980),  when  the  base  period  begins  to  include  a  year 
in  which  the  DISC  had  export  gross  receipts.  In  1980  its  base  period 
export  gross  receipts  would  be  its  1976  export  gross  receipts  divided 
by  4,  The  DISC  would  thus  first  have  a  full  4-year  base  period  in  1983,^ 

Short  taxable  years. — In  the  case  of  a  taxpayer  having  a  short  tax- 
able year  in  the  base  period,  the  Secretary  is  to  prescribe  regulations 
including  the  annualization,  if  necessary,  of  export  gross  receipts  in 
the  short  base  period  taxable  year  or  years  in  determining  base  period 
export  gross  receipts.  Similar  regulations  are  to  be  prescribed  if  the 
current  year  is  a  short  year  in  order  to  compute  the  deemed  distribu- 
tion. It  is  intended  that  under  these  regulations  short  taxable  years  in 
the  base  period  will  generally  be  annualized  for  purposes  of  deter- 
mining base  period  export  gross  receipts  so  that  the  amount  of  the 
increase  in  current  year  export  gross  receipts  is  based  on  an  equivalent 
full  year  amount  of  export  gross  receipts  in  each  base  period  year. 
Similarly,  in  cases  where  the  current  year  is  a  short  taxable  year, 
it  is  intended  that  export  gross  receipts  in  the  current  year  will  gen- 
erally be  expanded  proportionately  by  the  ratio  of  the  length  of  the 
short  taxable  year  to  a  full  taxable  year.  Of  course,  this  adjustment 
is  only  to  affect  the  computation  of  export  gross  receipts  to  be  used 
in  determining  the  amount  of  the  current  year's  taxable  income  which 
is  attributable  to  base  period  export  gross  receipts.  The  adjustment 
is  not  to  affect  the  amount  of  taxable  income  of  the  DISC  for  the 
current  taxable  year  or  the  amount  of  accumulated  DISC  benefits  from 
any  base  period  year. 

Adjustments  to  hose  period. — The  Act  includes  three  special  rules 
to  deal  with  situations  where  a  corporation  has  an  interest  in  more  than 
one  DISC,  or  where  a  DISC  and  the  underlying  trade  or  business 

iThe  Incremental  computation  of  DISC  benefits  can  be  illustrated  by  the  following 
example : 

In  1980  a  DISC  makes  exports  of  $13,400.  and  that  the  taxable  income  allocable  to  the 
DISC  Is  $500.  Assume  further  that  the  DISC  was  established  in  1974  and  that  the  exports 
through  the  DISC  during  the  applicable  base  period  are  : 

1973 0 

1974 $2,  000 

1975    6, 000 

1976 8,  000 

Assuming  all  the  exports  are  of  nonmilitary  goods,  the  DISC  benefits  would  be  computed 
as  follows : 

ia)   DISC'S  Income  on  exports $500 

(6)   Average  base  period  export  eross  receipts  (SIR  000/4) 4,000 

(c)  Adi'nsted  base  period  export  gross  receipts  (67  percent  of  (b)) 2,680 

(d)  Export  gross  receipts  for  current  year 13,  400 

(e)  Nonlncremental  portion  of  the  DISC'S  Income   ((a)   times   (c)/(d)) 100 

(/)    DTSC  Income  remaining  after  nonlncremental  dividend   ((a)  — (e)) 400 

ia)   Reeular  deemed  distribution  of  50  percent  of  DISC  income 200 

(h)   DISC  income  eligible  for  deferral 200 


234-120  O  -  77  -  20 


294 

giving  rise  to  the  DISC  income  have  been  separated.  The  purposes  of 
these  rules  are,  first,  to  insure  that  in  every  year  the  base  period  export 
gross  receipts  wliich  are  attributable  to  a  DISC  for  purposes  of  deemed 
distributions  in  the  current  year  are  appropriately  matched  with  the 
current  period  export  receipts  of  the  DISC  and,  second,  to  prevent 
taxpayei-s  from  creating  multiple  DISCs,  or  trading  DISCs,  to  re- 
duce deemed  distributions  attributable  to  base  period  export  gross 
receipts. 

ControUed  grouj).  The  Act  provides  tliat  if  one  or  more  members 
of  a  controlled  group  of  corporations  (as  defined  in  sec.  993(a)  (3)  to 
include  all  corporations  with  50  percent  or  more  common  ownership) 
qualify  as  a  DISC  in  the  current  or  base  period  years,  the  amount 
deemed  distributed  as  taxable  income  attributable  to  adjusted  base 
period  export  gross  receipts  to  the  common  shareholder  of  the  DISCs 
(and  the  adjusted  taxable  income  for  purposes  of  the  small  DISC  rule) 
is  to  be  determined  by  aggregating  taxable  income,  current  year  export 
gross  receipts,  and  base  period  export  gross  receipts  of  the  commonly 
owned  DISCs.  This  aggregation  is  to  be  accomplished  under  regula- 
tions prescribed  by  the  Secretary  and  is  to  be  reflected  on  a  pro  rata 
basis  (i.e.,  according  to  taxable  income)  in  each  DISC  for  purposes  of 
determining  the  deemed  distribution  from  each  DISC.  The  Secre- 
tary's regulations  thus  are  not  intended  to  require  aggregation  of 
commonly  owned  DISCs  for  all  purposes  (including  for  purposes  of 
meeting  the  qualifications  of  a  DISC).  Rather,  this  aggregation  is  to 
be  required  only  to  the  extent  necessary  so  that  a  taxpayer  which  ex- 
ports through  more  than  one  related  DISC  (in  the  current  year  or 
the  base  period) ,  cannot  gain  any  advantage  by  increasing  its  exports 
in  one  DISC  or  the  other,  since  the  base  period  of  all  DISCs  are 
taken  into  account  in  determining  the  amount  of  the  deemed  distribu- 
tion of  taxable  income  attributable  to  base  period  export  gross  receipts. 
In  determining  base  period  export  receipts  for  this  purpose,  commonly 
owned  DISCs  are  to  use  the  same  4  base  years  during  the  base  period. 
It  is  intended  that  in  cases  where  two  DISCs  are  members  of  a  con- 
trolled group,  but  (where  an  unrelated  person  owns  some  stock  in  one 
of  the  DISC?,  the  aogres^ation  rule  does  not  apply  in  computing  any 
deemed  distribution  to  that  shareholder. 

Separation,  of  DISC  and  its  trade  or  husin'^''^. — A  second  special 
rule  is  provided  for  situations  where  the  ownership  of  a  DISC  and 
the  underlying  trade  or  business  which  gives  rise  to  the  export  gross 
receipts  of  the  DISC  are  separated.  This  could  arise  through  the  sale 
of  the  underlying  trade  or  business  or  through  a  tax-free  reorganiza- 
tion in  which  the  DISC  and  the  underlying  trade  or  business  are  sep- 
arated. The  special  rule  requires  that  a  person  owning  the  underlying 
trade  or  business  during  the  taxable  yeai-s  after  the  separation  of  the 
trade  or  business  from  the  DISC  be  treated  as  having,  in  any  DISC  in 
which  the  owner  of  the  trade  or  business  has  an  interest,  an  amount 
of  additional  export  gross  receipts  for  base  period  vears  eqaal  to  ex- 
port gross  receipts  in  base  period  years  of  the  DISC  attributable  to 
that  trade  or  business. 

The  effect  of  this  provision  is  to  provide  a  double  attribution  of  base 
period  export  gross  receipts  in  cases  where  a  DISC  is  separated  from 
the  underlying  trade  or  business  through  a  tax-free  reorganization  or 


295 

through  a  sale  of  the  underlying  trade  or  business.  In  these  cases  the 
base  period  export  gross  receipts  of  the  DISC  also  remain  with  the 
DISC  and  are  to  be  taken  into  account  by  the  shareholders  of  the  DISC 
(whether  or  not  the  DISC  has  acquired  new  shareholders  in  a  tax-free 
reorganization)  in  computing  adjusted  base  period  export  gi'oss  re- 
ceipts of  the  DISC  for  years  prior  to  the  reorganization  or  sale.- 

Since,  in  the  case  of  a  sale  or  disqualification  of  a  DISC,  the  DISC 
benefits  for  jDrior  years  are  recaptured,  export  gross  receipts  for  base 
period  years  prior  to  any  sale  (or  disqualification)  are  to  be  reduced  on 
a  pro  rata  basis  to  the  extent  of  the  recapture.  For  example,  if  a  DISC 
which  was  disqualified  was  entitled  to  defer  $100  of  accumulated  DISC 
income,  $40  of  which  was  recaptured,  the  export  gross  receipts  for  the 
base  period  years  are  to  be  reduced  by  40  percent. 

A  separation  of  the  DISC  and  the  underlying  trade  or  business  does 
not  occur  if  the  DISC  and  the  trade  or  business  which  gave  rise  to  the 
base  period  export  gross  receipts  of  the  DISC  are  owned  throughout 
the  current  taxable  year  by  members  of  the  same  controlled  groups,  but 
only  to  the  extent  that  the  ownership  of  the  DISC  and  the  trade  or 
business  is  proportionate  during  all  of  the  current  taxable  year  (i.e., 
the  taxpayer  owns  the  same  proportionate  amount  of  stock  in  the 
DISC  as  it  owns  in  the  trade  or  business  during  the  current  year).  As 
a  result,  in  cases  where  a  DISC  is  transferred  at  the  same  time  that  the 
underlying  trade  or  business  is  transferred  (either  by  sale  or  tax-free 
reorganization) ,  the  double  attribution  of  the  base  period  export  gross 
receipts  of  the  DISC  does  not  apply.  The  intent  of  these  provisions  is 
to  prevent  taxpayers  from  separating  a  DISC  from  the  underlying 
trade  or  business  giving  rise  to  the  export  gross  receipts  of  the  DISC  in 
order  to  reduce  base  period  export  gross  receipts. 

In  order  to  permit  the  transfer  of  a  DISC  and  the  transfer  of  the 
underlying  trade  or  business  as  part  of  the  same  exchange,  the  Act  pro- 
vides special  rules  modifying  the  corporate  spinoff  provisions.  The  Act 
provides  that  if  (i)  a  corporation  owns  the  stock  of  a  subsidiary  and 
of  a  DISC,  (ii)  the  subsidiary  has  been  engaged  in  the  active  conduct 
of  a  trade  or  business  for  the  requisite  5-year  period,  and  (iii)  during 
the  taxable  year  of  the  subsidiary  in  which  its  stock  is  transferred  and 
during  its  preceding  taxable  year,  the  trade  or  business  of  the  sub- 
sidiary gave  rise  to  qualified  export  receipts,  the  Secretary  is  to  pre- 
scribe regulations  under  which  the  transfer  of  assets,  stock,  or  both 
will  be  treated  as  a  reorganization  within  the  meaning  of  section  368, 
a  transaction  to  which  section  855  applies,  or  an  exchange  to  which 
section  351  applies.  This  special  treatment  will  apply  only  to  the  extent 
that  the  transfer  is  for  the  purpose  of  preventing  the  separation  of  the 
ownership  of  the  stock  in  the  DISC  from  the  ownership  of  the  trade 
or  business  which  produced  the  base  period  export  gross  receipts  of  the 
DISC. 


*  For  example.  If  a  r>ISC  alone  is  transferred  in  a  section  355  spin-off  transaction,  the 
shareholders  of  the  DISC  after  the  transfer  will  in  computing  any  deemed  distributions, 
take  into  account  the  adjusted  base  period  export  gross  receipts  for  all  base  years  of  the 
DISC.  IncludlnR  years  prior  to  the  section  355  transaction.  In  addition,  the  owners  of 
the  trade  or  business  from  which  the  DISC  is  spun  off  will  also  be  treated  as  having  base 
period  export  gross  receipts  equal  to  the  amount  of  the  base  period  export  gross  receipts 
of  the  DISC  which  was  spun  off.  These  amounts  are  to  be  added  to  any  base  period  export 
gross  receipts  which  may  exist  in  any  DISC  in  which  the  owners  of  the  trade  or  business 
have  an  interest  or  subsequently  obtain  an  Interest. 


296 

Shareholders  of  two  or  more  unrelated  DISCs. — A  final  special 
rule  is  provided  to  apply  to  situations  where  a  person  owns  a  partial 
interest  in  a  DISC  (i.e.,  5  percent  or  more  of  the  stock  of  a  DISC). 
Under  this  rule,  if  a  person  has  had  an  interest  in  more  than  one  DISC 
(either  simultaneous  ownership  or  ownership  of  one  DISC  during  the 
base  period  and  ownership  of  the  second  DISC  during  the  current 
year),  then,  to  the  extent  provided  in  regulations  prescribed  by  the 
Secretary  to  prevent  circumvention  of  the  rules  for  deemed  distribu- 
tions of  taxable  income  attributable  to  adjusted  base  period  export 
gross  receipts,  amounts  equal  to  that  shareholder's  pro  rata  portion  of 
the  base  period  export  gross  receipts  of  DISCs  owned  during  the  base 
period  are  to  be  included  in  base  period  export  ^ross  receipts  of  DISCs 
currently  owned  by  the  shareholder.  This  provision  is  intended  to  give 
the  Secretar-y  general  authority  to  prevent  situations  where,  by 
having  an  interest  in  more  than  one  DISC,  a  taxpayer  could  artificially 
reduce  the  base  period  export  gross  receipts  that  would  otherwise  be 
attributable  to  a  currently  active  DISC  in  order  to  obtain  a  smaller 
deemed  distribution  in  the  current  year. 

Where  the  provisions  of  the  first  two  special  rules  are  applied,  it  is 
contemplated  that  generally  the  rules  regarding  deemed  distributions 
will  not  have  been  circumvented,  and  thus  no  further  adjustment  of 
base  period  export  gross  receipts  is  to  be  required.  Further,  it  is  in- 
tended that  this  provision  will  generally  not  be  applied  in  cases  where 
a  taxpayer  has  sold  all  the  shares  he  held  in  any  DISC,  since  the 
amount  of  benefits  received  from  that  DISC  will  have  been  recaptured. 
HoM-ever,  the  Secretary  is  to  have  authority  to  attribute  base  period 
gross  receipts  to  more  than  one  DISC  in  cases  of  separations  and 
acquisitions  of  DISCs  from  underlying  trades  or  businesses  if  such 
double  attribution  is  consistent  with  the  purposes  of  the  special  rules 
of  the  Act  and  is  appropriate  to  eliminate  any  incentive  to  separate 
DISC  assets  from  their  underlying  trades  or  businesses. 

Small  DISCs  exception.- — The  Act  exempts  small  DISCs  from  the 
new  incremental  rules.  Under  the  Act,  DISCs  with  adjusted  taxable 
income  in  the  current  taxable  year  of  $100,000  or  less  are  not  subject 
to  the  new  incremental  rules.  Instead,  these  DISCs  will  continue  to 
receive  the  full  DISC  benefits  provided  under  prior  law.  The  excep- 
tion is  phased-out  on  a  2-for-l  basis  so  that  DISCs  with  taxable  income 
of  $150,000  or  more  receive  no  benefit.  In  computing  adjusted  taxable 
income  for  purposes  of  the  small  DISC  exception  to  the  incremental 
rules,  if  more  than  one  member  of  a  controlled  group  qualifies  as  a 
DISC,  the  small  DISC  exemption  is  computed  by  aggregating  the 
adjusted  taxable  income  of  each  DISC  who  is  a  member  of  that  group. 

DISCs  with  taxable  income  of  over  $100,000  for  a  taxable  year  are  to 
be  treated  as  having  made  deemed  distributions  equal  to  the  amount  of 
their  adjusted  base  period  gross  export  receipts,  but  this  amount  is  first 
to  be  reduced  by  twice  the  excess  (if  any)  of  the  $150,000  over  the 
disc's  adjusted  taxable  income.  The  effect  of  this  provision  is  to  phase 
out  the  special  treatment  for  small  DISCs  on  a  2-for-l  basis,  so  that 
DISCs  with  adjusted  taxable  income  of  $150,000  or  more  receive  no 


297 

benefit  from  the  rule  and  DISCs  with  adjusted  taxable  income  between 
$100,000  and  $150,000  will  lose  $2  out  of  the  $100,000  exemption  for 
each  $1  of  adjusted  taxable  income  beyond  $100,000.^ 

Reduction  of  DISC  benefits  foi'  military  goods. — The  Act  reduces 
the  DISC  deferral  on  sales  of  military  goods  to  half  the  amount  which 
would  otherwise  be  allowed.  The  reduction  in  DISC  benefits  on  mili- 
tary sales  is  accomplished  by  requiring  a  deemed  distribution  of  one 
half  of  the  DISCs  taxable  income  from  military  sales.  The  DISCs 
taxable  income  from  military  sales  is  its  gross  income  from  the  sale 
of  military  property  (gross  receipts  less  cost  of  goods  sold)  reduced  by  , 
the  deductions  properly  allocable  to  that  income.  The  determination/ 
of  this  amount  may  require  separate  accounting  for  militaiy  and  non- 
military  sales.  IMilitary  goods  are  defined  as  arms,  ammunition,  or  im- 
plements of  war  designated  in  the  munitions  list  published  pui"suant 
to  the  Military  Security  Act  of  1954  (22  U.S.C.  1934).  The  list  pub- 
lished pursuant  to  that  statute  appears  at  22  Code  of  Federal  Regula- 
tions, sec.  121. 

The  deemed  distribution  of  the  DISC  income  from  military  sales 
is  made  prior  to  the  nonincremental  and  the  regular  50  percent  deemed 
distributions.  In  computing  the  nonincremental  dividend,  only  half 
of  the  military  sales  are  included  in  the  ratio  of  the  average  gross  re- 
ceipts for  the  base  period  to  the  gross  receipts  for  the  current  year.* 

Exclusion  from  hose  period. — For  purposes  of  establishing  base 
period  export  gross  receipts  of  a  DISC  some  of  the  products  of  which 
have  been  made  ineligible  for  DISC  benefits  under  the  Tax  Reduction 
Act  of  1975,  an  adjustment  is  to  be  made  to  reduce  base  period  export 
gross  receipts  of  that  DISC  to  reflect  the  elimination  of  DISC  bene- 
fits for  those  products  or  commodities.  This  adjustment  is  to  be  made 
by  eliminating  from  each  base  period  year  the  amount  of  actual  exports 
of  those  commodities  or  products  for  which  DISC  benefits  are  elimi- 
nated for  the  current  year.  Thus,  the  amount  of  reduction  in  base  period 
export  gross  receipts  is  to  be  computed  by  tracing  and  eliminating 
actual  DISC  sales  in  base  period  years. 


'For  example,  a  DISC  with  adjusted  taxable  Income  of  $130,000  -which  had  adjusted 
base  period  exnort  receipts  of  »200.000  mleht.  without  the  small  DISC  provision,  have 
a  deemed  distribution  of  $75,000  and  thus  would  be  eligible  for  DISC  benefits  only  on  the 
remaining?  $55,000.  However,  under  the  2-for-l  phaseout  this  DISC  would  be  eligible  "for 
DISC  benefits  on  an  additional  $40,000  of  its  DISC  Income  beyond  the  $55,000  amount 
(2  times  ($150.000— $130,000) ).  The  DISC  would  thus  be  treated  as  having  made  a 
deemed  distribution  of  taxable  Income  attributable  to  base  period  export  gross  receipts  of 
$35,000  out  of  its  adjusted  taxable  Income  in  the  current  year  of  $130,000. 

*  The  following  example  illustrates  the  computation  of  DISC  benefits  under  the  iit-w 
rules.  In  19S0  a  DISC  exports  $10,000  of  military  goods  and  $1,700  of  other  goods, 
and  its  taxable  Income  for  the  venr  is  S700.  of  wMch  .^600  is  attributable  to  the  military 
sales.  Assume  further  that  $12,000  of  the  $16,000  exports  during  the  1973-1976  base 
period  were  exports  of  military  goods.  In  this  factual  situation,  the  DISC  benefits  would 
be  computed  as  follows  : 
Military  sales  deemed  distribution  : 

(a)  DISC'S  Income  on  exports $700 

(b)  DISC'S  Income  attributable  to  military  sales 600 

(c)  Deemed  distribution  of  %  of  income  attributable  to  military  sales 300 

(d)  DISC  Income  remaining  after  military  sales  deemed  distribution 400 

Incremental  distribution  : 

(e)  Average  base  period  export  gross  receipts  (($4,000  +  %  of  $12,000) /4) 2,  500 

(/)    Adiusted  base  period  export  gross  receipts   (67  percent  of  (e) ) 1.  P75 

(a)    Adjusted  export  gross  receipts  for  current  year  ($1.700+ V,  of  $10,000) 6.  700 

[h)    Nonincremental  portion  of  the  DISC  Income  ((d)  times  (f)/(g)) 100 

(i)    DISC  income  remaining  after  military  sales  and  nonincremental  distribu- 
tions           300 

(.})   Regular  deemed  distribution  of  50  percent  of  DISC  income  {%  of  (i)) 150 

(fc)   DISC  income  eligible  for  deferral 150 


298 


Special  rules. — The  Act  also  includes  two  provisions  relatingto  t' 
disqualification  and  recapture  of  accunnilated  DISC  income  of  DIS( 


the 
)ISCs 

which  exported  goods  for  which  DISC  benefits  have  been  eliminated. 
First,  under  the  Act,  if  these  1)1  SCs  continue  to  loan  their  accumu- 
lated DISC  earnings  to  the  parent  company,  these  loans  will  continue 
to  qualify  as  producers  loans  if  they  would  otherwise  qualify  under  the 
rules  that  were  applicable  before  DISC  benefits  were  eliminated  for  the 
goods  which  the  DISC  exported  and  which  the  parent  continues  to 
export.  For  example,  in  the  case  of  a  DISC'  selling  coal,  after  the  elimi- 
nation of  DISC  benefits  for  those  goods  the  DISC  can  continue  to  have 
qualified  producers'  loans  to  its  parent  to  the  extent  that  the  parent 
exports  goods  which  would  (but  for  the  elimination  of  DISC  benefits 
for  coal  under  the  Tax  Reduction  Act  of  1975)  qualify  for  DISC  bene- 
fits if  sold  through  the  DISC. 

In  addition,  tTie  Act  provides  that  recapture  of  accumulated  DISC 
earnings  (because  the  DISC  has  become  disqualified)  is  to  be  spread 
out  over  a  period  equal  to  two  years  for  each  year  tliat  the  DISC  was 
in  existence  (up  to  a  maximum  of  10  years),  instead  of  the  1  year  (up 
to  a  maximum  of  10  years)  provided  under  prior  law. 

The  Act  also  includes  two  provisions  to  resolve  technical  problems 
in  prior  law.  The  first  relates  to  recapture  of  accumulated  DISC  income 
upon  disposition  of  stock  of  a  DISC.  Under  prior  law  if  stock  in  a 
DISC  was  distributed,  sold,  or  exchanged  in  certain  tax-free  transac- 
tions (sec.  311,  336,  or  337)  there  was  no  recapture  because  neither  of 
the  conditions  for  recapture  were  satisfied :  no  gain  would  be  recog- 
nized and  the  corporate  existence  of  the  DISC  would  not  be  terminated. 
The  Act  specifically  requires  recapture  under  these  circumstances.  Con- 
forming amendments  with  respect  to  the  partnei-ship  provision  have 
also  been  made  (sec.  751  (c) ) . 

The  second  provision  relates  to  the  determination  of  the  source  of 
distributions  to  meet  qualification  requirements.  Under  prior  law  the 
combination  of  the  general  deemed  distribution  rule  (which  requires 
that  shareliolders  be  considered  to  have  received  50  percent  of  the 
Disc's  taxable  income)  and  the  rule  prescribing  the  source  of  any 
distribution  made  to  meet  the  95  percent  export  receipts  requirement 
could  result  in  partial  double  counting  of  the  DISCs  taxable  income 
insofar  as  terminating  deferral  of  taxation  to  its  shareholders  was 
concerned.'''  The  Act  meets  this  ])roblem  of  double  counting  by  altering 
the  source  rules  for  distributions  to  meet  qualification  requirements. 

Under  the  Act  one-half  of  a  disti-ibution  to  meet  qualification  re- 
quirements (which  is  made  to  satisfy  the  requirement  of  sec.  902(a) 
(1)(A)  relating  to  the  95  percent  qualified  export  receipts  require- 
ment) is  considered  distributed  according  to  the  sourc-e  rules  of  section 


*  For  exninplo,  nssunip  a  DISC  ha«  $100  of  tasnble  Income  $R0  of  which  Is  attributable 
to  qiinllflpfl  export  receipts  and  $20  of  which  is  not  attributable  to  oualifled  export 
receipts.  If  the  corporation  qualifies  as  a  DISC  by  reason  of  malcins  a  distril.ution  to 
meet  qualification  requirements,  $50  of  the  DISCs  taxable  income  is  taxed  to  the  share- 
holders. The  rules  relatincr  to  distributions  to  meet  qualification  requirements  make  it 
necessary  for  the  corporation  to  distribute  $20  (the  nonqualified  export  receipts).  Since 
under  prior  law  distributions  to  meet  qualification  requirements  wro  deemed  to  come 
first  from  accumulated  DISC  income  (and  next  from  other  earninirs  and  profits),  the  $20 
is  taxed  in  full  also.  This  results  in  the  taxable  income  attrlbutaMe  to  the  nonqualified 
receipts  beinp:  distributed  in  effect,  one  and  one-half  times  -one  half  as  part  of  the 
50  percent  deemed  distribution  and  In  full  as  a  distribution  to  meet  qualification 
requirements. 


299 

996(a)  (2)  (i.e.,  first  out  of  untaxed  earnings)  and  the  remaining 
one-half  is  considered  subject  to  the  source  rules  of  section  996(a)  (1) 
(lirst  out  of  previously  taxed  earnings)  .^ 

Finally,  the  Act  clarifies  the  category  of  products  for  which  DISC 
benefits  were  eliminated  under  the  Tax  Reduction  x\ct  of  1975.  In  that 
Act  it  was  intended  that  DISC  benefits  be  repealed  for  articles  the 
supply  of  which  is  exhaustible  or  nonrenewable  (such  as  products 
derived  from  oil  or  gas  or  hard  minerals) .  The  statute  as  drafted  refers 
to  products  "of  a  character  with  respect  to  which  a  deduction  for  de- 
pletion is  allowable  .  .  .  under  section  611".  This  reference  to  section 
611  had  the  unintended  result  of  including  some  articles  the  supply  of 
which  is  inexhaustible  or  can  be  renewed  (for  example,  timber).  Be- 
cause of  this  possible  interpretation,  the  Act  modifies  the  provision 
by  limiting  its  application  to  products  for  which  depletion  is  allowable 
under  sections  613  or  613A. 

Under  this  provision,  if  a  product  is  eligible  for  percentage  depletion 
(e.g.,  oil  or  gas),  the  exports  of  that  product  are  not  entitled  to  DISC 
benefits  regardless  of  whether  that  DISC  or  its  shareholder  is  eligible 
for  percentage  depletion. 

Ejfective  date 

In  general,  the  DISC  provisions,  including  the  provision  establish- 
ing an  incremental  base  for  DISCs,  apply  to  taxable  years  of  DISCs 
beginning  after  December  31,  1975.  The  new  incremental  rules  apply 
to  income  earned  by  the  DISC  in  years  beginning  after  1975  even  if 
the  income  is  derived  from  a  binding  contract  entered  into  in  prior 
years. 

The  reduction  in  DISC  benefits  for  military  sales  also  applies  to 
taxable  income  from  military  sales  earned  in  taxable  years  beginning 
after  December  31, 1975. 

In  addition,  the  Act  amends  the  effective  date  provisions  of  the 
Tax  Reduction  Act  of  1975  to  provide  a  fixed  contract  exception  for 
those  products  for  which  DISC  benefits  were  eliminated  under  the 
Tax  Reduction  Act  of  1975  (generally  hard  minerals  and  oil  and  gas) , 
and  allows  this  exception  for  sales,  exchanges  and  other  dispositions 
made  after  March  17, 1975,  but  before  March  18, 1980.  A  fixed  contrEUjt 
is  defined  as  any  contract  which  was,  on  March  17,  1975,  and  is  at  all 
times  thereafter,  binding  on  the  DISC,  or  on  a  taxpayer  which  is  a 
member  of  the  same  controlled  group  (within  the  meaning  of  sec.  993 
(a)  (3))  as  the  DISC. 


•  The  effect  of  this  provision  can  be  seen  by  referring  to  the  example  used  previously  la 
describing  the  problem  with  prior  law.  If  a  corporation  had  $100  taxable  Income,  $80 
of  which  was  attributable  to  qualified  export  receipts  and  $20  of  which  was  attributable  to 
receipts  which  did  not  qualify  as  qualified  export  receipts,  it  could  still  obtain  qualification 
as  a  DISC  if  it  made  a  distribution  to  meet  qualification  requirements  (pursuant  to  sec. 
992(c))  of  $20.  Under  prior  law,  the  full  $20  was  (according  to  the  applicable  source  rules) 
considered  to  be  first  from  accumulated  DISC  and  hence  taxable  in  full  to  tho  distributee 
shareholders.  Under  the  Act,  one-half  of  the  $20  distribution  Is  considered  (according  to 
to  the  source  rules  of  sec.  996(a)(1))  to  be  first  from  previously  taxed  income  with  the 
remaining  one-half  first  from  accumulated  DISC  Income  (pursuant  to  sec.  996(a)(2).  In 
this  manner,  the  full  amount  of  taxation  to  the  shareholders  (as  a  result  of  the  deemed 
distribution  of  $50  pursuant  to  sec.  995(b)(1)(F)  and  the  $20  distribution  to  meet 
qualification  requirements)  is  $60  ($20  of  nonqualified  Income  plus  $40,  one-half  of  the 
qualified  income)  rather  than  $70  as  under  prior  law. 


300 

The  contract  need  not  be  formalized  in  writing  in  order  to  be  bind- 
ing, if  the  taxpayer  can  establish  through  substantial  documentary 
evidence  (such  as  Board  of  Directors'  resolutions,  letters  of  intent, 
etc.)  that  the  contract  was  in  fact  binding  and  contained  fixed  price 
and  fixed  quantity  provisions  on  and  after  March  17,  1975.  However, 
the  contract  must  not  have  been  binding  at  any  time  prior  to  the  date 
on  which  the  DISC  became  qualified  as  a  DISC  or  prior  to  the  time 
the  taxpayer  and  the  DISC  became  members  of  the  same  controlled 
group. 

In  addition,  only  contracts  under  which  the  price  and  quantity 
terms  relating  to  the  products  or  commodities  to  be  sold,  exchanged, 
or  otherwise  disposed  of  cannot  be  increased  with  any  discretion  are  to 
be  considered  fixed  contracts.  For  example,  if  a  contract  permits  a 
price  increase  only  upon  the  occurrence  of  specified  conditions  not 
within  the  discretion  of  the  seller  (such  as  increased  labor  or  raw 
material  costs),  which  conditions  do  not  include  increases  for  income 
taxes,  the  contract  is  to  be  considered  a  fixed  price  contract.  However, 
if  the  seller  can  vary  the  price  of  the  product  for  unspecified  cost  in- 
creases (which  could  include  tax  cost  increases),  the  contract  is  not  to 
be  considered  a  fixed  price  contract.  Furthermore,  if  the  quantity  of 
products  or  commodities  to  be  sold  can  be  increased  or  decreased 
under  the  contract  by  the  seller  without  penalty,  the  contract  is  not 
to  be  considered  a  fixed  contract  with  respect  to  the  amount  over 
which  the  seller  has  discretion.  For  example,  if  a  contract  calls  for  a 
minimum  delivery  of  x  amount  of  a  product  but  allows  the  seller 
to  refuse  to  deliver  goods  beyond  that  minimum  amount  (or  allows  a 
renegotiation  of  the  sales  price  of  goods  beyond  that  amount) ,  then 
with  respect  to  the  amount  above  the  minimum  the  contract  is  not  a 
fixed  quantity  contract. 

In  cases  where  the  binding  contract  rule  allows  for  a  continuation  of 
DISC  benefits  for  any  DISC,  the  decrease  in  base  period  export  gross 
receipts  which  is  provided  under  the  Act  attributable  to  products  for 
which  DISC  is  eliminated  is  to  be  modified  by  adding  back  into  the 
base  period  an  amount  of  export  sales  equal  to  the  amount  of  export 
sales  in  the  base  period  for  which  DISC  benefits  have  since  been  elimi- 
nated (without  regard  to  the  binding  contract  rule)  multiplied  by  a 
fraction,  the  numerator  of  which  is  the  amount  of  export  sales  for 
which  DISC  benefits  are  allowed  (because  of  the  binding  contract 
rules)  and  the  denominator  of  which  is  the  amount  of  export  sales  for 
which  DISC  benefits  would  be  eliminated  in  the  current  year  (assuming 
that  the  binding  contract  rule  were  not  in  effect.)  Tliis  rule,  in  effect, 
requires  that  a  portion  of  the  base  period  export  gross  receipts  reduc- 
tion due  to  the  general  elimination  of  DISC  benefits  for  certain  types 
of  products  is  t3  be  included  in  base  period  export  gross  receipts  to  the 
extent  that  the  binding  contract  rule  allows  a  continuation  of  any 
DISC  benefits  for  any  products  in  the  current  year. 

Revenue  effect 
This  provision  will  increase  budget  receipts  by  $468  million  in  fiscal 
year  1977,  $553  million  in  fiscal  year  1978,  and  $728  million  \\\  fiscal 
year  1981. 


K.  ADMINISTRATIVE  PROVISIONS 

1.  Public  Inspection  of  Written  Determinations  by  Internal  Reve- 
nue Service  (sec.  1201  of  the  Act  and  sec.  6110  of  the  Code) 

Prior  law 

As  a  well-established  part  of  the  tax  system,  the  National  Ofl5.ce  of 
the  Internal  Revenue  Service  provides  written  advice  to  taxpayers  on 
the  tax  treatment  of  their  specific  transactions.^ 

Advice  with  respect  to  a  proposed  transaction  may  be  issued  upon 
a  written  request  from  the  taxpayer,  giving  factual  details  about  the 
transaction  and  after  the  taxpayer  answers  the  questions  the  IRS 
may  have  about  the  transaction,  (Information  provided  by  the  tax- 
payer to  the  IRS  often  contains  confidential  financial  (or  personal) 
information  about  the  taxpayer.  Some  of  this  information  is  repeated 
in  the  letter  of  advice  that  is  issued  by  the  IRS.)  The  letter  of  advice 
generally  is  called  a  "ruling"  and  is  in  the  form  of  a  letter  to  the 
taxpayer.^ 

The  letter  ruling  to  the  taxpayer  has  been  treated  as  "private"  in  the 
sense  that  it  is  issued  in  response  to  the  request  of  the  taxpayer  and 
is  officially  kept  confidential.  Even  if  another  taxpayer  obtained  a 
copy  of  a  private  ruling,  he  could  not  use  it  as  a  precedent  in  his  own 
case.  Private  rulings  applied  only  to  the  taxpayer  who  is  the  subject 
of  the  ruling. 

In  addition,  the  IRS  publishes  revenue  rulings  in  its  official  bulle- 
tins. Taxpayers  and  IRS  employees  may  rely  on  these  published  rul- 
ings as  precedent.  However,  before  publication,  all  identifying  infor- 
mation is  deleted  from  the  proposed  revenue  ruling,  facts  may  be 
altered  to  conceal  identity,  the  position  of  the  Service  may  be  changed, 
and  this  sanitized  version  is  subject  to  extensive  administrative  review. 

In  1974,  the  Technical  Office  of  the  National  Office  handled  28,346 
ruling  requests.  Approximately  one-half  of  these  (14,329)  dealt  with 
requests  for  changes  in  accounting  periods  and  methods;  these  re- 

1  statement  of  Procedural  Rules  §  601.201  ;  Rev.  Proc.  72-3,  1972-1  Cum.  Bui.  698, 
modified  by  Rev.  Proc  73-7,  1973-1  Cum.  Bui.  776.  However,  the  IRS  will  not  rule  on 
all  transactions.  For  example,  the  IRS  will  not  rule  on  whether  compensation  is  reason- 
able in  amount  or  on  whether  a  taxpayer  who  advances  funds  to  a  charitable  organiza- 
tion and  receives  a  promissory  note  therefore  may  deduct  as  contributions  amounts  of  the 
note  forgiven  by  the  ta.xpayer  in  later  years.  Rev.  Proc.  72-9,  1972-1  Cum.  Bui.  718.  In 
addition,  in  some  cases,  the  IRS  has  established  guidelines  describing  the  form  of  a  transac- 
tion must  take  before  a  favorable  ruling  will  be  issued.  See,  e.g.  Rev.  Proc.  75-21,  1975-1, 
Cum.  Bui.  715,  which  sets  out  conditions  which  a  transaction  must  meet  before  a  favorable 
ruling  will  be  granted  t^at  a  transnctlon  is  a  leveraged  lease  and  not  a  conditional  sale. 

2  While  an  erroneous  ruling  issued  to  a  taxpayer  may  be  modified  or  revoked,  generally 
(in  the  absence  of  an  omission  or  misstatement  of  material  facts  or  change  in  law)  an 
advance  letter  ruling  which  is  relied  upon  by  the  taxpayer  in  good  faith  will  not  be  modi- 
fled  or  revoked  retroactively  if  the  facts  which  subsequently  develop  are  not  materially 
different  from  the  facts  on  which  the  ruling  was  based.  Statement  of  Procedural  Rules 
§  601.201(1) (5). 

(301) 


302 

quests  are  handled  rapidly  and  normally  do  not  involve  any  substan- 
tive issue  of  general  interest.^ 

Of  the  remaining  rulings  in  1974,  the  Technical  Office  responded  to 
14,017  taxpayer  ruling  requests.  These  ruling  requests  were  on  the 
following  general  subjects : 

Taxpayers' 
Subject  requests 

Actuarial  matters 1, 019 

Administrative  provisions 42 

Employment  and  self-employment  taxes 423 

Engineering  questions 69 

Estate  and  gift  taxes 317 

Exempt  organizations 4, 120 

Other  excise  taxes 421 

Other  income  tax  matters 6, 196 

Pension  trusts 1,  410 

Total  14,  017 

The  National  Office  of  the  IRS  also  will  answer  requests  for  advice 
from  the.  district  offices  on  issues  that  arise  in  the  course  of  an  audit 
of  a  taxpayer's  return.  This  advice  is  in  the  form  of  a  technical  advice 
memorandum.  Technical  advice  memoranda  are  addressed  to  a  field 
office  of  the  IRS  but  have  an  effect  similar  to  that  of  a  private  letter 
ruling  in  that  the  technical  advice  involves  a  determination  of  tax 
questions  concerning  a  particular  taxpayer  who  generally  has  a  right 
to,  and  usually  does,  participate  in  the  technical  advice  proceeding. 
In  1974,  the  IRS  handled  1,602  requests  for  technical  advice. 

In  1974,  the  IRS  published  626  revenue  rulings  in  its  official  bulle- 
tin. The  source  of  these  revenue  rulings  was  both  private  rulings  and 
technical  advice  memoranda.  In  one  of  the  areas  of  tax  law  generally 
considered  to  be  very  complex — that  of  corporate  reorganizations — 
the  IRS  published  25  rulings  in  1974.  In  that  same  year,  there  were 
approximately  2,000  private  rulings  issued  in  the  corporate  reorgani- 
zation area. 

The  Freedom  of  Information  Act  (FOIA)  (5  U.S.C.  §  552)  be- 
came effective  on  July  4,  1967.  The  FOIA  requires  each  agency  to 
make  available  for  public  inspection  and  copying  "interpretations 
which  have  been  adopted  by  the  agency  *  *  *."  (5  U.S.C.  §  552(a) 
(2)(B).)  However,  there  are  a  number  of  exceptions  from  the  re- 
quirement of  disclosure  under  the  FOIA,  including  matters  that  are 
specifically  exempted  from  disclosure  by  statute.  (5  U.S.C.  §  552(b) 
(3).) 

Recently,  the  courts  have  considered  the  issue  of  whether  private 
rulings  are  exempt  from  disclosure  under  the  FOIA  because  they 
constitute  tax  returns  (or  return  information)  under  the  Internal 
Revenue  Code  (sees.  6103  and  7213).  In  these  case,«,  both  the  United 
States  Court  of  Ap^x-als  for  the  District  of  Columbia  and  the  United 
States  Court  of  Appeals  for  the  Sixth  Circuit  held  that  private  letter 
rulings  were  not  covered  under  sees.  6103  and  7213  of  the  Code  and 
were  subject  to  disclosure  under  the  FOIA.  Taw  Analysts  d'  Advo- 


*  Under  the  Code,  generally  a  taxpayer  who  changes  his  period  or  method  of  account- 
ing miiRt.  be^'ore  computine  his  taxable  income  under  the  new  method,  secure  the  consent 
of  the  IRS.  (Sees  442  and  446(e).) 


303 

cates  V.  Internal  Revenue  Service,^  and  Fruehauf  Corp.  v.  Internal 
Revenue  Service.^ 

In  addition,  in  Fruehauf^  the  court  held  that  technical  advice  mem- 
oranda were  to  be  open  to  inspection  to  the  extent  intended  for  issu- 
ance to  a  taxpayer.  However,  in  Tax  Analysts^  the  court  held  that 
a  technical  advice  memorandum  was  not  open  to  inspection,  being  a 
part  of  a  tax  return  and  therefore  exempt  from  disclosure  under  the 
FOIA  (by  reason  of  sees.  6103  and  7213  of  the  Code) . 

In  1975,  a  suit  was  brought  under  the  FOIA  to  compel  release  of 
all  private  letter  rulings  issued  by  the  IRS  since  July  4, 1967,  the  effec- 
tive date  of  the  FOIA.  Tax  Analysts  &  Advocates  v.  Internal  Revenue 
Service,  Civil  Action  No.  75-0650  (D.D.C.),  filed  April  28,  1975. 

On  December  10,  1974,  the  IRS  issued  proposed  procedural  rules 
dealing  with  the  publication  of  private  rulings.  In  general,  these  pro- 
posed rules  provided  for  public  inspection  beginning  approximately  30 
days  after  the  issuance  of  the  ruling.  (Furthermore,  in  certain  cases,  a 
delay  in  public  inspection  could  be  granted  for  an  additional  period 
not  to  exceed  13  weeks.)  Under  these  proposed  rules,  the  IRS  would 
make  available  for  public  inspection  the  full  text  of  private  rulings, 
including  identifying  information.  However,  these  proposed  rules  pro- 
vided procedures  for  protecting  trade  secrets  and  certain  matters  re- 
lating to  national  defense  or  foreign  policy. 

On  March  25, 1975,  the  IRS  held  public  hearings  on  these  proposed 
rules,  at  which  time  there  was  substantial  public  comment.  In  addi- 
tion, the  IRS  was  informed  by  the  Justice  Department  that  at  least 
one  part  of  the  proposed  rules  (  dealing  with  "required  rulings")  might 
be  contrary  to  other  principles  of  law. 

Reasons  for  change 

Although  the  private  rulings  procedure  had  significant  advantages 
for  both  the  IRS  and  taxpayers,  the  system  also  contained  some  sub- 
stantial problems.  It  has  been  argued  that  the  private  ruling  system 
developed  into  a  body  of  law  known  only  to  a  few  members  of  the  tax 
profession.  For  example,  an  accounting  or  law  firm  with  offices  in 
Washington  could  have  a  library  of  all  the  private  ruling  letters  issued 
to  its  clients.  Such  a  firm  was  in  a  position  to  advise  other  clients  as  to 
the  current  IRS  ruling  position  because  of  its  special  access  to  these 
rules  of  law.  This,  in  turn,  tended  to  reduce  public  confidence  in  the 
tax  laws.  Additionally,  the  secrecy  surrounding  letter  rulings  gener- 
ated suspicion  that  the  tax  laws  were  not  being  applied  on  an  even- 
handed  basis. 

These  types  of  concerns  led  to  the  lawsuits  described  above  to  open 
private  rulings  to  public  inspection.  Wliile  two  courts  have  held  pri- 
vate rulings  to  be  open  to  public  inspection,  significant  additional 
questions  were  raised  since  these  court  decisions.  These  questions  con- 
cerned the  parts  of  a  ruling  file  that  should  be  published,  whether 
private  rulings  should  be  available  as  "precedent"  for  other  tax- 
payers, what  procedures  should  be  established  to  allow  taxpayers  to 
claim  that  protected  material  should  not  be  disclosed,  etc. 


*  505  F.  2(1  350  m.C.  Olr.  1974). 

B  522  F.  2d  284  (6th  Clr.  1975).  petition  for  cert,  granted  Jan.  12. 1976. 


304 

The  foregoing  questions  generally  applied  to  future  as  well  as  to 
past  rulings.  There  were  additional  questions  concerning  past  rulings, 
however,  because  taxpayers  who  previously  obtained  rulings  applied 
for  them  in  reliance  on  the  IRS  position  that  the  information  sub- 
mitted to  the  IRvS  would  be  treated  as  confidential  tax  information. 

The  Congress  agrees  with  the  previous  court  decisions  that  private 
rulings  should  be  made  public.  Only  in  this  way  can  all  taxpayers  be 
assured  of  access  to  the  ruling  positions  of  the  IRS.  Also,  this  tends 
to  increase  the  public's  confidence  that  the  tax  system  operates  fairly 
and  in  an  even-handed  manner  with  respect  to  all  taxpayers.  However, 
the  Congress  believes  that  the  problems  described  above  should  be 
resolved  by  legislation,  since  the  courts  have  not  previously  been 
given  guidance  by  the  Congress  on  these  difficult  issues  in  the  tax 
field. 

The  problems  should  be  resolved  so  that  the  public  will  have  an 
exclusive  remedy  with  respect  to  the  disclosure  of  rulings  and  related 
material. 

Explanation  of  provision 
Under  the  Act,  IRS  written  determinations  (^.e.,  rulings,  technical 
advice  memoranda,  and  determination  letters)  will  generally  be  open 
to  public  inspection;  that  is,  they  will  be  made  available  for  public 
inspection  and  copying  in  a  public  reading  room  in  or  near  the  issuing 
office.  A  complete  set  of  IRS  rulings  and  technical  advice  memoranda 
will  be  made  available  in  a  central  public  reading  room  in  Washing- 
ton, D.C.  It  is  intended  that  a  subject-matter  index  will  also  be 
placed  in  the  public  reading  rooms.  This  index  will  classify  rulings, 
etc.,  on  the  basis  of  the  Code  sections  and  issues  involved.  (It  is  antic- 
ipated that,  as  is  presently  the  case  with  respect  to  other  aspects  of 
the  tax  law,  various  commercial  services  will  make  pertinent  parts  of 
this  material  available  to  people  located  elsewhere.)  However,  it  is  not 
contemplated  that  existing  IRS  indices  will  be  disclosed. 

Generally,  any  written  determination  issued  by  the  IRS  (including 
written  determinations  issued  at  the  District  Director's  level  as  well 
as  National  Office  rulings)  is  to  be  open  to  public  inspection  under 
the  Act.  Generally,  a  written  determination  will  not  be  considered  a 
ruling,  technical  advice  memorandum,  or  determination  letter  unless 
it  recites  the  relevant  facts,  explains  the  applicable  provisions  of  law, 
and  shows  the  application  of  the  law  to  the  facts.  Thus,  documents 
such  as  a  notice  of  deficiency  (sec.  6211),  reports  on  claims  or  refund, 
or  similar  documents  required  to  be  issued  by  the  IRS  in  the  course  of 
tax  administration  will  not  be  considered  rulings.  Public  inspection 
will  apply  only  to  a  written  determination  actually  issued  to  a  person 
pursuant  to  his  request  and  to  a  written  determination  (such  as  a 
technical  advice  memorandum)  requested  by  an  IRS  employee  in  the 
course  of  an  audit,  tax  collection,  or  similar  proceeding.  Public  inspec- 
tion will  not  apply  to  unissued  written  determinations  or  background 
information  with  respect  to  them. 

Moreover,  the  Act  does  not  provide  for  the  public  inspection  of 
technical  advice  memoranda  issued  in  connection  with  fraud  and 
jeopardy  proceedings  until  after  such  proceedings  are  completed. 

Additionally,  the  Act  does  not  require  public  disclosure  of  a  closing 
agreement  entered  into  between  the  IRS  and  a  taxpayer  which  finally 


305 

determines  the  taxpayer's  tax  liability  with  respect  to  a  taxable  year. 
(Where  it  is  in  the  interest  of  a  taxpayer  and  the  IRS,  a  closing 
agreement  may  be  made  in  order  to  provide  certainty  as  to  a  person's 
past  tax  liability.)  The  Congress  understands  that  a  closing  agree- 
ment is  generally  the  result  of  a  negotiated  settlement  and,  as  such, 
does  not  necessarily  represent  the  IRS  view  of  the  law.  The  Congress 
intends,  however,  that  the  closing  agreement  exception  is  not  to  be 
used  as  a  means  of  avoiding  public  disclosure  of  determinations  which 
under  prior  practice,  would  be  issued  in  a  form  which  would  be  open 
to  public  inspection  under  the  committee  amendment. 

Similarly,  the  Act  does  not  apply  to  an  IRS  decision  to  accept 
a  taxpayer's  offer  in  compromise  under  a  special  procedure  designed 
to  permit  the  compromise  of  disputed  issues.  Summaries  of  accepted 
offers  in  compromise  were  open  to  public  inspection  under  prior  law. 
(The  Act  does  not  in  any  way  change  these  provisions.) 

The  Act  also  does  not  apply  to  IRS  determinations  issued  after 
September  2,  1974  as  to  whether  a  pension,  prcfitsharing,  etc.,  plan, 
an  individual  retirement  account  or  an  individual  retirement  annuity 
qualifies  under  the  tax  law.  or  as  to  whether  an  organization  is  tax- 
exempt,  because  these  determinations  were  generally  open  to  public 
inspection  under  prior  law  (sec.  6104(a)(1)).  Also,  the  Act  specifi- 
cally requires  the  disclosure  (sec.  6104)  of  determination  letters  with 
respect  to  applications  filed  after  October  31,  1976,  issued  to  an  orga- 
nization described  in  section  501  (c)  or  (d)  with  respect  to  its  tax- 
exempt  status. 

Generally,  the  text  of  a  determination,  after  having  been  sanitized 
so  that  there  are  no  identifying  details,  is  to  be  made  open  to  public 
inspection.  Identifying  details  consist  of  names,  addresses,  and  any 
other  information  which  the  Secretary  determines  could  identify  any 
person,  including  the  taxpayer's  representative.  In  some  situations, 
infoiTnation  included  in  a  determination  (other  than  a  name  or  ad- 
dress) may  not  identify  a  person  as  of  the  time  the  determination  is 
made  open  to  public  inspection,  but  that  information,  together  with 
information  that  is  expected  to  be  disclosed  by  another  source  at  a 
later  date,  will  serve  to  identify  a  person.  Consequently,  in  deciding 
whether  a  determination  contains  identifying  information,  the  Secre- 
tary is  to  take  into  account  information  that  is  available  to  the  public 
at  the  time  that  the  determination  is  made  open  to  public  inspection  as 
well  as  information  that  is  expected  to  be  publicly  available  from 
other  sources  within  a  reasonable  time  after  the  determination  is  made 
open  to  public  inspection. 

Generally,  it  is  intended  that  the  standard  the  IRS  is  to  use  in 
determining  whether  information  will  identify  a  pereon  is  a  standard 
of  a  reasonable  person  generally  knowledgeable  with  respect  to  the 
appropriate  community.*'  The  standard  is  not,  however,  to  be  one  of 
a  person  with  inside  knowledge  of  the  particular  taxpayer. 

Before  any  written  determination  requested  after  October  31,  1976, 
is  made  available  for  public  inspection,  any  person  who  receives  a 

"  The  appropriate  community  could  be,  e.g.,  an  industry  or  a  geograpjiical  community  and 
will  vary  for  tlip  problem  Involved.  For  example,  the  "community"  for  a  steel  company 
will  be  all  steel  producers,  but  may  also  be  the  locale  in  which,  e.g.,  the  main  plant  is  to 
be  located  if  the  determination  deals  with  a  land  transaction. 


306 

ruling  or  determination  letter  or  to  whom  a  technical  advice  memo- 
randum pertains  must  be  personally  notified  in  writing  that  public 
disclosure  is  about  to  occur.  It  is  intended  that  this  notification  be 
made  at  the  time  the  written  determination  is  issued.  Such  person  will 
then  have  60  days  within  which  to  discuss  with  the  IRS  the  informa- 
tion to  be  made  available  for  public  inspection  and  to  bring  a  suit  to 
restrain  disclosure.  It  is  expected  that  the  IRS  will  develop  admin- 
istrative procedures  which  will  facilitate  the  settlement  of  disputes 
without  litigation.  It  is  also  expected  that  the  IRS  will  not  make  any 
written  determination  open  to  public  inspection  before  it  advises  the 
person  to  whom  it  pertains,  in  writing,  as  to  any  deletion  which  he  has 
requested  but  with  which  the  IRS  disagrees.  Moreover,  the  IRS  may 
not  make  any  written  determination  available  for  public  inspection 
until  15  days  after  the  initial  60-day  period  has  expired,  but  it  must 
make  the  written  determination  available  no  later  than  30  days  after 
such  initial  60-day  period  has  expired  if  no  court  proceedings  are 
commenced.  Such  60-day  period  will  start  on  the  date  the  IRS  actually 
mails  a  notice  to  the  person  to  whom  the  determination  pertains,  indi- 
cating that  the  written  determination  that  he  received  is  about  to  be 
made  public.  If  any  court  action  is  commenced  during  such  60-day 
period  to  challenge  the  decision  of  the  IRS  with  respect  to  disclosure, 
the  IRS  may  not  make  the  disputed  portion  of  the  written  determina- 
tion open  to  public  inspection  until  after  a  final  court  decision. 

In  order  to  protect  against  impropriety  and  undue  influence  in  the 
rulings,  etc.,  process,  the  Act  establishes  a  flagging  procedure  with 
respect  to  written  determinations  requested  after  October  31,  1976. 
If  a  particular  determination  is  the  subject  of  a  contact  (written 
or  otherwise)  by  anyone  other  than  the  taxpayer  or  his  representa- 
tive before  the  determination  is  issued,  the  IRS  will  be  required  to 
note  that  fact  at  the  time  the  determination  is  made  public,  by  noting 
the  date  of  the  contact  and  by  identifying  the  nature  of  the  contact 
by  category,  e.g..  White  House,  Congressional,  Department  of  the 
Treasury,  trade  association,  etc.  It  is  expe-cted  that  the  IRS  will  make 
a  written  notation  of  all  telephone  contacts  from  outside  parties  with 
respect  to  a  particular  written  determination.  Contacts  made  by  an 
employee  of  the  IRS  are  not  to  be  noted.  For  this  purpose  employees 
of  the  Office  of  Chief  Counsel  of  the  IRS  are  to  be  considered  em- 
ployees of  the  IRS.  In  addition,  contacts  made  by  the  Chief  of  Staff 
of  the  Joint  Committee  on  Taxation  are  not  to  be  noted. 

Communications  concerning  a  pending  determination  from  another 
agency  which  provides  assistance  to  the  IRS  upon  its  request  are 
also  not  to  be  flagged.  Moreover,  internal  memoranda  within  the 
Internal  Revenue  Service  relating  to  a  particular  written  determina- 
tion, or  the  question  involved  therein,  which  relate  to  development  of 
the  Service's  legal  position  on  the  question  involved,  should  not  be  a 
part  of  the  background  file  (and  for  this  purpose  Chief  Counsel 
should  be  considered  part  of  the  Internal  Revenue  Service).  However, 
correspondence  which  seeks  to  elicit  further  factual  information,  and 
the  response  thereto,  will  not  be  excluded  from  the  background  file 
by  the  previous  sentence  (for  example,  in  a  case  where  the  National 
Office  seeks  further  information  regarding  a  district  director's  request 
for  technical  advice).  Because  of  their  similarity  to  internal  memo- 


307 

randa  and  attorneys  work  product,  correspondence  between  the  In- 
ternal Revenue  Service  and  the  Department  of  Justice  regarding  a 
particular  civil  or  criminal  investigation  or  case,  which  is  related  to  a 
particular  written  determination,  or  with  respect  to  the  relationship 
of  a  determination  to  any  civil  or  criminal  investigation  or  case,  shall 
not  be  considered  part  of  the  background  file.  (The  question  of  the 
availability  of  these  documents  is  to  be  governed  by  other  provisions 
of  law,  including  the  Freedom  of  Information  Act.) 

If  any  person  wishes  to  obtain  further  information  regarding  the 
identity  of  the  contacting  party  and  the  nature  of  the  contact,  he  may 
i-equest  access  to  the  IRS  background  files.  Upon  payment  of  the 
charges  for  search,  deletion  and  copying  (subject  to  provisions  for  a 
reduction  or  waiver  of  these  charges  where  the  disclosure  is  in  the 
public  interest),  the  IRS  will  be  required  to  make  available  to  the 
third  party  information  in  the  background  file  pertaining  to  the  con- 
tact made,  including  the  name  of  the  contacting  party  and  the  person 
to  whom  the  contact  was  addressed.  Moreover,  if  a  third  party  wishes 
to  learn  the  identity  of  the  applicant  for  the  written  determination,  he 
may  bring  suit  in  the  Tax  Court  or  the  United  States  District  Court 
for  the  District  of  Columbia.  The  identity  of  the  applicant  may  not  be 
disclosed  unless  the  court  finds  evidence  in  the  record  from  which  one 
could  reasonably  conclude  that  an  impropriety  occurred  or  that  undue 
influence  was  exercised,  and  if  the  court  finds  that  the  disclosure  would 
be  in  the  public  interest. 

The  Act,  in  addition  to  providing  for  the  deletion  of  identifying 
details  from  determinations  made  available  for  public  inspection, 
adopts  in  general  the  exemptions  from  public  disclosure  under  the 
FOIA. 

As  part  of  the  procedure  for  obtaining  an  IRS  determination,  a  tax- 
payer is  required  to  submit  detailed  revelant  factual  information  for 
IRS  consideration.  Frequently,  this  information  is  repeated  in  the 
IRS  determination.  The  Congress  is  concerned  that  if  a  taxpayer's 
confidential  information  necessary  for  an  IRS  determination  is  open 
to  public  inspection,  the  taxpayer  may  be  injured  financially  or  by 
loss  of  his  personal  privacy.  As  a  consequence,  taxpayers  may  become 
reluctant  to  request  an  IRS  determination  (even  though  their  names 
will  be  deleted  from  the  material  made  public) . 

The  Congress  does  not  intend  that  the  IRS  ruling  program  should 
be  hindered  by  public  disclosure.  The  ruling  program  benefits  both 
taxpayers  and  the  IRS  (which  obtains  advance  information  about 
transactions  through  the  ruling  program).  The  Act  therefore,  pro- 
vides that  trade  secrets  and  commercial  or  financial  information  ob- 
tained from  a  person  and  privileged  or  confidential  is  not  to  be  pub- 
licly disclosed.  However,  in  determining  the  information  to  be  deleted, 
the  IRS,  except  where  the  item  to  be  disclosed  relates  to  a  trade  secret, 
is  directed  to  take  into  account  the  fact  that  generally,  the  identity  of 
the  taxpayer  will  not  be  made  public. 

Where  the  structure  of  a  transaction  is  disclosable  but  disclosure  of 
the  amounts  involved  is  not  allowed  under  this  rule,  the  Congress 
believes  that  in  normal  circumstances  the  application  of  the  tax  law 
can  be  fully  demonstrated  bv  using  "artificial"  numbers,  for  example, 
by  substituting  $8X  and  $9X  for  $400  and  $450. 


308 

The  Act  also  provides  for  the  deletion  of  information  the  dis- 
closure of  which  would  constitute  an  unwarranted  invasion  of  personal 
privacy.  Under  this  provision,  matters  including  (but  not  limited  to) 
a  pending  (but  not  yet  public)  divorce;  medical  treatment  for,  e.g.^ 
cancer;  adoption  of  a  child;  or  the  amount  of  an  individual's  gift 
usually  will  be  protected. 

The  Act,  following  the  FOIA  exceptions,  provides  for  the 
deletion  of  matters  that  are  specifically  required  by  Executive 
order  to  be  kept  secret  in  the  interest  of  the  national  defense  or  for- 
eign policy,  and  which  are  in  fact  properly  classified  pursuant  to  the 
Executive  order;  geological  and  geopliysical  information  and  data, 
including  maps,  concerning  wells;  and  matters  contained  in  or  re- 
lated to  examination,  operating  or  condition  reports  prepared  by,  on 
behalf  of,  or  for  the  use  of  an  agency  responsible  for  the  regulation 
or  supervision  of  financial  institutions.  This  last  exception  is  needed 
e.g.^  to  protect  the  standing  of  financial  institutions.  For  example,  a 
regulatory  agency  may  issue  a  confidential  report  requiring  such  an 
institution  to  classify  a  loan  as  a  bad  debt.  Subsequently,  the  IRS  may 
be  called  upon  to  determine  whether  the  loan  should  be  treated  as  a 
bad  debt  for  tax  purposes.  The  IRS  may,  of  course,  take  the  agency's 
report  into  account  in  deciding  upon  the  proper  tax  treatment  of  the 
item.  The  Congress  believes,  however,  that  the  banking  agency's  re- 
port should  not  be  publicly  disclosed  by  the  IRS  determination  be- 
cause it  may  damage  the  standing  of  the  bank.  Consequently,  the  Act 
provides  for  deletion  of  this  type  of  information  contained  in  the 
reports  of  such  agencies. 

Additionally,  the  Act  requires  deletion  of  information  which  is 
exempt  from  disclosure  under  another  Federal  statute  which  applies 
to  the  IRS.  In  some  cases,  a  statutory  nondisclosure  provision  applies 
only  to  a.  particular  agency;  in  other  cases,  such  a  provision  may 
apply  to  all  agencies.  Under  the  Act,  information  submitted  to  an- 
other Federal  agency  by  a  person  under  a  nondisclosure  rule  applicable 
only  to  that  agency  would  not  be  exempt  from  disclosure  by  the  IRS 
merely  because  that  person  also  submitted  the  information  to  the 
IRS.  Of  course,  if  the  IRS  obtained  the  information  directly  from 
the  other  agency  under  a  nondisclosure  rule  of  that  agency,  it  would 
not  be  subject  to  disclosure  by  the  IRS. 

However,  if  in  an  action  for  disclosure  of  the  identity  of  an  appli- 
cant for  a  written  determination,  the  court  determines  that  disclosure 
of  identity  is  appropriate,  it  may  also,  under  appropriate  circum- 
stances, direct  the  IRS  to  make  public  any  portion  of  the  material 
deleted  under  the  exemptions  provided  by  the  Act. 

Under  the  Act,  disclosure  is  not  limited  to  the  written  determination 
alone.  Although  initially  only  the  determination  will  be  made  avail- 
able, the  background  file  may  be  obtained  by  the  public  upon  request, 
after  payment  of  charges  for  search,  deletion  of  identifying  details, 
and  copying.  However,  these  charges  may  be  reduced  or  waived  where 
disclosure  is  in  the  public  interest,  and  it  is  anticipated  that  no  fur- 
ther charge  will  be  made  for  deletions  in  the  case  of  a  subsequent  re- 
quest for  the  same  background  file  document.  Background  files  need 
not  be  made  available  for  public  inspection  and  copying  in  a  public 
reading  room. 


309 

Aside  from  the  request  for  a  determination,  the  background  file  in- 
cludes, but  is  not  limited  to,  correspondence  between  the  IRS  and  the 
taxpayer  and  third  party  subnnssions.  However,  background  files 
will  not  be  available  for  public  inspection  with  respect  to  general 
written  determinations  issued  prior  to  July  4,  1967. 

Also,  the  Act  recognizes  that,  under  some  circumstances,  it  serves 
no  purpose  to  disclose  written  determinations  dealing  with  changes 
of  accounting  methods  or  taxable  years,  which  are  almost  always  rou- 
tine. Therefore,  an  IRS  determination  regarding  approval  of  the 
change  of  a  taxpayer's  taxable  year  or  accounting  method,  of  the  ac- 
counting year  or  funding  method  of  a  qualified  pension,  etc.,  plan,  or  of 
a  partner's  or  partnership's  taxable  year  must  be  disclosed  only  if  the 
IRS  regards  it  as  a  guideline.  Routine  determinations  in  this  area,  to- 
gether with  background  information,  will  be  subject  to  disclosure 
only  if  the  determination  is  requested  after  October  31,  1976,  and, 
then,  only  if  the  third  party  seeking  such  a  determination  pays  the 
charges  for  search,  deletions,  and  copying. 

Information  which  is  contained  in  a  written  determination  or  back- 
ground file  document,  but  which  is  not  made  open  to  public  inspection 
under  the  new  rules,  is  treated  as  "return  information"  and  subject 
to  the  nondisclosure  rules  of  section  6103. 

Under  prior  administrative  rules,  a  private  letter  ruling,  techni- 
cal advice  memorandum,  or  determination  letter  was  not  to  be  used  as 
a  precedent  by  the  IRS  or  any  person.  If  all  publicly  disclosed  written 
determinations  were  to  have  precedential  value,  the  IRS  would  be 
required  to  subject  them  to  considerably  greater  review  than  is  pro- 
vided under  present  procedures.  The  Congress  believes  that  the  result- 
ing delays  in  the  issuance  of  determinations  would  mean  that  many 
taxpayers  could  not  obtain  timely  guidance  from  the  IRS  and  the  rul- 
ings program  would  suffer  accordingly.  Consequently,  the  Act  codifies 
the  prior  administrative  rules  by  providing  that  determinations  which 
are  required  to  be  made  open  to  public  inspection  are  not  to  be  used  as 
precedent.  Thus,  if  the  IRS  issued  a  written  d^t/ermination  to  a  tax- 
payer with  respect  to  a  specified  transaction  wh  ch  occurred  in  a  par- 
ticular year,  and  that  taxpayer  or  any  other  taxpayer  engages  in  the 
same  transaction  in  a  subsequent  year,  the  earlier  determination  could 
not  be  used  by  the  taxpayer  or  the  IRS  as  a  precedent  for  the  subse- 
quent year  unless  the  determination  specifies  that  it  applies  to  a  series 
of  such  transactions. 

However,  under  the  Act,  the  IRS  may  designate  in  a  widely  cir- 
culated official  government  publication  (such  as  the  Internal  Revenue 
Bulletin)  determinations  which  will  be  used  as  precedent,  except 
that  the  precedential  value,  if  any,  of  excise  tax  determinations  will 
remain  the  same  as  under  prior  law. 

The  Act  relates  to  the  disclosure  of  all  ruliiigs,  technical  advice 
memoranda,  and  determination  letters,  whether  or  not  issued  after 
July  4,  1967.  However,  certain  rules  to  determine  the  order  in  which 
disclosure  is  to  occur  are  provided  in  the  case  of  those  rulings,  etc.,  re- 
quested prior  to  November  1,  1976.  In  general,  no  such  rulings,  etc., 
will  be  available  prior  to  the  prescribed  time.  Contingent  upon  the 
availability  of  funds  specifically  api)ropriated  to  the  IRS  for  the  pur- 
pose of  making  prior  determinations  open  to  public  inspection,  the 


234-L20  O  -  77  -  21 


310 

IRS  is  directed  to  release,  on  a  last-in,  first-out  basis,  all  prior  deter- 
minations issued  under  the  1954  Code  which  have  been  used  by  the 
IRS  as  guidelines  for  other  determinations.  Thereafter,  the  IRS  is  di- 
rected to  release,  on  the  same  basis,  all  prior  non-guideline  determina- 
tions (other  than  non-guideline  determination  letters)  issued  after 
July  4, 1967.  Third,  the  IRS  is  directed  to  release,  on  a  last-in,  hrst-out 
basis,  all  prior  determinations  issued  under  the  internal  revenue  laws 
as  in  effect  prior  to  the  1954  Code  which  have  been  used  by  the  IRS 
as  guidelines  for  other  determinations.  Finally,  determinations  issued 
on  or  before  July  4,  1967  will  not  be  formally  released  by  the  IRS, 
although  they  will  be  available  upon  request  after  they  are  made  open 
for  public  inspection,  but  only  upon  payment  of  charges  for  search, 
deletion,  and  copying.  In  no  event,  however,  is  the  disclosure  of  IRS 
written  determinations  under  pending  court  actions  to  be  delayed  un- 
der the  above  rides. 

The  Act  includes  a  records  disposal  provision,  to  enable  the  IRS  to 
follow  its  normal  records  disposition  procedures.  The  IRS  may  not 
dispose  of  any  written  determination  which  it  uses  as  a  guideline 
for  other  determinations.  The  IRS  may  dispose  of  any  other  written 
determination  requested  after  October  31, 1976  not  earlier  than  3  years 
after  the  document  is  first  made  available  to  the  public.  For  general 
written  determinations  requested  prior  to  November  1,  1976,  however, 
the  Act  extends  the  retention  date  to  January  20,  1979.  Moreover,  if 
funds  are  appropriated  so  that  the  IRS  will  be  able  to  make  prior  de- 
terminations open  to  public  inspection,  the  IRS  will  be  unable  to  dis- 
pose of  such  prior  determinations  earlier  than  3  years  after  the  docu- 
ment is  first  made  available  to  the  public.  This  record  retention  pro- 
vision in  the  Act  relates  not  only  to  a  written  determination  but  also 
to  the  related  background  file. 

It  is  anticipated  that  the  IRS  is  to  establish  a  special  temporary  unit 
for  the  purpose  of  making  prior  determinations  open  to  public  inspec- 
tion and  that  this  unit  is  to  be  phased  out  as  these  prior  determinations 
are  made  public. 

Under  the  Act,  the  IRS  is  to  issue  notice  in  the  Federal  Register  of 
the  application  of  the  new  disclosure  rules  to  prior  determinations  re- 
quested before  November  1,  1976,  and  the  intent  to  make  them  public. 
It  is  understood  that  a  notice  may  relate  only  to  a  limited  category  of 
determinations  (for  example,  determinations  issued  between  July  4, 
1967,  and  December  1,  1967).  No  part  of  such  a  prior  determination  is 
to  be  made  open  to  public  inspection  under  these  rules  before  the  ex- 
piration of  90  days  following  the  notice  in  the  Federal  Register.  If 
any  court  action  is  commenced  during  the  first  75  days  within  such  90- 
day  period  to  challenge  the  decision  of  the  IRS  with  respect  to  dis- 
closure, the  IRS  may  not  make  the  disputed  portion  of  the  written 
determination  open  to  public  inspection  until  after  a  final  court 
decision. 

Generally,  a  written  determination  which  is  required  to  be  made 
open  to  public  inspection  under  the  Act  is  to  be  placed  in  a  public 
reading  room  in  or  near  the  office  where  issued  (such  as  the  National 
Office  or  the  District  Office,  where  appropriate)  no  earlier  than  75 
days  and  no  later  than  90  days  after  the  IRS  actually  notifies  the 
person  who  receives  any  ruling  or  determination  letter  or  to  whom  a 


311 

technical  advice  memorandum  pertains  of  the  impending  disclosure. 
However,  prior  determinations  may  not  be  made  open  to  public  in- 
spection until  90-days  after  publication  of  the  required  notice  in  the 
Federal  Register.  Moreover,  m  the  event  of  litigation,  disclosure  is  to 
be  made  within  30  days  after  the  final  determination,  unless  an  exten- 
sion is  granted  by  the  court. 

In  order  to  prevent  interference  with  pending  transactions,  how- 
ever, the  Act  provides  for  public  inspection  to  be  delayed  where  nec- 
essary until  the  completion  of  a  transaction  involved  in  the  determina- 
tion. Under  this  provision,  disclosure  may  be  delayed  (for  an  initial 
period  of  up  to  90  days)  until  15  days  after  the  Secretary  determines 
that  the  transaction  is  completed.  The  first  extension  is  to  be  auto- 
matic on  a  showing  that  the  transaction  will  not  be  completed  until  the 
period  in  question  has  passed.  A  second  extension  (up  to  an  additional 
180  days)  could  be  granted  where  the  transaction  is  not  complete  at  the 
end  of  the  initial  period  and  the  Secretary  determines  that  there  is  good 
cause  for  delay.  The  burden  of  showing  good  cause  is  to  be  on  the  per- 
son requesting  the  delay.  The  second  extension  would  expire  not  later 
than  15  days  after  the  date  of  the  Secretary's  determination  that  the 
transaction  is  complete.  Thus,  if  both  extensions  are  allowed  for  the 
completion  of  a  transaction,  the  determination  is  to  be  made  open  to 
public  inspection  within  360  days  after  it  is  issued. 

If  a  written  determination  and  related  background  file  is  made  open 
for  public  inspection  and  the  IRS  intentionally  or  willfully  fails  to 
delete  any  information  required  to  be  deleted  or  to  follow  the  pre- 
scribed disclosure  procedures,  the  recipient  of  the  written  determina- 
tion or  any  pereon  identified  in  the  written  determination  may  bring 
a  civil  action  in  the  Court  of  Claims  for  damages. 

If  agreement  cannot  be  reached  between  the  Secretary  and  the  per- 
son who  receives  a  ruling  or  determination  letter  or  to  whom  a  tech- 
nical advice  memorandum  pertains  as  to  the  extent  of  public  dis- 
closure, and  administrative  remedies  have  been  exhausted,  the  person 
involved  may  petition  the  Tax  Court  for  a  decision  as  to  whether  the 
disputed  portion  of  the  IRS  determination  or  background  file  docu- 
ment is  properly  open  to  public  inspection  under  the  new  rules.  If  such 
a  petition  is  not  filed,  the  Secretary  is  to  make  the  determination  or 
document  open  to  public  inspection  under  the  new  rules  in  accordance 
with  his  fidings,  within  the  time  period  described  above. 

A  petition  must  be  filed  with  the  Tax  Court  before  the  IRS  deter- 
mination or  background  file  document  has  been  made  open  to  public 
inspection  under  the  new  rules.  A  petition  is  to  be  served  on  the  Sec- 
retary, and  within  15  days  after  the  petition  is  served  on  him,  the  Sec- 
retary is  to  notify  (by  registered  or  certified  mail)  any  person  to  whom 
the  determination  pertains  (other  than  the  petitioner)  of  the  filing  of 
the  petition.  Once  a  person  has  received  a  notice  of  the  filing  of  the 
petition,  he  may  intervene  in  the  case  but  he  may  not  thereafter  file 
a  petition  himself.  (This  will  ensure  that  all  issues  of  confidentiality 
raised  before  public  inspection  is  allowed  and  arising  out  of  a  single 
IRS  determination  are  heard  in  one  action  before  the  Tax  Court.) 
The  Tax  Court  proceedings  could  be  in  cmnera  to  the  extent  necessary 
to  preserve  protected  information  from  being  disclosed  as  a  result  of 
the  proceedings.  The  Tax  Court  will  be  required  to  make  a  decision 
in  the  case  at  the  earliest  practicable  date  and  expedited  in  every  way. 


312 

It  is  expected  that  the  rules  of  the  Tax  Court  will  permit  disclosure 
cases  to  be  heard  at  the  same  locations  at  which  tax  cases  are  heard  and 
additionally  will  permit  any  disclosure  case  under  the  amendment  to 
be  heard  in  Washington,  D.C.  The  burden  in  the  case  will  be  on  the 
person  seeking  to  restrain  disclosure. 

A  decision  of  the  lax  Court  in  such  a  case  could  be  appealed  only  to 
the  United  States  Court  of  Appeals  for  the  District  of  Columbia  un- 
less the  Secretary  agrees  with  the  person  involved  to  review  by  another 
court  of  appeals  (sec.  7482(b)).  The  IRS  determination  will  be 
made  open  to  public  inspection  solely  in  accordance  with  a  final  deci- 
sion of  the  Tax  Court,  except  to  the  extent  that  additional  disclosure  is 
required  in  a  later  action  to  obtain  additional  public  disclosure  (dis- 
cussed below). 

A  special  procedure  is  provided  for  third  parties  to  obtain  addi- 
tional disclosure  of  an  IRS  written  determination  or  background  file 
document  (or  portion  thereof)  which  has  not  been  made  open  to  public 
inspection.  This  is  required  so  that  independent  third  parties  can  chal- 
lenge IRS  decisions  as  to  what  part  of  a  written  determination  or  docu- 
ment is  to  be  made  public.  A  person  seeking  additional  disclosure  of  an 
IRS  written  determination  or  background  file  document  is  to  submit 
a  written  request  for  the  information  to  the  IRS.  The  Secretary  is  to 
provide  administrative  remedies  for  a  person  seeking  greater  disclo- 
sure. After  exhausting  such  remedies,  the  person  seeking  additional 
disclosure  could  petition  the  Tax  Court  or  file  a  complaint  in  the  Dis- 
trict Court  for  the  District  of  Columbia  to  compel  additional  disclo- 
sure. It  is  expected  that  the  rules  of  the  Tax  Court  will  prove  that  the 
actions  may  be  brought  at  the  same  locations  at  which  tax  cases  are 
heard  and  at  Washington,  D.C,  and  that  rules  will  be  developed  to 
prevent  subsequent  relitigation  with  respect  to  the  same  written  deter- 
mination or  document.  No  action  to  compel  additional  disclosure  of  a 
written  determination  could  be  brought  more  than  3  years  after  any 
portion  of  the  determination  is  made  open  to  public  inspection  under 
the  new  rules. 

The  court  is  to  examine  the  matter  de  novo  and  without  regard  to  a 
decision  to  restrain  or  permit  disclosure  in  any  court  action  between 
the  IRS  and  a  person  involved  in  the  written  determination  or  related 
background  file  document.  The  proceedings  will  be  subject  to  the 
same  rules  that  would  apply  under  the  FOIA  if  the  proceeding  were 
brought  under  the  FOIA  on  the  date  of  enactment  of  the  bill.  Thus, 
for  example,  the  IRS  will  generally  be  required  to  file  its  answer 
within  30  days  after  the  petition  or  complaint  is  filed,  the  case  will 
have  a  high  priority  on  the  docket  of  the  court,  the  petitioner  or  com- 
plainant could  be  awarded  costs  where  he  substantially  prevails  in  the 
action,  disciplinary  proceedings  could  be  commenced  against  IRS  em- 
ployees in  appropriate  cases,  and  failure  to  comply  with  a  court 
order  compelling  additional  disclosure  could  be  punished  under  con- 
tempt rules.  As  under  the  FOIA,  the  burden  will  be  on  the  Secre- 
tary or  other  parties  seeking  to  prevent  additional  disclosure. 

Additionally,  where  a  petition  or  complaint  is  filed  to  compel  addi- 
tional disclosure,  the  Secretary  is  to  notify  any  person  identified  by 
name  and  address  in  the  written  determination  within  15  days  after 
/the  petition  or  complaint  is  served  on  the  Secretary.  Such  pei"Son  and 
any  person  to  whom  such  written  determination  pertains  could  inter- 


313 

vene  in  the  case.  After  sending  the  notice,  the  Secretary  will  not  be 
required  to  defend  the  case  and  would  not  be  liable  on  account  of  dis- 
closure of  the  determination  (or  any  portion  thereof)  in  accordance 
with  a  final  decision  of  the  court. 

A  decision  of  the  Tax  Court  in  such  a  case  could  be  appealed  only 
to  the  United  States  Court  of  Appeals  for  the  District  of  Columbia 
unless  the  Secretary  agrees  with  the  person  involved  to  review  by 
another  court  of  appeals  (sec.  7482(b) ) . 

The  public  inspection  of  rulings,  technical  advice  memoranda,  and 
determination  letters  and  related  background  files  could  be  accom- 
plished only  pursuant  to  the  rules  and  procedures  set  forth  in  this 
section,  and  not  those  of  any  other  provision  of  law,  such  as  the  FOIA. 
However,  this  section  is  not  to  be  construed  as  excluding  production 
pursuant  to  a  discovery  order  made  in  connection  with  a  judicial  pro- 
ceeding, or  with  respect  to  requests  pending  in  the  courts  under  the 
FOIA. 

Effective  date 
The  new  rules  apply  after  October  31,  1976. 

Revenue  effect 
This  provision  has  no  effect  on  Federal  revenues. 

2.  Disclosure  of  Tax  Returns  and  Tax  Return  Information  (sec. 
1202  of  the  Act  and  sec.  6103  of  the  Code) 

a.  In  general 

Prior  law 

Under  p  ior  law,  all  income  tax  returns  were  described  as  "public 
records."  However,  tax  returns  generally  were  open  to  inspection  only 
under  regulations  approved  by  the  President,  or  under  Presidential 
order.  This  applied  to  returns  concerning  income  tax,  estate  tax,  gift 
tax,  manufacturers  excise  taxes,  the  communications  excise  tax  and  the 
transportation  excise  tax.^ 

Additionally,  the  statute  provided  a  number  of  specific  situations  in 
which  tax  returns  could  be  disclosed.  These  statutory  rules  had  been 
supplemented  by  a  number  of  regulations  and  executive  orders.  The 
regulations  were  of  two  general  types,  those  allowing  inspection  on  a 
case-by-case  basis  and  those  allowing  general  inspection  of  tax  returns. 
On  a  case-by-case  basis,  every  Federal  agency  had  access  to  tax  returns 
on  the  written  lequest  of  the  head  of  the  agency  and,  in  most  cases,  in 
the  discretion  of  the  Secretary  of  the  Treasury  or  the  Commissioner. 
Under  these  "case-by-case"  regulations,  returns  were  made  available 
to  a  number  of  agencies.^ 


1  Under  the  statute,  income  tax  returns  were  open  to  inspection  upon  order  of  the  Presi- 
dent and  under  Treasury  rules  and  refrulations  approved  by  the  President  (sec.  6103(a) 
(D)  and  also  were  "open  to  public  examination  and  inspection"  to  the  extent  authorized 
in  rules  and  regulations  established  by  the  President.  (See.  6103(a)  (2).) 

Estate  and  pift  tax  returns  and  miscellaneous  excise  tax  returns  also  were  open  to 
inspection  under  rules  and  regulations  established  bv  the  President. 

2  Disclosure  of  tax  returns  had  been  made  under  this  provision,  to  the  Civil  Service 
Commission,  the  Department  of  Defense,  the  Federal  Communications  Commission,  the 
Federal  Deposit  Insurance  Corporation,  the  Federal  Home  Loan  Bank  Board,  the  Federal 
Power  Commission,  the  Federal  Trade  Commission,  the  Department  of  the  Interior,  the 
Interstate  Commerce  Commission,  the  National  Labor  Relations  Board,  the  Post  OflBce, 
the  Small  Business  Administration,  the  Tennessee  Valley  Authority,  the  Department  of 
Transportation,  and  the  Veterans  Administration.  In  many  of  these  situations,  only  a  few 
returns  were  involved.  Generally,  the  returns  were  used  for  investigative  purposes  in 
connection  with  matters  within  the  jurisdiction  of  the  agency. 


ai4 

Also,  returns  were  made  available  on  a  case-by-case  basis  to  an  at- 
torney of  the  Department  of  Justice  (or  U.S.  attorney)  "where  nec- 
essary in  the  performance  of  his  official  duties."  Returns  were  also 
available  to  the  Department  of  Justice  for  use  in  litigation  in  which 
the  United  States  was  interested  in  the  result. 

The  regulations  allowing  general  inspection  of  tax  returns  applied  to 
a  few  specific  agencies  and  provided  that  the  agency  in  question  could 
obtain  tax  returns  for  given  purposes.  Under  these  regulations,  the 
agency  in  question  did  not  have  to  specify  the  reason  for  inspection, 
the  person  who  would  inspect,  etc.  The  amount  of  information  disclosed 
under  these  regulations  varied  with  the  agency.  In  some  cases  dis- 
closure occurred  with  respect  to  several  thousand  returns  a  year  and 
in  other  cases  (involving  use  for  statistical  purposes)  disclosure  of 
limited  amounts  of  information  regarding  million -,  of  taxpayers 
occurred  each  year.^ 

ReasoTis  for  change 

The  IRS  probably  has  more  information  about  more  people  than 
any  other  agency  in  this  country.  Consequently,  almost  every  other 
agency  that  has  a  need  for  information  about  U.S.  citizens  sought  it 
from  the  IRS.  However,  in  many  cases  the  Congress  had  not  spe- 
cifically considered  whether  the  agencies  which  had  access  to  tax  in- 
formation should  have  had  that  access. 

The  statutory  rules  governing  the  disclosure  of  tax  information 
had  not  been  reviewed  by  the  Congress  for  40  years.  Since  that  time 
a  number  of  rules  allowing  disclosure  of  tax  information  to  other 
government  agencies  had  been  established  by  executive  order  and 
regulation. 

Additionally,  questions  recently  arose  with  respect  to  disclosure  of 
tax  information  to  the  White  House.  Apparently,  tax  information  had 
been  obtained  by  the  White  House  pertaining  to  a  number  of  well 
known  individuals  for  use  for  non-tax  purposes.  Also,  tax  returns  had 
been  provided  White  House  employees  in  previous  administrations. 

Questions  were  raised  and  substantial  controversy  created  as  to 
whether  the  extent  of  actual  and  potential  disclosure  of  returns 
and  return  information  to  other  Federal  and  State  agencies  for  non- 
tax purposes  breached  a  reasonable  expectation  of  privacy  on  the  part 
of  the  American  citizen  with  respect  to  such  information.  This,  in 
turn,  raised  the  question  of  whether  the  public's  reaction  to  this  possi- 
ble abuse  of  privacy  would  seriously  impair  the  effectiveness  of  our 
country's  very  successful  voluntary  assessment  system,  which  is  the 
mainstay  of  the  Federal  tax  system. 

In  a  more  general  sense,  questions  were  raised  with  respect  to 
whether  tax  returns  and  tax  information  should  be  used  for  any  pur- 
poses other  than  tax  administration. 


s  Under  the  peneral  Inspection  regulations,  tax  Information  was  obtained  by  the 
Department  of  Health,  Education,  and  Welfare  to  administer  title  II  (old  aee.  etc. 
benefits)  of  the  Social  Securltv  Act  (Rep;s.  §  301.6103(a)-100)  ;  by  the  Securities  and 
Exchange  Commission  for  statistical  purposes  (Regs.  §  301.6103 (a)-102)  ;  by  the  Advi- 
sory Commission  on  Intergovernmental  Relations  for  studying  the  coordination  and 
simplification  of  the  tax  laws  (Regs.  §  301.6103(a)-103)  ;  by  the  Department  of  Com- 
merce and  the  Renegotiation  Board  "In  the  Interest  of  the  Internal  management  of  the 
government"  (Regs.  $  301.6103 (a)-104.  105);  and  bv  the  Federal  Traf^e  Commission 
to  aid  In  carrying  out  the  Federal  Trade  Commission  Act  (Regs,  g  301.fil03(a)-106). 
Also,  the  regulations  provided  that  standing  committees  of  Congress  could  obtain  tax 
information  as  authorized  by  executive  order  and  resolution  of  the  committee  (Regs, 
|301.6103(a)-101). 


315 

Recent  Congressional  action  with  respect  to  privacy  in  general  has 
had  an  impact  on  the  disclosure  of  tax  information.  (Privacy  Act  of 
1974,  Public  Law  93-579).  However,  the  Congress  did  not  specifically 
focus  on  the  unique  aspects  of  tax  returns  in  the  Privacy  Act. 

The  Congress  reviewed  each  of  the  areas  in  which  returns  and  re- 
turn information  were  subject  to  disclosure.  With  respect  to  each 
of  these  areas,  the  Congress  strove  to  balance  the  particular  office  or 
agency's  need  for  the  information  involved  with  the  citizen's  right  to 
privacy  and  the  related  impact  of  the  disclosure  upon  the  continuation 
of  compliance  with  our  country's  voluntarj'  tax  assessment  system. 

Although  prior  law  describes  income  tax  returns  as  "public  records" 
open  to  inspection  under  regulations  approved  by  the  President  or 
under  Presidential  order,  the  Congress  felt  that  returns  and  return 
information  should  generally  be  treated  as  confidential  and  not  sub- 
ject to  disclosure  except  in  those  limited  situations  delineated  in  the 
newly  amended  section  6103  where  it  was  determined  that  disclosure 
was  warranted. 

Explanation  of  provision 

The  Act  provides  that  as  the  general  rule  returns  and  return  in- 
formation are  to  be  confidential  and  not  subject  to  disclosure  except 
as  specifically  provided  in  section  6103  or  other  sections  of  the  Code. 
Only  those  regulations  now  in  effect  and  subsequently  promulgated  by 
the  Secretary  which  interpret  a  specific  provision  of  section  6103  are 
to  continue  to  have  force  and  effect  after  the  effective  date  of  this  sec- 
tion of  the  Act.  Consequently,  those  regulations  promulgated  under 
Presidential  authority  prior  to  the  effective  date  of  this  section  of  the 
Act  which  do  not  interpret  any  specific  provision  of  this  section  are  no 
longer  to  have  any  force  and  effect  after  the  effective  date  of  this 
section  of  this  Act. 

Under  the  Act,  section  6103  applies  to  the  disclosure  of  a  "return" 
or  "return  information."  "Return"  is  defined  to  mean  any  tax  or  in- 
formation return,  declaration  of  estimated  tax  or  claim  for  refund 
which,  under  the  Code,  is  required  (or  permitted)  to  be  filed  on  behalf 
of,  or  with  respect  to,  any  person.  It  also  includes  any  amendment,  sup- 
plemental schedule  or  attachment  filed  with  the  tax  return,  informa- 
tion return,  etc.  However,  a  "written  determination"  (as  defined  under 
section  6110(b) )  which  is  included  with  or  attached  to  a  return  filed 
by  a  taxpayer  is  not  to  be  considered  a  return. 

The  term  "return  information"  is  to  include  the  following  data  per- 
taining to  a  taxpayer :  his  identity,  the  nature,  source  or  amount  of  his 
income,  payments,  receipts,  deductions,  exemptions,  credits,  assets,  lia- 
bilities, net  worth,  tax  liability,  tax  withheld,  deficiencies,  overassess- 
ments  and  tax  payments.  It  also  includes  any  particular  of  any  data, 
received  by,  recorded  by,  prepared  by,  furnished  to,  or  collected  by  the 
IRS  with  respect  to  a  return  filed  by  the  taxpayer  or  with  respect  to 
the  determination  of  the  existence,  or  possible  existence,  of  liability 
(including  the  amount  of  liability)  for  any  tax,  penalty,  interest,  fine, 
forfeiture,  or  other  imposition,  or  offense  provided  for  under  the  Code. 
A  summary  of  data  contained  in  a  return  would  constitute  return  in- 
formation. Information  as  to  whether  a  taxpayer's  return  was,  is  being, 
or  will  be  examined  or  subject  to  other  investigation  or  i:)rocessing  is 
also  to  be  considered  return  information.  Return  information  is  to 


316 

include  any  part  of  any  "written  determination  or  any  background 
file  document  relating  to  such  written  determination"  (as  these  terms 
are  defined  in  section  6110(b) )  which  is  not  open  to  public  inspection 
under  section  6110. 

Return  information  is  not  to  include  data  in  a  form  which  cannot 
be  associated  with,  or  otherwise  identify,  directly  or  indirectly,  a  par- 
ticular taxpayer.  Thus,  statistical  studies  and  other  compilations  of 
data  now  prepared  by  the  IRS  and  disclosed  by  it  to  outside  parties 
will  continue  to  be  subject  to  disclosure  to  the  extent  allowed  under 
prior  law.  Thus,  for  research  purposes,  the  IRS  can  continue  to  release 
statistical  studies  and  compilations  of  data,  such  as  the  tax  model, 
which  do  not  identify  individual  taxpayers.  The  definition  of  "return 
information"  was  intended  to  neither  enhance  nor  diminish  access  now 
obtainable  under  the  Freedom  of  Information  Act  to  statistical  studies 
and  compilations  of  data  by  the  IRS.  Thus,  the  addition  by  the  IRS 
of  easilj'  deletable  identifying  information  to  the  type  of  statistical 
study  or  compilation  of  data  which,  under  its  current  practice,  has 
been  subject  to  disclosure,  will  not  prevent  disclosure  of  such  study  or 
compilation  under  the  newly  amended  section  6103.  In  such  an  instance, 
the  identifying  information  would  be  deleted  and  disclosure  of  the 
statistical  study  or  compilation  of  data  could  be  made. 

"Taxpayer  return  information"  is  return  information  wliich  is  filed 
with  or  furnished  to  the  IRS  by  or  on  behalf  of  the  taxpayer  to  whom 
the  return  information  relates.  This  includes,  for  example,  data  sup- 
plied by  a  taxpayer's  representative  (e.g.,  his  accountant)  to  the  IRS 
in  connection  with  an  audit  of  his  return.  It  would  also  include  any 
data  received  by  the  IRS  from  a  taxpayer's  representative  pursuant  to 
an  administrative  summons  which  was  issued  in  connection  with  an 
IRS  civil  or  criminal  tax  investigation  of  the  taxpayer.  It  would  not 
include  "taxpayer  identity",  defined  below,  where  the  taxpaj^er  iden- 
tity was  received  from  a  source  other  than  the  taxpayer  or  his  rep- 
resentative; this  would  be  the  case  notwithstanding  that  the  same 
taxpayer  identity  data  was  also  furnished  by  the  taxpayer  or  his 
representative. 

The  term  "taxpayer  identity"  means  the  name  of  a  person  with 
respect  to  whom  a  return  is  filed,  his  mailing  address,  and  his  taxpaver 
identifying  number  (as  defined  in  section  6109),  or  a  combination 
thereof. 

The  term  "disclosure"  means  the  making  known  to  any  person  in 
any  manner  whatever,  including  inspection,  a  return  or  return  infor- 
mation. The  terms  "inspected"  and  "inspection"  mean  any  examination 
of  a  return  or  return  information. 

b.  Disclosure  to  Congress 

Prior  law 
Under  prior  law,  congressional  committees  fell  into  three  categories 
for  disclosure  purposes.  The  tax  committees  inspected  tax  information 
in  executive  session.  Select  committees  of  the  House  and  Senate  in- 
spected tax  information,  in  executive  session  if  specifically  authorized 
to  do  so  by  a  resolution  of  the  appropriate  body.  Standing  and  select 
committees  inspected  tax  information  under  an  executive  order  issued 
by  the  President  for  the  committee  in  question  and  on  the  adoption 


317 

of  a  resolution  (by  the  full  committee)  authorizing  inspection.  The 
resolution  was  required  to  set  out  the  names  and  addresses  of  the  tax- 
payers in  question  and  the  periods  covered  by  the  returns  to  be  in- 
spected. Subcommittees  inspected  tax  information  under  an  executive 
order  and  resolution  of  the  full  committee.  The  designated  agents  of 
any  authorized  committee  also  inspected  tax  information. 

Under  prior  lave,  the  tax  committees  and  select  committees  author- 
ized to  inspect  tax  information  were  permitted  to  submit  "any  relevant 
or  useful"  information  obtained  to  the  House  or  Senate. 

Reasons  for  change 
While  the  Congress,  particularly  its  tax-writing  committees,  re- 
quires access  in  certain  instances  to  returns  and  return  ijiformation  in 
order  to  carry  out  its  legislative  responsibilities,  it  was  decided  that  the 
Congress  could  continue  to  meet  these  responsibilities  under  more 
restrictive  disclosure  rules  than  those  provided  mider  prior  law. 

Explanation  of  provision 

Under  the  Act,  the  House  Committee  on  Ways  and  ]Means,  the  Sen- 
ate Committee  on  Finance,  and  the  Joint  Committee  on  Taxation,  upon 
written  request  of  their  respective  chairmen,  would  continue  to  have 
access  to  returns  and  return  information.  However,  returns  and  return 
information  would  be  required  to  be  received  in  a  closed  executive 
session  unless  the  returns  and  return  information  would  not  identify  a 
taxpayer  or  that  taxpayer  consented  in  writing  to  the  disclosure  of 
his  identity. 

The  Chief  of  Staff  of  the  Joint  Committee  on  Taxation  is  to  have 
access  to  returns  and  return  information  without  first  obtain- 
ing a  delegation  of  that  authority  from  the  Joint  Committee  on  Taxa- 
tion. The  Chief  of  Staff  is  to  have  the  right  to  submit  any  relevant  or 
useful  information  to  any  of  the  tax-writing  committees,  but  only  in 
closed  executive  session  unless  the  returns  and  return  information 
would  not  identify  a  taxpayer  or  that  taxpayer  consented  in  writing 
to  the  disclosure  of  his  identity. 

The  nontax  committees  are  to  be  furnished  returns  and  return  in- 
formation in  closed  executive  session  upon  (1)  a  committee  action 
approving  the  decision  to  request  such  returns,  (2)  an  authorizing 
resolution  of  the  House  or  Senate,  as  the  case  may  be,  and  (3)  the 
written  request  by  the  Chairman  of  the  committee  on  behalf  of  the 
committee  for  disclosure  of  the  returns  or  return  information.  The 
resolution  of  the  appropriate  body  authorizing  these  committees  to 
obtain  returns  or  return  information  would  specify  the  purpose  for 
inspection  and  that  inspection  w^as  to  be  made  only  if  there  was  no 
alternative  source  of  information  reasonably  available  to  the  commit- 
tee. The  committees,  through  the  committee  Chairman  and  ranking 
minority  member,  could  designate  no  more  than  4  agents  (2  majority 
and  2  minority)  to  inspect  the  returns  or  return  information  requested. 

The  tax-writing  committees  could  submit  relevant  return  informa- 
tion to  the  Senate  or  House,  as  the  case  may  be.  The  nontax-writing 
committees  could  submit  such  return  information  to  the  Senate  or 
House  sitting  in  closed  executive  session. 

The  Joint  Committee  on  Taxation  could  submit  tax  information  to 
the  Committee  on  Ways  and  Means  or  to  the  Committee  on  Finance 


318 

sitting  in  closed  executive  session.  However,  a  closed  executive  session 
would  not  be  required  if  a  taxpayer  were  not  identified  or  if  the  tax- 
payer consented  in  writing  to  the  disclosure  of  his  identity. 

c.  White  House  (and  other  Federal  Agencies) 

Prior  law 

The  Code  did  not  specifically  provide  for  disclosure  of  tax  returns 
or  return  information  to  the  President.  However,  the  Code  did  provide 
that  disclosure  could  be  made  as  authorized  in  rules  and  regulations 
established  by  the  President.  Under  this  provision,  the  President  could 
issue  a  "rule  or  regulation"  providing  for  his  access,  and  that  of  White 
House  employees,  to  tax  information.  Additionally,  in  a  previous 
administration,  the  then-Chief  Counsel  of  the  IRS  informed  the  Com- 
missioner in  a  legal  opinion  that,  as  a  constitutional  matter,  there  were 
no  restrictions  on  the  Commissioner  disclosing  tax  information  to  the 
President.  This  interpretation  was  based  on  that  part  of  the  Constitu- 
tion which  vests  executive  power  in  the  President  and,  on  this  basis, 
it  was  contended  that  he  was  entitled  to  all  information  relative  to  his 
control  of  the  Executive  Branch. 

Under  Executive  Order  11805,  September  20, 1974,  tax  returns  were 
available  for  inspection  by  the  President.  Requests  for  inspection  were 
to  be  in  writing  and  signed  by  the  President  personally.  Requests  were 
to  state  the  name  and  address  of  the  taxpayer  in  question,  the  kind 
of  returns  which  were  to  be  inspected,  and  taxable  periods  covered 
by  the  returns. 

Under  this  executive  order,  other  White  House  employees  also  could 
obtain  tax  infonnation.  The  order  provided  that  the  President  could 
designate,  by  name,  employees  of  the  White  House  Office  who  could 
receive  tax  information.  This  was  limited  to  employees  with  an  annual 
rate  of  basic  pay  at  least  equal  to  that  prescribed  by  5  U.S.C.  §  5316.  No 
further  disclosure  (except  to  the  President)  could  be  made  by  such 
employees  without  the  written  direction  of  the  President. 

Reasons  for  change 
The  President  needs  certain  tax  information,  particularly  (if  not 
entirely)  in  the  "tax  check"  area.  The  Act,  to  a  large  extent,  codifies 
Executive  Order  11805,  which,  among  other  things,  restricts  access  to 
tax  information  to  a  relatively  limited  number  of  people  in  the  White 
House.  Moreover,  the  Congress  felt  that  the  White  House  should 
report  to  the  Congress  regarding  the  disclosures  of  tax  information 
made  to  it.  Consequently,  quarterly  reporting  requirements  were  im- 
posed upon  the  White  House.  Similar  requirements  were  also  provided 
with  respect  to  tax  checks  made  by  other  Federal  agencies. 

Explanation  of  provision 
Under  the  Act,  upon  the  written  request  of  the  President,  signed  by 
him  personally,  disclosure  of  returns  and  return  information  is  to  be 
made  to  the  President  and/or  to  certain  employees  of  the  White  House 
Office  named  in  the  request.  A  request  is  to  specify  the  name  and  ad- 
dress of  the  taxpayer  whose  return  is  sought,  the  kind  of  return  and 
return  information  sought,  the  taxable  period  or  periods  of  such 
returns  and  return  information,  and  the  reason  disclosure  is  requested. 


319 

The  President  and  the  head  of  a  Federal  agency  (and  desig- 
nated employees)  also  may  make  a  written  request  for  a  "tax  check" 
with  respect  to  an  individual  who  is  designated  as  being  under  consid- 
eration for  appointment  to  a  position  in  the  Executive  or  Judicial 
Branch  of  the  Federal  Government.  The  "tax  check"  is  limited  to  the 
inquiry  as  to  whether  an  individual  has  filed  income  tax  returns  for  the 
last  3  years,  has  failed  in  the  current  or  preceding  3  years  to  pay  any 
tax  within  10  days  after  notice  and  demand,  has  been  assessed  a  negli- 
gence penalty  within  this  time  period,  has  been  or  is  under  any  crim- 
inal tax  investigation  (and  the  results  of  such  investigation),  or  has 
been  assessed  a  civil  penalty  for  tax  fraud.  Within  3  days  of  the  receipt 
of  a  tax  check  request,  the  IRS  is  to  notify  the  individual  who  is  the 
subject  of  the  tax  check  of  the  identity  of  the  requesting  party  (i.e., 
the  White  House  or  Federal  agency  involved)  and  the  return 
information  requested. 

Disclosure  of  returns  and  return  information  under  this  provision 
is  not  to  be  made  to  any  employee  of  the  White  House  or  Federal 
agency  (other  than  personnel  of  the  FBI  when  acting  as  agents  for 
the  White  House  or  the  Federal  agency  or  necessary  clerical  personnel 
of  the  White  House  or  agency)  who  does  not  earn  the  rate  of  com- 
pensation specified  by  section  5316  of  title  5,  United  States  Code. 
Moreover,  these  employees  will  not  be  allowed  to  disclose  returns  and 
return  information  to  any  other  person  except  the  President  or  the 
head  of  the  agency,  as  the  case  may  be,  without  the  personal  written 
direction  of  the  President  or  the  head  of  the  agency. 

The  President  and  the  head  of  any  agency  requesting  returns  and 
return  information  under  this  section  will  be  required  to  file  a  report 
with  the  Joint  Committee  on  Taxation  within  30  days  after  the  close  of 
each  calendar  quarter.  This  report  is  to  set  forth  the  taxpayers  with 
respect  to  whom  the  requests  were  made,  the  returns  or  return  informa- 
tion involved,  and  the  reasons  for  requesting  such  returns  or  return 
information.  However,  the  President  will  not  be  required  to  report 
on  requests  for  returns  and  return  information  pertaining  to  an  indi- 
vidual who  was  an  employee  of  the  Executive  Branch  at  the  time  the 
request  was  made.  The  reports  will  not  be  disclosed  unless  the  Joint 
Committee  on  Taxation  determines  that  disclosure  of  such  reports  (or 
parts  of  the  reports)  would  be  in  the  national  interest.  Thus,  if  the 
Joint  Committee  on  Taxation  determined  that  the  A^^iite  House  or 
any  Federal  agency  used  the  return  or  return  information  obtained 
under  this  section  for  improper  political  purposes,  it  would  have  the 
authority  to  make  a  report  of  this  to  the  Congress. 

The  reports  will  be  maintained  by  the  Joint  Committee  on  Taxation 
for  a  period  not  exceeding  2  years  unless,  within  that  period  of  time, 
it  determined  that  a  disclosure  to  the  Congress  was  necessar3\ 

d.  Tax  Cases 

Prior  law 
Where  the  Justice  Department  was  investigating  a  possible  viola- 
tion of  the  civil  or  criminal  tax  laws  and  the  matter  had  not  been 
referred  by  the  IRS,  a  Justice  Department  attorney  or  U.S.  Attorney 
could  obtain  tax  information  upon  written  application  where  it  was 
"necessary  in  the  performance  of  his  official  duties." 


320 

The  Justice  Department  could  obtain  the  returns  of  potential  wit- 
nesses and  third  parties.  Also,  in  a  tax  case  (as  well  as  any  other 
case),  the  IRS  would  answer  an  inquiry  from  the  Justice  Department 
as  to  whether  a  prospective  juror  had  been  investigated  by  the  IRS. 
However,  other  tax  information  was  not  made  available  for  examining 
prospective  jurors. 

Tax  information  obtained  by  the  Justice  Department  was  subject 
to  use  in  proceedings  conducted  by  or  before  any  department  or  es- 
tablishment of  the  Federal  Government  or  in  which  the  United  States 
was  a  party. 

Tax  returns  obtained  by  the  Justice  Department  generally  pertained 
to  the  taxpayer  whose  civil  or  criminal  tax  liability  was  directly  in- 
volved in  the  case.  However,  the  Justice  Department  also  obtained 
tax  returns  of  potential  witnesses  for  the  taxpayer  or  Government  and 
third  parties  with  whom  the  taxpayer  had  had  some  transactional  or 
other  relationship. 

The  returns  of  witnesses  generally  were  obtained  for  purposes  of 
cross  examination  and  impeachment.  In  many  cases,  the  information 
obtained  from  the  witness'  tax  return  was  used  to  cast  doubt  upon  his 
credibility  as  a  witness,  as  opposed  to  establishing  the  tax  liability  in 
issue. 

Additionally,  in  the  course  of  tax  cases,  the  Justice  Department 
obtained  the  returns  of  third  parties  who  were  not  to  be  witnesses  in  the 
case,  but  who  had  a  transactional  relationship  with  the  taxpayer  in- 
volved in  the  case.  In  a  criminal  tax  case,  third-party  returns  were 
used  to  develop  leads  to  evidence  establishing  the  guilt  of  a  defend- 
ant. In  civil  tax  cases,  third-party  returns  were  used  to  develop  evi- 
dence pertaining  either  directly  to  the  tax  liability  of  a  taxpayer  or 
to  impeach  the  testimony  of  the  party  whose  tax  liability  was  at  issue 
(or  to  impeach  the  testimony  of  witnesses  testifying  on  his  behalf). 

The  Government  also  obtained  the  tax  returns  of  its  own  witnesses 
to  determine  the  veracity  of  their  proposed  testimony  and  their  credi- 
bility in  general. 

Reasons  for  change 
The  Justice  Department  must  have  continued  access  to  tax  returns 
and  return  inf  onnation  in  order  to  carry  out  its  statutory  responsibility 
in  the  civil  and  criminal  tax  areas.  While  the  Congress  decided  to  main- 
tain the  present  rules  pertaining  to  the  disclosure  of  returas  and  return 
information  of  the  taxpayer  whose  civil  and  criminal  tax  liability  is  at 
issue,  restrictions  were  imposed  in  certain  instances  at  the  pre-trial  and 
trial  levels  with  respect  to  the  use  of  third-party  returns  where,  after 
comparing  the  minimal  benefits  derived  from  the  standpoint  of  tax 
administration  to  the  potential  abuse  of  privacy,  it  was  concluded  that 
the  particular  disclosure  involved  was  unwarranted. 

Explanation  of  provision 
The  Justice  Department  is  to  continue  to  receive  returns  and  return 
information  with  respect  to  the  taxpayer  whose  civil  or  criminal  tax 
liability  is  at  issue.  The  return  or  return  information  of  a  third  party 
may  be  disclosed  to  the  Justice  Department  in  the  event  that  the  treat- 
ment of  an  item  reflected  on  his  return  is  or  may  be  relevant  to  the 
resolution  of  an  issue  of  the  taxpayer's  liability  under  the  Code.  Thus, 


321 

for  example,  the  returns  of  subchapter  S  corporations,  partnerships, 
estates  and  trusts  may  reflect  the  treatment  of  certain  it^ms  Avhich 
may  be  relevant  to  the  resolution  of  the  taxpayer's  liability  because 
of  some  relationship  (i.e.,  shareholder,  partner,  beneficiary)  of  the 
taxpayer  with  the  corporation,  partnership,  estate,  or  trust.  In  cases 
involving  the  assessment  of  a  penalty  upon  a  person  for  failure  to 
pay  withholding  taxes,  the  reflection  of  such  items  on  a  corporate 
return  such  as  wages  paid,  taxes  withheld,  and  the  corporate  oiRce 
held  by  the  person,  may  be  relevant  to  the  resolution  of  the  issue  of 
liability  for  the  penalty.  The  treatment  (or  absence  of  treatment)  of 
alleged  loans  and  gifts  on  a  return  may  also  be  relevant  to  the  resolu- 
tion of  the  issue  in  criminal  fraud  net  worth  cases. 

The  return  or  return  information  of  a  third  party  could  also  be 
disclosed  to  the  .Justice  Department  where  the  third  party's  return  or 
return  information  relates  or  may  relate  to  a  transaction  between  the 
third  party  and  the  taxpayer  whose  tax  liability  is  or  may  be  at  issue 
and  the  return  information  pertaining  to  that  transaction  may  affect 
the  resolution  of  an  issue  of  the  taxpayer's  liability.  For  example,  the 
treatment  on  a  buyer's  return  regarding  his  purchase  of  a  business 
would  be  relevant  to  the  seller's  tax  liability  resulting  from  the  sale  of 
the  business.  The  buyer  may  be  amortizing  Avhat  he  claims  to  be  "a 
covenant  not  to  compete,"  whereas  the  seller  may  be  claiming  capital 
gain  treatment  upon  the  alleged  sale  of  "goodwill." 

The  return  reflecting  the  compensation  paid  to  an  individual  by  an 
employer  other  than  the  taxpayer  whose  liability  is  at  issue  would  not 
meet  either  the  item  or  transaction  tests  described  above  in  a  reasonable 
compensation  case.  Thus,  for  example,  the  reflection  on  a  corporate 
return  of  the  compensation  paid  its  president  would  not  represent  an 
item  the  treatment  of  which  was  relevant  to  the  liability  of  an  un- 
related corporation  with  respect  to  the  deduction  it  claims  for  the 
salary  paid  its  president. 

In  section  482  cases  (involving  the  reallocation  of  profits  and  losses 
among  related  companies) ,  where  it  is  sometimes  necessary  to  deter- 
mine the  prices  paid  for  certain  services  and  products  at  arms-length 
between  unrelated  companies,  the  return  or  return  information  of  a 
company  which  was  unrelated  to  (and  not  transactionally  involved 
with)  the  taxpayer  company  would  not  be  disci osable  under  either 
the  item  or  transaction  tests  described  above. 

The  disclosure  of  a  third  party  return  in  a  tax  proceeding  (includ- 
ing the  U.S.  Tax  Court)  will  be  subject  to  the  same  item  and  transac- 
tional tests  described  above,  except  that  such  items  and  transactions 
must  have  a  direct  relationship  to  the  resolution  of  an  issue  of  the 
taxpayer's  liability. 

Only  such  part  or  parts  of  the  third  party's  return  or  return  in- 
formation which  reflects  the  item  or  transaction  will  be  subject  to 
disclosure  both  before  and  in  a  tax  proceeding.  Thus,  the  return  of  a 
third-party  witness  could  not  be  introduced  in  a  tax  proceeding  for 
purposes  of  discrediting  that  Avitness  except  on  the  item  and  transac- 
tional grounds  stated  above. 

In  those  cases  where  the  absence  of  the  reflection  of  an  item  or 
transaction  on  a  third  party's  return  is  or  may  be  related  (or  directly 
related  in  a  tax  proceeding)  to  the  resolution  of  an  issue,  the  IRS 


322 

would  not  be  authorized  to  disclose  the  return,  but  would  be  .tuthor- 
ized  to  verify  in  a  written  statement  the  absence  of  the  reflection  of 
the  item  or  transaction. 

The  Secretary  will  have  the  discretion  to  refuse  to  disclose  third 
party  return  information  for  purposes  of  use  in  a  tax  proceeding  if 
he  determines  that  the  disclosure  would  identify  a  confidential  in- 
formant or  seriously  impair  a  pending  civil  or  criminal  tax  investi- 
gation. 

Except  in  those  instances  where  a  tax  matter  was  referred  by  the 
IRS  to  the  Department  of  Justice,  and  tax  refund  cases  under  Sub- 
chapter B  of  Chapter  76,  the  Justice  Department  would  be  required 
to  make  a  written  request  (by  the  Attorney  General,  the  Deputy  At- 
torney General,  or  an  Assistant  Attorney  General)  for  the  inspection 
or  disclosure  of  returns  and  return  information,  setting  forth  the 
reasons  for  the  disclosure  or  inspection.  For  purposes  of  this  provi- 
sion, the  referral  of  a  tax  matter  by  the  IRS  to  the  Justice  Depart- 
ment would  include  those  disclosures  made  by  the  IRS  to  the  Justice 
Department  in  connection  with  the  necessary  solicitation  of  advice  and 
assistance  with  respect  to  a  case  prior  to  formal  referral  of  the  entire 
case  to  the  Justice  Department  for  defense,  prosecution,  or  other 
affirmative  action. 

In  tax  cases,  the  Justice  Department  will  be  allowed  to  inquire  of 
the  IRS  as  to  whether  a  prospective  juror  has  been  under  an  audit  or 
investigation  by  the  IRS.  The  IRS  will  onlv  be  allowed  to  respond 
affirmatively  or  negatively  to  that  inquiry.  The  taxpayer  whose  civil 
or  criminal  tax  liability  is  at  issue  (and  his  legal  representative)  in 
the  case  will  have  the  same  right  to  this  limited  disclosure. 

e.  Federal  Agencies — Nontax  Criminal  Cases 

Prior  law 

Under  Treasury  regulations,  a  U.S.  Attornev  or  an  attorney  of  the 
Justice  Department  could  obtain  tax  information  in  any  case  "where 
necessary  in  the  performance  of  his  official  duties."  This  was  obtained 
on  written  application,  giving  the  name  of  the  taxpayer,  the  kind  of 
tax  involved,  the  taxable  period  involved,  and  the  reason  inspection 
was  desired.  The  application  was  to  be  signed  by  the  U.S.  Attorney  in- 
volved or  by  the  Attorney  General,  Deputy  Attorney  General,  or  an 
Assistant  Attorney  General. 

Tax  information  obtained  by  the  Justice  Department  could  be  used 
in  proceedings  conducted  by  or  before  any  department  or  establish- 
ment of  the  Federal  Government  or  in  which  the  United  States  was 
a  party. 

The  IRS  also  answered  inquiries  from  the  Justice  Department  as 
to  whether  a  prospective  juror  had  been  investigated  by  the  IRS. 
However,  other  tax  information  was  not  available  for  examining  pro- 
spective jurors. 

Tax  information  obtained  in  Justice  Department  investigations  was 
used  in  prosecuting  criminal  offenses.  Thus,  requests  were  made  for 
tax  information  pertaining  to  the  defendant  and  to  defense  witnesses 
in  the  course  of  the  investigation,  at  the  pretrial  level,  and  sometimes 
during  the  trial.  The  returns  of  defense  witnesses  in  nontax  criminal 
trials  were  often  requested  to  obtain  information  for  cross-examina- 


323 

tion  and  impeachement  of  these  witnesses.  The  tax  returns  of  Govern- 
ment witnesses  were  also  obtained  in  order  to  evahuite  the  veracity  of 
their  proposed  testimony  as  well  as  to  evaluate  their  credibility  in 
general.  Tax  information  was  also  obtained  with  respect  to  third 
parties  who  had  some  transactional  or  other  relationship  with  the 
defendant  in  order  to  seek  investigative  leads. 

During  the  calendar  year  1975,  there  were  166  requests  for  tax  infor- 
mation by  strike  forces  (and  an  additional  62  by  the  Criminal  Divi- 
sion) of  the  Justice  Department.  The  strike  force  requests  concerned 
8,103  tax  returns  of  1,711  taxpayers. 

As  the  chief  law  enforcement  representatives  of  the  Attorney  Gen- 
eral within  their  respective  judicial  districts,  U.S.  Attorneys  are  re- 
sponsible for  investigating  and  prosecuting  persons  who  violate  the 
Federal  criminal  laws.  U.S.  Attorneys  have  used  tax  information  in 
investigating  and  prosecuting  criminal  activities.  In  calendar  year 
1975,  U.S.  Attorneys  made  1,350  disclosure  requests  for  tax  informa- 
tion. These  requests  pertained  to  17,678  tax  returns  of  4,330  taxpayers. 
It  appears  that  a  significant  proportion  of  the  requests  made  by 
U.S.  Attorneys  were  for  criminal  investigative  purposes.  Most  U.S. 
Attorney  tax  data  requests  for  investigative  purposes  pertained  to 
potential  "white  collar"  crimes  involving  some  form  of  corruption 
(e.g.,  bribery,  illegal  kickbacks)  or  "major  fraud"  (e.g.,  bank,  invest- 
ment, and  mail  frauds).  Ordinarily,  requests  for  tax  returns  were  not 
made  with  respect  to  crimes  of  violence  or  for  routine  misdemeanor 
cases. 

In  connection  with  the  enforcement  of  nontax  criminal  statutes 
(as  well  as  nontax  civil  statutes),  tax  information  was  made  avail- 
able to  each  executive  department  and  other  establishments  of  the 
Federal  Government  (e.g.,  SEC  and  FTC)  in  connection  with  matters 
officially  before  them,  on  the  written  request  of  the  head  of  the  agency. 
Tax  information  obtained  in  this  manner  could  be  used  as  evidence  in 
any  proceedings  before  any  "department  or  establishment"  of  the 
United  States  or  any  proceedings  in  which  the  United  States  was  a 
party. 

Reasons  for  change 

The  Congress  believes  that  the  American  citizen  is  compelled  by 
our  tax  laws  to  disclose  to  the  IRS  is  entitled  to  essentially  the  same 
degree  of  privacy  as  those  piivate  papers  maintained  in  his  home. 
Prior  law  and  practice  did  not  afford  him  that  protection — the  Justice 
Department  and  other  Federal  agencies,  as  a  practical  matter,  being 
able  to  obtain  that  information  for  nontax  purposes  almost  at  their 
sole  discretion. 

The  Congress  decided,  therefore,  that  the  Justice  Department  and 
any  other  Federal  agency  responsible  for  the  enforcement  of  a  non- 
tax criminal  law  should  be  required  to  obtain  court  approval  for  the 
inspection  of  a  taxpayer's  return  or  return  information.  The  court 
approval  procedure  would  not  be  required,  however,  with  respect  to 
information  Avhich  is  derived  from  a  source  other  than  the  taxpayer. 

Explanation  of  provision 
Under  the  Act,  disclosure  of  a  return  or  return  information  received 
from  a  taxpayer,  subject  to  one  exception  noted  below,  would  be  made 


324 

to  a  Federal  agency  for  nontax  criminal  purposes  only  upon  the  grant 
of  an  ex  'parte  order  by  a  Federal  district  court  judge.  The  order 
would  be  granted  upon  the  determination  of  the  judge  that  (1)  there 
is  reasonable  cause  to  believe,  based  upon  information  believed  to  be 
reliable,  that  a  specific  criminal  act  has  been  committed,  (2)  there  is 
reason  to  believe  that  the  return  or  return  information  is  probative 
evidence  of  a  matter  in  issue  related  to  the  commission  of  the  criminal 
act,  and  (3)  the  information  sought  to  be  disclosed  cannot  reasonably 
be  obtained  from  any  other  source.  Notwithstanding  that  the  infor- 
mation sought  can  be  reasonably  obtained  from  another  source,  the 
third  requirement  described  above  would  be  inapplicable  if  the  judge 
determined  that  the  return  or  return  information  sought  constitutes 
the  most  probative  evidence  of  a  matter  in  issue  relating  to  the  com- 
mission of  the  criminal  act. 

The  first  requirement  set  forth  above  ("reasonable  cause  .  .  .")  is 
intended  to  be  less  strict  than  the  "probable  cause"  standard  for  issuing 
a  search  warrant,  and  this  requirement  is  to  be  construed  according  to 
the  plain  meaning  of  the  words  involved.  The  term  "criminal  act"  in- 
cludes any  act  with  respect  to  which  the  criminal  penalty  provisions 
of  a  Federal  nontax  statute  (which  may  also  include  civil  penalty 
provisions)  would  apply. 

In  the  case  of  the  Justice  Department,  only  the  Attorney  General, 
the  Deputy  Attorney  General,  or  an  Assistant  Attorney  General  may 
authorize  an  application  for  an  order.  In  the  case  of  other  Federal 
agencies,  the  head  of  the  agency  would  be  required  to  authorize  an 
application. 

This  court  procedure  contemplates  an  in-cwmera  inspection  of  the 
return  or  return  information  by  the  judge  to  determine  whether  any 
part  or  parts  thereof  meet  these  requirements.  Only  the  part  or  parts  of 
the  return  or  return  information  determined  by  the  court  to  meet  these 
requirements  would  be  subject  to  disclosure.  In  this  regard,  the  more 
personal  the  information  involved  (for  example,  medical  and  psychi- 
atric information),  the  more  restrictive  the  court  is  to  be  in  allowing 
disclosure. 

In  the  event  that  the  Secretary  determines  that  a  disclosure  would 
identify  a  confidential  informant  or  seriously  impair  a  civil  or 
criminal  tax  investigation,  he  would  have  the  authority  to  withhold 
the  requested  return  or  return  information  from  the  court  order  pro- 
cedure described  above.  This  w'ould  be  accomplished  by  a  certification 
by  the  Secretary  to  the  court  of  this  determination.  Proper  implemen- 
tation of  this  provision  will  necessarily  involve  notification  of  the 
IRS  by  the  Justice  Department  or  other  agency  prior  to  seeking  the 
court  order  to  provide  the  IRS  with  the  opportunity  to  make  the 
determination. 

The  IRS  would  be  precluded  under  this  subsection  from  disclosing 
return  information  indicating  the  commission  of  a  crime  to  the  Justice 
Department  or  any  other  Federal  agency  where  the  return  information 
was  supplied  by  the  taxpayer  or  his  representative.  The  Justice  De- 
partment and  other  Federal  agencies  would  only  be  able  to  obtain  this 
information  through  the  court  approval  procedure  described  above. 

The  IRS  would  not,  however,  be  precluded  from  disclosing  to  the 
Justice  Department  or  any  other  Federal  agency  information  which  is 
received  from  sources  other  than  the  taxpayer  and  his  representatives. 


325 

It  is  contemplated  that  only  in  those  situations  where  the  information 
is  clearly  identified  and  segregable  as  being  from  sources  other  than 
the  taxpayer  would  disclosure  occur,  and  then,  only  in  those  instances 
where  the  information  indicates  the  possible  commission  of  a  nontax 
Federal  crime. 

All  such  information  is  to  be  supplied  in  writing  to  the  Justice  De- 
partment and  other  Federal  agencies  either  upon  the  initiation  of  the 
Commissioner  or  upon  the  written  request  of  such  agencies.  The  writ- 
ten request  would  specify  the  name  of  the  taxpayer,  the  kind  of  tax 
involved,  the  taxable  period  involved,  and  the  reasons  why  inspection 
is  desired. 

Once  the  Justice  Department  or  any  Federal  agency  has  received  a 
return  (or  parts  thereof)  or  return  information  pursuant  to  the  court 
order  procedure,  further  disclosure  in  an  administrative  hearing  or 
trial  relating  to  the  violation  of  a  nontax  criminal  law  would  not  be 
allowed  unless  there  is  a  showing  to  the  presiding  hearing  officer  or 
judge  that  the  return  (or  parts  thereof)  or  return  information  is 
probative  of  a  matter  in  issue  relevant  in  establishing  the  commission 
of  the  crime  or  the  guilt  of  a  party.  Thus,  a  return  (or  parts  thereof) 
or  return  information  would  not  be  admissible  for  purposes  of  "col- 
lateral impeachment",  i.e.,  discrediting  a  witness  on  matters  not  bear- 
ing upon  the  question  of  the  commission  of  the  crime  or  the  guilt  of  a 
party. 

As  with  the  initial  court  order  procedure,  the  Secretary  would  have 
the  authority  to  withhold  return  information  from  the  subsequent 
criminal  trial  or  hearing  upon  his  determination  that  the  disclosure 
would  identify  a  confidential  informant  or  seriously  impair  a  civil  or 
criminal  tax  investigation.  This  authority  would  apply  to  return  in- 
formation received  under  the  initial  court  order  procedure  and  to 
return  information  from  sources  other  than  the  taxpayer  furnished  by 
the  IRS  to  the  agency.  The  Secretary  would  notify  the  Attorney  Gen- 
eral or  the  head  of  the  agency  (or  their  delegates)  of  the  exercise  of 
this  authority. 

Admission  of  the  return  in  this  proceeding  would  not,  of  itself,  con- 
stitute reversible  error  in  the  event  of  an  appeal  of  the  criminal  trial 
court's  decision  in  the  nontax  criminal  case.  Thus,  while  the  admis- 
sion of  the  return  or  return  information  in  the  proceeding  would  not 
constitute  reversible  error  because  it  was  admitted  into  evidence  in 
violation  of  this  provision,  it  may  nevertheless  constitute  reversible 
error  on  other  grounds. 

By  this  Act,  the  Congress  does  not  intend  to  limit  the  right  of  an 
agency  (or  other  party)  to  obtain  returns  or  return  information  di- 
rectly from  the  taxpayer  through  the  applicable  discovery  procedures. 

f.  Nontax  Civil  Matters— Justice  Department  and  Other  Federal 
Agencies 

Prior  law 

Under  the  regulations,  a  U.S.  Attorney  or  an  attorney  of  the  Justice 
Department  could  obtain  tax  information  in  nontax  civil  cases  in  the 
same  manner  and  to  the  same  extent  as  in  nontax  criminal  cases. 

The  Justice  Department  used  tax  returns  in  suits  brought  against 
the  Government  seeking  money  damages  for  injury  or  wrongful  death. 


234-120   O  -  77  -  22 


326 

The  tax  information  was  used  in  these  cases  to  verify  the  claims  of 
loss  of  income,  and  also  to  determine,  through  claimed  medical  ex- 
pense deductions,  whether  the  plaintiff  had  suffered  other  injurie*' 
before  or  after  the  accident  in  question. 

Tax  information  was  also  used  in  suits  concerning  the  renegotiation 
of  Government  contracts,  where  the  Renegotiation  Board  had  made  a 
determination  that  excess  profits  were  earned  on  renegotiable  contracts. 
Here,  tax  information  was  used  to  verify  the  income  earned  on,  and  the 
costs  related  to,  the  contracts  in  question. 

Nontax  civil  cases  also  involve  affirmative  money  claims,  including 
civil  fraud  claims,  by  the  Government  against  various  private  parties. 
In  these  cases,  tax  information  was  used  to  determine  whether  the 
defendant  was  financially  able  to  pay  the  demand  contemplated  by 
the  Government. 

Tax  returns  were  also  requested  after  the  Government  had  obtained 
a  judgment  against  a  party  in  order  to  verify  statements  made  by  the 
judgment  debtor  as  to  his  financial  ability  to  make  payment  of  the 
debt  involved. 

Tax  information  was  also  made  available  to  each  executive  depart- 
ment and  other  establishments  of  the  Federal  Government  in  con- 
nection with  matters  officially  before  them.  Information  obtained 
could  be  used  as  evidence  in  proceedings  conducted  by  or  before  any 
Federal  agency  or  proceedings  to  which  the  United  States  was  a  party. 

Under  the  regulations,  tax  information  could  be  inspected  for  nontax 
administration  purposes  by  Treasury  employees  (who  were  not  in  the 
IRS)  on  the  written  request  of  the  head  of  the  appropriate  bureau 
or  office.  Also,  Customs,  Secret  Service,  and  other  Treasury  enforce- 
ment agents  could  obtain  limited  tax  information  on  their  own  request, 
without  the  request  of  the  head  of  their  office. 

Reasons  for  change 
The  current  use  by  the  Justice  Department  and  other  Federal  agen- 
cies in  the  nontax  civil  cases  described  above  were  not  warranted  in 
light  of  the  invasions  of  privacy  involved  and  the  fact  of  the  alterna- 
tive sources  of  information  available  to  the  Justice  Department  and 
other  agencies  in  these  situations.  However,  in  one  limited  instance, 
the  Congress  decided  that  disclosure  of  returns  and  return  informa- 
tion would  be  made  to  the  Justice  Department  in  those  cases  involving 
renegotiation  of  contracts  where  the  Justice  Department,  in  defending 
the  United  States  in  such  cases,  would  use  such  returns  and  return 
information  to  verify  the  income  earned  on  the  contracts  in  question. 

Explanation  of  provision 

Under  the  Act,  disclosure  of  returns  and  return  information  could 
be  made  to  the  Justice  Department  in  those  instances  where  it  was 
defending  the  United  States  in  a  suit  involving  a  renegotiation  of 
contracts  case  previously  determined  by  the  Renegotiation  Board. 

The  Act  would  not  permit  disclosure  to  Treasury  personnel  (other 
than  employees  of  the  IRS)  of  returns  or  return  information  for 
purposes  other  than  tax  administration  or  statistical  use. 

By  this  Act,  the  Congress  did  not  intend  to  limit  the  right  of 
an  agency  (or  other  party)  to  obtain  returns  or  return  informa- 
tion directly  from  the  taxpayer  through  the  applicable  discovery 
procedures. 


327 

g.  Statistical  Use 

Prior  law 

Under  prior  law,  several  agencies  obtained  information  from  tax 
returns  for  statistical  purposes.  Under  regulations  allowing  general 
inspection  of  tax  information,  the  Department  of  Commerce  (Census 
Bureau  and  Bureau  of  Economic  Analysis)  was  authorized  to  use  in- 
formation from  tax  returns  for  statistical  purposes  (Reg.  §  301.6103 
(a)-104).  The  Federal  Trade  Commission  (Reg.  §  301.6103 (a)-106) 
and  the  Securities  and  Exchange  Commission  (Reg.  §  301.6103(a)- 
102)  also  were  authorized  to  use  information  for  statistical  purposes. 

Census  Bureau. — The  most  extensive  user  of  tax  information  for 
statistical  purposes  has  been  the  Census  Bureau,  within  the  Depart- 
ment of  Commerce.*  In  most  cases  the  Census  Bureau  does  not  obtain 
the  full  tax  returns.  The  Bureau  uses  information  from  tax  returns  to 
assist  in  preparing  the  Economic  Indicators,  the  Survey  of  Minority- 
owned  Business  Enterprises,  and  the  Survey  of  County  Business  Pat- 
terns. The  Economic  Census  (conducted  every  five  years)  is  used  for  the 
Index  of  Industrial  Production  (of  the  Federal  Reserve  Board),  the 
Index  of  Wholesale  Prices  (of  the  Bureau  of  Labor  Statistics),  and 
the  Gross  National  Product  accounts.  The  Current  Economic  Indica- 
tors include  information  on  retail  sales,  manufacturers'  shipments, 
orders  and  inventories,  investment,  and  are  used  for  the  Index  of  In- 
dustrial Production  (Federal  Reserve  Board) .  These  statistics  are  used 
as  a  basis  for  national  economic  policy,  for  distributing  funds  by 
agencies,  by  State  and  local  governments  in  determining  their  pro- 
grams, and  by  private  business  in  forecasting,  marketing,  investment, 
etc. 

In  general,  these  statistics  are  not  based  on  data  from  tax  returns. 
Instead,  information  from  tax  returns  is  used  by  the  Census  Bureau 
to  prepare  lists  of  persons  to  be  surveyed  by  the  Bureau,  to  tabulate 
statistical  links  between  data  reported  by  the  IRS  and  the  Census  Bu- 
reau, to  excuse  smaller  firms  from  filing  reports  (by  using  data  from 
tax  returns  instead) ,  and  to  weed  out  firms  that  do  not  need  to  report. 

The  Census  Bureau  has  made  an  analysis  of  the  effect  of  not  allowing 
it  to  use  tax  data.  Generally,  the  Bureau  has  stated  that  the  effect  of 
entirely  prohibiting  it  from  having  access  to  information  from  tax 
returns  would  be  to  increase  significantly  the  costs  of  collecting  data 
and  to  decrease  significantly  the  quality  of  the  statistics  developed. 

The  Census  Bureau  also  uses  "relatively  small  samples  of  individual 
tax  records,"  on  a  case-by-case  basis,  to  compare  income  reported  in 
tax  returns  with  income  reported  in  the  census.  Similar  evaluation 
studies  are  used  by  the  Bureau  in  connection  with  surveys  such  as  the 
Current  Population  Survey. 

Information  from  tax  returns  is  also  used  by  the  Bureau  in  deter- 
mining amounts  to  be  allocated  under  revenue  sharing;  this  use  was 
specifically  contemplated  by  the  Congress  in  establishing  the  revenue 
sharing  program.  (See  General  Explanation  of  the  State  and  Local 

*  For  example,  in  1975.  the  following  Income  tax  return  records  were  transferred  to  the 
Census  Bureau  : 

1.  8.400.000  Business  Master  File  Entity  Change  Records  showing  employer  identifica- 
tion number  (BIN),  name,  address,  and  zip  code. 

2.  21,200,000  Forms  941  showing  BIN,  total  compensation,  FICA  wages,  taxable  tips, 
master  file  account,  tax  period,  and  address  change. 


328 

Fiscal  Assistance  Act,  H.R.  14370,  92nd  Congress,  Public  Law  92-512, 
page 39  (Feb.  12, 1973).) 

Bureau  of  Economic  Analysis. — The  Bureau  of  Economic  Analysis 
(BEA)  prepares  the  National  Income  Accounts,  including  the  Na- 
tional Income  and  Product  Accounts  focusing  on  GNP,  and  the  Bal- 
ance of  Payments  Accounts.  BEA  has  stated  that  a  major  input  into 
GNP  is  the  IRS  published  Statistics  of  Income  series.  However,  BEA 
has  also  stated  that  it  needs  access  to  a  sample  of  large  cor- 
poration's tax  returns  to  prepare  "industry  extrapolators,"  and  to 
be  able  to  distinguisli  changes  in  the  IRS  Statistics  of  Income  series 
that  occur  on  account  of  shifts  in  economic  development  from  changes 
that  occur  on  account  of  shifts  in  tax  reporting. 

BEA  obtains  tax  information  from  returns  of  large  corporations. 
It  does  not  obtain  tax  information  from  returns  of  individuals.  Gen- 
erally, BEA  employees  examine  IRS  transcript  cards  that  summarize 
information  from  500  to  1,000  returns  of  the  largest  corporations. 
(In  calendar  year  1974,  BEA  obtained  300  "transcript-edit  sheets" 
of  corporate  returns.)  BEA  employees  copy  data  from  these  cards 
and  also  inspect  20  to  100  tax  returns  over  the  course  of  a  year. 

Federal  Trade  Commission. — The  Federal  Trade  Commission 
obtains  tax  information  for  use  in  the  Industrial  and  Financial  Re- 
ports Program  and  the  Quarterly  Financial  Report  series.^  For 
the  most  part,  the  FTC  does  not  need  detailed  financial  information 
from  the  IRS.  It  does  not  use  information  about  individuals. 
The  FTC  uses  the  information  it  receives  to  develop  a  sample  of  cor- 
porations which  it  then  surveys.  To  develop  this  sample,  the  FTC 
needs  the  following  information :  name,  address,  EIN,  industry  code, 
sample  code,  and  gross  assets  indicator.  The  "industry  code"  tells  what 
the  principal  industrial  activity  of  the  corporation  is.  The  "sample 
code"  tells  the  sampling  process  used  by  the  IRS  with  respect  to  its 
Statistics  of  Income  (not  with  respect  to  audit,  etc.)  and  does  not  ap- 
pear to  be  tax  information.  A  gross  assets  indicator  would  tell,  e.g., 
whether  the  corporation  has  gross  assets  of  over  $10  million,  $5-$i0 
million,  $3-$5  million,  $l-$3  million,  or  less  than  $1  million.  Other 
infoi'mation,  such  as  the  accounting  period  and  the  consolidat-ed  return 
indicator,  are  helpful  to  the  FTC  in  developing  more  accurate  statis- 
tics but  are  not  basic  to  its  statistical  process. 

Securities  and  Exchange  Commissimi. — The  SEC  has  not  obtained 
tax  information  for  statistical  purposes  for  several  years,  since  the 
functions  for  which  the  SEC  required  this  information  were  moved 
to  the  Federal  Trade  Commission. 

Reasons  for  change 

Congress  recognizes  the  importance  to  other  Federal  agencies  to 

be  allowed  the  use  of  returns  and  return  information  in  connection 

with  certain  of  their  statistical  and  research  functions.  Since  there 

does  not  appear  to  be  any  real  likelihood  that  the  use  of  returns  and 


"  The  Federal  Trade  Commission  obtained   the  following  tax  information  in  1974  : 

1.  58.729  sneciallv  prepared  abstract  sheets  for  corporation  returns. 

2.  43,000  Forms  1120,  etc.,  including  name,  address,  EIN.  date  Incorporated,  gross 
receipts,  taxable  Income,  total  assets,  industry  code,  accounting  period,  and  name, 
address  and  EIN  of  consolidated  subsidiaries. 

.3.  31,000  abstracts  of  corporate  tax  returns  showing  name,  address,  zip  code,  EIN, 
date  incorporated,  gross  receipts,  taxable  income,  total  assets,  industry  code,  account- 
ing period,  and  name,  address,  and  EIN  of  consolidated  subsidiaries. 


329 

return  information  by  these  agencies  would,  under  the  procedures  and 
safeguards  provided  for  in  the  Act,  result  in  an  abuse  of  the  privacy 
or  other  rights  of  the  taxpayers  whose  returns  and  return  information 
are  used,  Congress  decided  that  the  use  of  returns  and  return  informa- 
tion should  be  available  for  statistical  use  by  certain  agencies  other 
than  the  IRS. 

Explanation  of  provision 

Under  the  Act,  the  Census  Bureau,  the  Bureau  of  Economic  Anal- 
ysis, and  the  Federal  Trade  Commission  can  obtain  tax  returns  and 
limited  tax  information  solely  for  statistical  and  research  purposes 
authorized  by  law,  but  only  such  tax  information  as  is  necessary  to 
carry  out  those  statistical  and  research  activities.  The  Federal  Trade 
Commission  and  the  Bureau  of  Economic  Analysis  will  only  be  entitled 
to  receive  corporate  tax  information. 

In  addition,  returns  and  return  information  will  be  open  to  inspec- 
tion by,  or  disclosure  to,  officers  and  employees  of  the  Department  of 
the  Treasury  (other  than  officers  and  employees  of  the  Internal  Reve- 
nue Service)  whose  official  duties  require  such  inspection  or  disclosure 
for  purposes  of  preparing  economic  or  financial  forecasts,  projections, 
analyses,  and  statistical  studies  and  conducting  related  activities.  In- 
spection or  disclosure  is  permitted  only  upon  a  written  request  setting 
forth  the  specific  reason  or  reasons  why  such  inspection  or  disclosure 
is  desired  and  signed  by  the  head  of  the  bureau  or  office  of  the  Depart- 
ment of  the  Treasury  requesting  the  inspection  or  disclosure. 

Treasury  regulations  are  to  specify  the  limited  types  of  tax  infor- 
mation (e.g.,  name,  address,  social  security  number,  gross  receipts, 
etc.)  which  may  be  supplied  to  each  agency  under  this  provision.  The 
publication  of  any  statistical  study  which  would  identify  any  particu- 
lar taxpayer  is  prohibited. 

h.  Other  Agencies — Inspection  on  a  General  Basis 

Prior  law 

Under  the  regulations,  several  agencies  could  generally  inspect  tax 
information  for  qualified  purposes  without  the  head  of  the  agency 
having  to  write  a  specific  request  to  the  IRS  identifying  the  taxpayer 
and  the  reason  for  the  desired  inspection.  Inspection  of  tax  informa- 
tion on  a  general  basis  was  made  most  often  by  the  Department  of 
Health,  Education,  and  Welfare,  the  Renegotiation  Board  and  the 
Federal  Trade  Commission. 

The  Department  of  Health,  Education,  and  Welfare  could  inspect 
individual  tax  returns  as  required  to  administer  Title  II  of  the  Social 
Security  Act  (old-age,  survivor,  etc.,  benefits).  Inspection  was  author- 
ized on  the  written  application  of  anv  authorized  officer  or  employee 
of  the  department.  (Reg.  §  301.6103 (a)-lOO.)  In  calendar  year  1974. 
the  Social  Security  Administration  was  furnished  6,633  returns  for 
administering  Title  II  of  the  Social  Security  Act.  In  most  cases  tax 
data  were  requested  by  the  Social  Security  Administration  to  obtain 
evidence  of  earnings  so  that  an  individual's  entitlement  to  monthly 
benefits  could  be  properlv  determined.  This  information  could  be  used 
to  the  benefit  of  the  individual  or  to  the  benefit  of  the  government 
with  respect  to  determining  Social  Security  benefits.  In  addition,  27,- 
000,000  employment  tax  schedules  were  furnished  annually  to  the 


330 

Social  Security  Administration  for  purposes  of  administering  the 
Social  Security  Act. 

The  Renegotiation  Board  was  authorized  to  obtain  income  tax  in- 
formation "in  the  interest  of  the  internal  management  of  the  govern- 
ment." The  Renegotiation  Board  is  charged  with  administering  the 
laws  to  renegotiate  contracts  with  government  contractors  to  eliminate 
excess  profits.  (Reg.  §  301.6103 (a)-105.)  In  1974  the  Renegotiation 
Board  was  furnished  1,803  transcripts  (i.e.,  abstracts  of  corporation 
tax  returns),  including  information  on  the  taxpayer's  gross  receipts, 
taxable  income,  accounting  period,  identification  of  related  companies, 
etc.  The  Renegotiation  Board  used  tax  information  to  lielp  determine 
whether  excessive  profits  have  been  derived  from  negotiable  contracts 
and  related  subcontracts  made  with  the  United  States. 

The  Federal  Trade  Commission  was  authorized  to  oibtain  income  tax 
information  of  corporations  "as  an  aid  in  executing  the  powers  con- 
ferred upon  such  Commission  by  the  Federal  Trade  Commission  Act." 
Any  authorized  officer  or  employee  of  the  FTC  could  make  inspection. 
(Reg.  §  301.6103 (a)-106.) 

Reasons  for  change 
Congress  decided  that  in  many  situations  the  current  use  of  returns 
and  return  information  on  a  general  basis  is  not  warranted.  Congress 
decided  to  limit  strictly  the  types  of  returns  and  return  information 
which  will  be  made  available  to  other  agencies  on  a  general  basis  for 
purposes  other  than  tax  administration  or  statistical  use  and  the 
situations  in  which  they  'will  be  made  available.  Generally,  these  are 
situations  where  the  return  information  is  directly  related  to  pro- 
grams administered  by  the  agency  in  question. 

Explanation  of  provisions 

The  Act  permits  limited  disclosures  on  a  general  basis  (upon  writ- 
ten request)  to  the  Social  Security  Administration,  the  Railroad  Retire- 
ment Board,  the  Department  of  Labor,  the  Pension  Benefit  Guaranty 
Corporation  and  the  Renegotiation  Board  for  purposes  other  than  tax 
administration.  Under  this  provision,  disclosure  will  be  made  to  officers 
and  employees  of  the  receiving  agency  who  are  duly  authorized  and 
specifically  designated  in  writing  by  the  receiving  agency  to  receive  the 
returns  or  return  information.  Any  authorized  research  or  statistical 
project  conducted  by  these  agencies  which  involves  the  use  of  return 
information  will  not  be  subject  to  disclosure  by  them  in  a  form  which 
can  be  associated  with,  or  otherwise  identify,  directly  or  indirectly,  a 
particular  taxpayer. 

The  Act  permits  the  Social  Security  Administration  to  obtain  re- 
turns and  return  information  concerning  employment  taxes  for  pur- 
poses of  the  administration  of  the  civil  and  criminal  provisions  of  the 
Social  Security  Act.  Also,  the  Railroad  Retirement  Board  can  obtain 
returns  and  return  information  for  purposes  of  the  administration  of 
the  civil  and  criminal  provisions  of  the  Railroad  Retirement  Act.  The 
Internal  Revenue  Service  is  also  authorized  to  furnish  certain  returns 
and  limited  return  information  to  designated  officers  and  employees  of 
the  Department  of  Labor  and  the  Pension  Benefit  Guaranty  Corpora- 
tion for  purposes  of  the  administration  of  the  civil  and  criminal  pro- 
visions of  the  pension  reform  act  (the  Employees  Retirement  In- 
come Security  Act  of  1974).  In  addition,  as  provided  in  the  pension 


331 

reform  act,  copies  of  annual  registration  statements  of  employee  bene- 
fit plans  and  related  information  concerning  vested  benefits  of  em- 
ployees may  be  furnished  to  the  Social  Security  Administration. 

Under  the  Act,  the  Kenegotiation  Board  can,  upon  the  written 
request  of  its  chairman,  continue  to  receive  returns  and  return  informa- 
tion with  respect  to  the  income  tax  for  purposes  of  administering  the 
Renegotiation  Act.  The  returns  and  return  information  so  provided 
will  be  open  to  duly  authorized  and  specifically  designated  officers 
and  employees  of  the  Board  personally  and  directly  engaged  in,  and 
solely  for  their  use  in,  verifying  (,r  analyzing  financial  information 
required  by  the  Kenegotiation  Act  to  be  filed  with,  or  otherwise  dis- 
closed to  the  Board,  or  to  the  extent  necessary  to  implement  the  pro- 
vision in  the  Code  relating  to  the  mitigation  of  the  effect  of  the 
renegotiation  of  government  contracts  (sections  1481  and  1482). 
The  Renegotiation  Board,  through  its  chairman,  will  be  allowed 
to  disclose  these  returns  and  return  infoimation  to  the  Justice  Depart- 
ment upon  a  referral  of  one  of  its  casas  to  this  agency  for  further  legal 
action. 

i.  State  and  Local  Governments 

Prior  law 

On  the  written  request  of  the  State  governor,  individuals'  and  or- 
ganizations' tax  returns  could  be  inspected  by  State  tax  officials  for 
purposes  of  administering  the  State's  tax  laws.  At  the  governor's 
written  request,  tax  information  could  also  be  obtained  for  local  gov- 
ernments to  be  used  in  administering  their  tax  laws.  (Sec.  6103(b).) 
Income  tax  information  was  not  furnished  directly  by  the  IRS  to  local 
governments.  Instead,  State  tax  officials  furnished  such  information 
to  local  governments  where  the  IRS  had  approved  such  action  at  the 
request  of  the  governor. 

Under  the  regulations,  with  the  permission  of  the  Commissioner 
and  for  purposes  of  State  tax  administration,  a  State  was  allowed  to 
inspect  on  a  general  basis  all  income,  estate,  and  gift  tax  returns  filed 
in  the  district  in  which  the  State  is  located.  The  same  was  true  for 
other  types  of  returns  such  as  estate  tax  and  gift  tax  returns.  Addi- 
tionally, the  specifically  identified  returns  of  taxpayers  who  filed  with- 
in the  relevant  district,  and  of  taxpayers  who  filed  in  districts  not  in- 
cluding the  State  in  question,  could  be  inspected  on  a  case-by-case 
basis  on  the  written  request  of  the  State  governor. 

On  request,  the  Commissioner  could  allow  each  State  to  inspect  on  a 
general  basis  all  tax  returns  filed  by  residents  of  the  State.  The  ability 
to  inspect  returns  under  this  procedure  applied  to  the  physical  inspec- 
tion of  the  documents  in  question. 

The  States  could  also  enter  into  tax  coordination  agreements  with 
the  IRS  with  respect  to  inspection  of  tax  information.  These  agree- 
ments generally  provided  for  cooperation  between  the  IRS  and  the 
States  in  tax  administration,  for  an  exchange  of  tax  information,  for 
assistance  in  locating  delinquent  taxpayers  (and  their  property),  and 
for  cooperative  audits;  the  agreements  also  provided  for  preserving 
the  confidentiality  of  tax  information.^ 


«  A  State  was  not  precluded  from  Inspecting  tax  information  if  it  had  not  entered  into  an 
agreement. 


332 

By  far  the  largest  IRS/State  information  exchange  program,  in 
terms  of  amounts  of  information  transferred,  was  the  furnishing  of 
Federal  tax  information  on  magnetic  tape.  In  1975,  48  States  (plus  the 
District  of  Columbia,  American  Samoa,  Guam,  and  Puerto  Rico)  par- 
ticipated in  this  program.  Under  the  1975  Individual  Master  File 
(IMF)  program,  information  on  nearly  66  million  taxpayers  was  pro- 
vided to  the  States.  (This  covered  approximately  80  percent  of  individ- 
ual taxpayer  records.)  IMF  tax  data  available  to  the  States  included 
name,  address,  social  security  number,  filing  status,  tax  period,  exemp- 
tions claimed,  wages  and  salaries,  adjusted  gross  income,  interest  in- 
come, taxable  dividends,  total  tax,  and  audit  adjustment  amount.  Un- 
der the  tape  exchange  programs,  the  States  agreed  to  conduct  a  joint 
review  with  the  IRS  of  safeguards  of  tax  information. 

A  Business  Master  File  (BMF)  program  was  also  available  to  the 
States  to  aid  them  in  establishing  their  own  business  master  files. 
Information  from  the  Exempt  Organization  Master  File  was  also 
available  to  the  States,  as  was  gift  tax  data. 

Under  the  cooperative  audit  program,  copies  of  examination  reports 
were  furnished  the  States.  In  1974,  nearly  700,000  abstracts  of  these 
reports  were  furnished  the  States.  Also,  the  IRS  furnishes  the  States 
information  on  returns  that  appear  to  have  good  audit  potential  but 
will  not  be  audited  by  IRS  because  of  manpower  restrictions.  In  1974, 
information  was  furnished  on  more  than  70,000  returns  under  this 
program. 

Reasons  for  change 

It  has  been  suggested  that  tax  information  that  is  supplied  to  tax 
officials  at  the  State  and  local  levels  may  not  always  be  subject  to 
appropriate  safeguards  on  confidentiality.  Also,  it  has  been  suggested 
that  political  considerations  may  produce  unwarrant-ed  interest  by 
State  and  local  governments  in  tax  information  for  nontax  purposes. 

IRS  studies  have  indicated  that  in  several  situations.  State  authori- 
ties have  allowed  other  States  (or  local  governments)  to  inspect  Fed- 
eral tax  information,  have  not  maintained  adequate  records  of  in- 
spection of  Federal  tax  information,  and  have  inadequate  procedures 
to  instruct  employees  with  respect  to  Federal  tax  return  confidenti- 
ality. However,  it  is  understood  that  when  these  problems  have  been 
brought  to  the  attention  of  the  State  authorities  involved,  remedial 
action  has  been  taken. 

Congress  feels  that  it  is  important  that  the  States  continue  to  have 
access  to  Federal  tax  information  for  tax  administration  purposes. 
With  Federal  tax  information,  the  States  are  able  to  determine  if 
there  are  discrepancies  between  the  State  and  Federal  returns  in,  e.g., 
reported  income.  Also,  many  States  have  only  a  few.  if  any,  of  their 
own  tax  auditors  and  rely  largely  (or  entirely)  on  Federal'tax  infor- 
mation in  enforcing  their  own  tax  laws. 

Explanation  of  provision 
The  Act  authorizes,  upon  the  written  request  of  th'>  principal  tax 
official  of  the  State  (other  than  the  governor),  the  disclosure  of  in- 
come, estate,  gift,  social  security  (FICA),  unemployment  (FUTA), 
self -employment  (SECA) ,  withholding,  alcohol,  tobacco,  and  highway 
use  tax  returns  and  return  information  solely  for  the  pui-pose  of,  and 


333 

only  to  the  extent  necessary  in,  the  administration  of  the  State's  tax 
laws.  It  is  intended  that  regulations  be  issued  specifying  the  manner 
in  which  and  the  conditions  under  which  returns  and  return  informa- 
tion would  be  disclosed  to  State  tax  officials.  The  Act  also  authorizes 
disclosures  of  this  Federal  tax  data  to  the  legal  representative  of  the 
State  tax  agency  for  purposes  of  administering  State  tax  laws.  Con- 
gress intended  that  the  statutory  relevancy  tests  applicable  to  access 
to  Federal  tax  data  by  the  Justice  Department  in  a  Federal  tax  in- 
vestigation or  in  preparing  for  Federal  tax  litigation  be  applicable 
to  disclosures  to  the  State  tax  agency's  legal  representative. 

The  returns  and  return  information  will  only  be  open  to  inspection 
by  or  disclosure  to  those  duly  authorized  representatives  of  a  State 
agency,  body,  or  commission  charged  with  the  responsibility  of  the 
administration  of  State  tax  laws  who  are  designated  in  the  written  re- 
quest as  the  individuals  who  are  to  inspect  or  receive  the  returns  or 
return  information  on  behalf  of  the  agency,  body,  or  commission.  The 
returns  and  return  information  so  disclosed  will  not  be  available  to 
the  State  governor  or  any  other  nontax  personnel.  The  prohibition 
against  disclosure  of  Federal  returns  and  return  information  to  the 
State  governor  will  apply  even  in  those  situations  where  the  gover- 
nor, under  State  law,  is  considered  to  be  the  principal  tax  official  of 
the  State. 

The  general  authority  provided  to  the  IRS  by  the  Act  (see  the  dis- 
cussion below  of  Procedures  and  Safeguards)  to  require  recipients  of 
Federal  returns  and  return  information  to  maintain  adequate  proce- 
dures for  safeguarding  the  Federal  returns  and  return  information  also 
applies  with  respect  to  the  States.  Thus,  the  IRS  is  authorized  to  take 
such  steps  as  it  considers  necessary,  including  the  withholding  of  fur- 
ther Federal  returns  and  return  information  (subject  to  the  adminis- 
trative appeal  procedure ;  see  Safeguards  below) ,  in  the  event  the  State 
did  not  maintain  adequate  safeguards  for,  or  in  the  event  of  unauthor-' 
ized  disclosures  of,  Federal  returns  and  return  information.  It  is  in- 
tended that  this  authority  should  be  broadly  construed  to  cover  dis- 
closures of,  and  the  failure  to  maintain  adequate  safeguards  for,  State 
returns  and  return  information  or  other  information,  to  the  extent 
disclosures  of  such  information  might  indirectly  jeopardize  the  con- 
fidentiality of  the  Federal  return  or  return  information  furnished  to 
the  States. 

No  disclosure  may  be  made  to  any  State  that  requires  taxpayers  to 
attach  to,  or  include  in.  State  tax  returns  a  copy  of  any  portion  of  the 
Federal  return  (or  any  information  reflected  on  the  Federal  return) 
unless  the  State  adopts  provisions  of  law  by  December  31.  1978,  pro- 
tecting the  confidentiality  of  the  attached  copies  of  the  Federal  re- 
turns and  the  included  return  information.  Although  the  copies  of 
the  Federal  returns  or  the  return  information  required  by  a  State  or 
local  government  to  be  attached  to,  or  included  in,  the  State  or  local 
return  do  not  constitute  Federal  "returns  or  return  information"  sub- 
ject to  the  Federal  confidentiality  rules,  the  policy  underlying  this 
requirement  is  that  the  attached  copy  of  the  return  and  the  included 
information  should  be  treated  bv  State  and  local  governments  as  con- 
fidential rather  than  effectively  as  public  information.  However,  it  is 
not  intended  that  States  be  required  to  enact  confidentiality  statutes 


334 

which  are  copies  of  the  Federal  statutes.  Thus,  State  tax  authorities 
can  disclose  State  returns  and  return  information,  including  any  por- 
tion of  tlie  Federal  return  (or  information  reflected  on  the  Federal 
return)  which  the  State  requires  the  taxpayer  to  attach  to,  or  to  in- 
clude in,  his  State  tax  return,  to  any  State  or  local  officers  or  em- 
ployees whose  official  duties  or  responsibilities  require  access  to  such 
State  return  or  return  information  pursuant  to  specific  laws  of  that 
State. 

In  order  to  protect  the  confidentiality  of  returns  which  the  States 
receive  from  the  IRS  under  the  present  exchange  programs,  the  re- 
turns are,  in  most  States,  processed  on  computers  used  solely  by  the 
State  tax  authorities.  In  certain  States,  however,  the  requirements  of 
the  tax  authorities  are  not  sufficient  to  justify  a  separate  computer, 
and,  accordingly,  the  tax  authorities  have  the  Federal  tax  returns 
processed  on  central  computers  shared  by  several  State  agencies  which 
are  operated  by  State  employees  who  are  not  in  the  tax  department. 
In  such  situations,  the  IRS  requires  that  tax  department  personnel 
be  present  at  all  times  when  the  Federal  tax  returns  are  being  proc- 
essed. The  Act  permits  time-sharing  with  other  State  agencies  so  to 
the  extent  authorized  and  under  the  conditions  specified  in  Treasury 
regulations. 

The  Act  does  not  permit  the  disclosure  of  Federal  returns  and  re- 
turn information  (other  than  information  with  respect  to  tax  return 
preparers  as  described  below)  to  local  tax  authorities,  either  directly 
by  the  IRS  or  indirectly  by  the  State  tax  authorities.  However,  Con- 
gress does  not  intend  by  this  decision  to  limit  the  disclosure  by  State 
tax  officials  to  local  tax  authorities  of  State  tax  returns  and  return 
information.  For  this  purpose,  State  return  information  which  may 
be  disclosed  to  local  tax  authorities  includes  information  resulting 
from  tax  audits  and  investigations  conducted  by  State  tax  authorities, 
even  where  that  information  is  based  on  or  is  substantially  similar  to 
Federal  return  information  supplied  or  made  available  to  the  State 
tax  authorities.  It  is  not,  of  course,  permissible  for  State  tax  officials 
merely  to  transcribe  Federal  return  information,  designate  it  as  State 
tax  information,  and  furnish  it  to  local  tax  authorities  as  information 
resulting  from  a  State  tax  audit  investigation.  Moreover,  under  the 
general  authority  of  the  IRS  to  require  States  to  maintain  adequate 
procedures  for  safeguarding  Federal  returns  and  return  information, 
the  IRS  may  take  such  steps  as  it  considers  necessary,  including  with- 
holding Federal  returns  and  return  information  from  the  States,  in 
any  situation  where  it  finds  that  disclosures  of.  or  the  failure  to  main- 
tain adequate  safegards  for,  such  State  return  information  furnished 
to  local  tax  authorities  may  have  the  result  of  jeopardizing  the  con- 
fidentiality of  the  Federal  return  information. 

In  those  States  electing  piggvbacking  under  section  6361  of  the  Code. 
Congress  intends  State  tax  administration  to  include  the  activities  of 
State  tax  authorities  in  conducting  supplemental  audits,  however 
limited  in  scope  and  authority.  Thus,  to  the  extent  that  State  tax  au- 
thorities in  States  electing  pigg^'backing  can,  consistent  with  section 
6361,  conduct  supplemental  audits  directed  towards  increasincf  State 
tax  revenues  (whether  by  rpferrinir  the  informat'on  gathered  in  the 
audits  to  the  IRS  for  final  action,  by  auditing  under  the  supervision  of 


335 

the  IRS,  or  through  some  other  approach),  disclosure  of  Federal  re- 
turns and  return  information  to  those  State  tax  authorities  generally 
will  be  required  under  section  6103(d) . 

In  addition,  taxpayer  identity  information  (name,  mailing  address, 
and  taxpayer  identifying  number)  of  any  tax  return  preparer  (as  de- 
fined in  section  7701(a)  (36) )  may  be  disclosed  to  any  State  or  local 
agency,  body,  or  commission  charged  with  licensing,  registration,  or 
regulation  of  tax  return  preparers.  The  fact  of  any  penalty  imposed 
on  a  tax  return  preparer  under  sections  6694,  6695,  or  7216  for  the 
unlawful  disclosure  or  use  of  tax  information  may  also  be  disclosed. 

As  in  the  case  of  returns  and  return  information  disclosed  to  other 
agencies,  the  unauthorized  disclosure  by  State  tax  officials  of  Federal 
returns  or  return  information  is  a  violation  of  Federal  law  subject  to 
civil  liability  and  criminal  penalties. 

Return  infonnation  will  not  be  disclosed  to  a  State  in  the  event  the 
Secretary  determined  that  the  disclosure  would  identify  a  confidential 
informant  or  seriously  impair  any  civil  or  criminal  tax  investigation. 

/.  Taxpayers  With  a  Material  Interest 

Prior  law 

Under  the  regulations,  income  tax  returns  were  open  to  the  filing 
taxpayer,  trust  beneficiaries,  partners,  heirs  of  the  decedent,  etc.  "Re- 
turn information",  as  opposed  to  the  tax  returns  themselves,  was  only 
available  to  the  taxpayer,  etc.,  at  the  discretion  of  the  IRS. 

Also,  the  statute  specifically  authorized  the  inspection  of  a  corpora- 
tion's income  tax  returns  by  a  holder  of  1  percent  or  more  of  the  cor- 
poration's stock.  (Sec.  6103(c).) 

Reasons  for  change 
Congress  decided  that  persons  with  a  material  interest  should  con- 
tinue to  have  the  right  to  inspect  returns  and,  where  appropriate,  re- 
turn   information    to    the    same    extent    as    provided    under    prior 
regulations. 

Explanation  of  provision 
Under  the  Act,  disclosure  can  be  made,  upon  written  request,  to 
the  filing  taxpayer,  either  spouse  who  filed  a  joint  return,  the  partners 
of  a  partnership,  the  shareholders  of  subchapter  S  corporations,  the 
administrator,  executor  or  trustee  of  an  estate  (and  the  heirs  of  the 
estate  with  a  material  interest  that  may  be  affected  by  the  informa- 
tion) ,  the  trustee  of  a  trust  (and  beneficiaries  with  a  material  interest) , 
persons  authorized  to  act  on  behalf  of  a  dissolved  corporation,  a  re- 
ceiver or  trustee  in  bankruptcy,  and  the  committee,  trustee  or  guardian 
of  an  incompetent  taxpayer.  The  provision  in  prior  law  authorizing 
a  one-percent  shareholder  to  inspect  a  corporation's  return  is  also 
retained.  Return  information  (in  contrast  to  "returns")  may  be  dis- 
closed to  persons  with  a  material  interest  only  to  the  extent  the  IRS 
determines  this  would  not  adversely  affect  the  administration  of  the 
tax  laws. 

k.  Miscellaneous  Disclosures 

Prior  law 
Under  prior  law,  several  provisions  of  the  regulations  allowed  dis- 
closure of  tax  information  for  miscellaneous  administrative  and  other 


336 

purposes.  For  example,  accepted  offers  in  compromise  (under  sec. 
7122)  were  open  to  inspection.  Internal  revenue  officers  could  disclose 
limited  information  to  verify  a  deduction,  etc.  Additionally,  in  a  num- 
ber of  cases,  tax  information  could  be  disclosed  at  the  discretion  of  the 
Commissioner,  as  the  statute  was  wholly  silent  with  respect  to  certain 
types  of  returns.  For  example,  FICA  tax  returns  were  within  this 
category. 

In  other  cases,  the  statute  specifically  required  public  disclosure  of 
certain  types  of  returns.  Under  the  Code,  applications  for  exempt 
status  by  organizations  and  applications  for  qualification  of  pension, 
etc.,  plans  were  generally  open  to  public  inspection.  (Sec.  6104(a).) 
Also,  the  annual  reports  of  private  foundations  were  open  to  public 
inspection.  (Sec.  6104(d).)  Returns  with  respect  to  the  taxes  on  gaso- 
line and  lubricating  oils  were  open  to  inspection  by  State  officials.  (Sec. 
4102.)  Under  certain  circumstances,  the  amount  of  an  outstanding  tax 
lien  could  be  disclosed.  ( Sec.  6323  ( f ) . ) 

Upon  inquiry,  the  IRS  was  required  to  disclose  whether  any  person 
had  filed  an  income  tax  return  for  the  year  in  question.  (Sec.  6103  (f) .) 
Inquiries  under  section  6103(f)  were  made  by,  among  others,  news 
media  and  commercial  concerns. 

Additionally,  the  IRS  sometimes  was  asked  to  provide  information 
concerning  a  taxpayer's  address.  Address  information  would  be  pro- 
vided to  State  or  local  officials  for  tax  administration  purposes,  to 
State  or  local  enforcement  officials  if  furnishing  the  information  would 
aid  in  Federal  special  enforcement  programs  {e.g.^  narcotics  pro- 
grams), to  Federal  agencies  in  general  to  assist  in  administering  their 
responsibilities  and  to  "educational  lending  institutions"  to  locate 
delinquent  borrowers  under  Federal  loan  guarantees.  Address  in- 
formation would  not,  however,  be  provided  to  commercial  concerns. 
Also,  address  information  was  provided  to  the  Federal  Parent  Locator 
Service  regarding  "absent  parents"  under  Public  Law  93-647  (section 
453  of  the  Social  Security  Act).  Address  information  also  could  be 
provided  individuals  in  emergency  situations. 

Under  prior  law,  the  GAO  did  not  have  independent  authority 
to  inspect  tax  returns.  It  did  have  access  to  tax  returns  when  it  audited 
IRS  operations  as  the  agent  of  the  Joint  Committee  on  Taxation. 

Reasons  for  change 
Congress  decided  that  it  was  necessary  to  allow  the  disclosure  of 
returns  and  return  information  in  certain  miscellaneous  situations. 
In  most  of  these  situations,  disclosure  was  permitted  under  prior  law. 
In  each  situation,  Congress  decided  either  that  the  returns  or  return 
information  should  be  public  as  a  matter  of  policy,  or  that  the  reasons 
for  the  limited  disclosures  involved  outweighed  any  possible  invasion 
of  the  taxpayer's  privacy  which  might  result  from  the  disclosure. 

Explanation  of  provision 
Returns  will  continue  to  be  open  to  public  inspection  in  those 
situations  where  public  disclosure  was  provided  for  in  prior  law 
under  section  6104.  This  includes  applications  for  exempt  status  by 
organizations,  applications  for  qualification  of  pension,  etc,  plans,  the 
annual  reports  of  private  foundations,  and  returns  filed  with  respect 


337 

to  the  excise  taxes  imposed  on  private  foundations  and  pension  plans 
(under  chapters  42  and  43) . 

Return  information  may  be  disclosed  to  members  of  the  general 
public  to  the  extent  necessary  to  permit  inspection  of  any  accepted 
offer-in-compromise  under  section  7122.  If  a  notice  of  lien  has  been 
filed  (pursuant  to  section  6323(f)),  the  amount  of  the  outstanding 
obligation  secured  by  the  lien  is  authorized  to  be  disclosed  to  any 
person  who  furnishes  satisfactory  written  evidence  that  he  has  a 
right  in  the  property  subject  to  such  lien  or  intends  to  obtain  a  right 
in  such  property.  Disclosures  to  foreign  governments  is  authorized 
to  the  extent  provided  for  in  tax  treaties. 

The  Act  authorizes  the  GAO  to  inspect  returns  and  return  informa- 
tion to  the  extent  necessary  in  conducting  an  audit  of  the  IRS  or  the 
Bureau  of  Alcohol,  Tobacco  and  Firearms  required  by  section  117  of 
the  Budget  and  Accounting  Procedures  Act  of  1950.  It  is  intended  that 
the  GAO  examine  returns  and  individual  tax  transactions  only  for 
the  purpose  of,  and  to  the  extent  necessary  to  serve  as  a  reasonable 
basis  for,  evaluating  the  effectiveness,  efficiency  and  economy  of  IRS 
operations  and  activities.  It  is  not  intended  that  the  GAO  would  super- 
impose its  judgment  upon  that  of  the  IRS  in  specific  tax  cases.  GAO 
is  to  notify  the  Joint  Committee  on  Taxation  in  writing  of  the  subject 
matter  of  the  planned  audit  and  any  plans  for  inspection  of  tax  re- 
turns. GAO  can  proceed  with  its  planned  audit  unless  the  Joint  Com- 
mittee, by  a  two-thirds  vote  of  its  members,  vetoes  the  GAO  audit  plan 
within  30  days  of  receiving  written  notice  of  the  proposed  audit  from 
GAO. 

The  Act  also  authorizes  the  GAO  to  review  and  evaluate  the  com- 
pliance by  the  Federal  and  State  agencies  which  have  received  returns 
and  return  information  from  the  IRS  with  the  requirements  regard- 
ing the  use  and  safeguarding  of  the  returns  and  return  information. 

Alcohol,  tobacco,  wagering  and  firearms  tax  information  may  be 
disclosed  pursuant  to  Treasury  regulations  to  Federal  agencies  that 
require  this  information  in  their  official  duties. 

The  Act  modifies  the  rules  for  the  disclosure  of  return  information 
to  the  Federal,  State  and  local  child  support  enforcement  offices  by 
providing  for  disclosure  of  certain  information  from  IRS  master  files. 
Disclosure  of  other  return  information  is  permitted  only  to  the  extent 
that  it  cannot  be  reasonably  obtained  from  another  source.  Congress 
did  not  intend,  however,  that  the  child  support  enforcement  agency 
be  authorized  to  disclose  Federal  return  information  to  third  parties 
or  in  litigation  relating  to  establishing  or  collecting  child  support 
obligations. 

The  Act  also  authorizes  the  IRS  to  disclose  to  other  Federal  agen- 
cies the  mailing  addresses  of  taxpayers  from  whom  the  agencies  are 
attempting  to  collect  a  claim  under  the  Federal  Claims  Collection  Act. 

The  Act  authorizes  the  IRS,  upon  written  request,  to  disclose  re- 
turns and  return  information  to  the  Privacy  Protection  Study  Com- 
mission, or  to  such  members,  officers,  or  employees  of  the  commission  as 
may  be  named  in  the  written  request,  to  the  extent,  and  for  such  pur- 
poses, as  provided  by  section  5  of  the  Privacy  Act  of  1974. 

The  IRS  is  authorized  to  disclose,  to  the  extent  necessary  for  pur- 
poses of  tax  administration,  returns  and  return  information  to  any 


338 

person  with  respect  to  his  performance  of  services  in  connection  with 
the  processing,  storage,  transmission,  or  reproduction  of  returns  and 
return  information  or  in  connection  with  the  programming,  main- 
tenance, repair,  testing,  and  procurement  of  equipment. 

Disclosures  to  the  press  and  other  media  are  permitted  for  purposes 
of  notifying  a  person  entitled  to  a  Federal  tax  refund  when,  after 
reasonable  time  and  effort,  the  IRS  is  unable  to  locate  the  person. 

The  IRS  is  authorized  to  disclose  relevant  returns  and  return  in- 
formation to  an  employee  (or  former  employee)  of  the  IRS  and  to 
his  attorney  in  an  adverse  proceeding  against  the  employee.  This  need 
for  limited  disclosures  arises,  for  example,  in  proceedings  brought 
against  the  employee  for  harassment  of  a  taxpayer. 

Disclosures,  as  necessary,  are  also  permitted  to  persons  (and  their 
legal  representatives)  whose  rights  to  practice  before  the  IRS  may  be 
affected  by  an  administrative  action  or  proceeding. 

Under  the  Act,  the  Secretary  may,  in  his  discretion  but  only  follow- 
ing approval  by  the  Joint  Committee  on  Taxation,  disclose,  as  he  con- 
siders advisable  for  purposes  of  tax  administration,  such  return  in- 
formation or  other  information  with  respect  to  anj^  specified  taxpayer 
to  the  extent  necessary  to  correct  a  misstotement  of  fact  published  or 
disclosed  with  respect  to  such  taxpayer's  return  or  dealing  with  the 
IRS. 

IRS  officials  and  employees  are  permitted,  if  no  reasonable  alterna- 
tive exists,  to  make  limited  disclosures  of  return  information  in  con- 
nection with  an  audit  or  investigation  to  the  extent  necessary  in  arriv- 
ing at  a  correct  determination  of  tax,  liability  for  tax,  or  the  amount 
to  be  collected,  or  otherwise  in  the  enforcement  of  any  provision  in  the 
Code.  In  certain  instances,  it  may  be  necessary  for  IRS  personnel,  in 
obtaining  information  with  respect  to  a  taxpayer  from  a  third  party, 
to  disclose  the  fact  that  the  request  for  information  is  in  connection 
with  an  audit  or  other  tax  mvestigation  of  the  taxpayer.  In  rare  and 
extraordinary  cases,  it  may  also  be  necessary  for  IRS  personnel  in 
obtaining  information  from  a  third  party  to  disclose  additional  return 
information,  such  as  the  manner  in  which  the  taxpayer  treated  on  his 
return  a  transaction  with  the  third  party.  Disclosures  under  this  provi- 
sion are  to  be  made  only  in  situations  and  under  conditions  specified 
in  the  regulations.  This  provision  is  not  intended  to  permit  disclosure 
which  would  not  have  been  permitted  under  prior  law. 

Certain  miscellaneous  disclosures  provided  for  in  prior  law  would 
no  longer  be  authorized.  For  instance,  the  provision  in  prior  law 
authorizing  the  IRS  to  disclose,  upon  inquiry,  whether  a  person  has 
filed  an  income  tax  return  for  a  particular  year,  is  repealed. 

/.  Procedures  and  Records  Concerning  Disclosure 

Prior  law 
Several  different  offices  of  the  IRS  had  responsibility  for  approving 
disclosure  of  tax  information  to  particular  agencies.  For  example, 
the  Disclosure  Staff  (National  Office)  dealt  with  case-by-case  requests 
for  tax  returns  by  other  Federal  agencies  while  the  Statistics  Division 
dealt  with  the  disclosure  of  information  to  Federal  agencies  (largely 
on  magnetic  tape)  to  be  used  for  statistical  purposes.  Additionally, 
the  Planning  and  Research  Division  dealt  with  disclosure  of  informa- 
tion on  magnetic  tape  to  the  States  while  the  Disclosure  Staff  dealt 
with  case-by-case  disclosure  to  the  States. 


339 

While  these  offices  negotiated  and  approved  disclosures  of  tax  in- 
formation, the  actual  transfer  of  the  information  generally  took  place 
in  other  offices,  such  as  the  Service  Centers,  District  Office,  Computer 
Center,  etc.  In  addition,  District  Directors  and  Service  Center  Direc- 
tors were  autliorized  to  approve  applications  for  certain  types  of  dis- 
closure, such  as  disclosure  to  persons  with  a  material  interest  in  the 
return,  or  disclosure  of  returns  of  the  taxpayer  (in  tax  cases)  to  U.S. 
attorneys. 

Although  the  IRS  maintained  records  concerning  disclosure,  it  is 
understood  that  the  type  of  records  maintained  were  not  standardized 
as  between,  e.g.^  Service  Centers,  and  that  the  IRS  did  not  maintain 
a  complete  inventory  of  records  so,  for  example,  it  could  not  determine 
what  had  been  disclosed  and  what  had  been  returned  or  destroyed. 

Under  the  Privacy  Act  of  1974  (P.L.  93-579),  each  Federal  agency 
is  to  account  for  disclosures  to  other  agencies,  noting  the  date,  nature, 
and  purpose  of  each  disclosure  and  the  name  and  address  of  the 
agency  to  which  disclosure  is  made.  This  rule  does  not  apply  to  dis- 
closures by  State  agencies.  The  accounting  is  designed  to  enable  the 
agency  to  inform  the  individual  concerned  of  disclosures  made  with 
respect  to  him. 

Reasons  for  change 
Recently,  there  have  been  reports  that  tax  information  was  improp- 
erly transferred  outside  the  IRS.  There  does  not  presently  appear 
to  be  a  standardized  system  of  accounting  for  disclosure  which  would 
permit  the  IRS  to  determine  what  information  has  been  transferred, 
for  what  purposes,  what  use  has  been  made  of  it,  and  whether  it  has 
been  destroyed,  returned,  etc.,  after  it  has  been  use.d.  Also,  studies  in- 
dicate that  in  several  situations,  inadequate  records  have  been  main- 
tained of  transfer  of  tax  information  to  the  various  Federal  agencies 
and  to  State  authorities  and  that  in  certain  instances  IRS  procedures 
have  not  been  properly  followed. 

ExpJ<ination  of  provision 

In  those  cases  in  which  disclosure  or  inspection  of  returns  and  return 
information  is  permitted  by  the  Act,  it  is  permitted  only  at  the  times, 
in  the  manner,  and  at  the  places  prescribed  by  the  IRS. 

It  is  intended  that,  to  the  extent  practical,  all  disclosures  of  return 
information  be  made  in  documentary  form  in  order  to  protect  the 
privacy  of  the  taxpayer  and  to  protect  the  IRS  personnel  making 
the  disclosure  from  subsequent  charges  that  information  was  improp- 
erly disclosed.  Disclosure  in  documentary  form  would  serve  to  pre- 
serve an  exact  record  of  the  information  disclosed  so  as  to  make  it 
possible  to  determine,  should  the  question  arise,  whether  an  unau- 
thorized disclosure  of  information  had  been  made.  Congress  recog- 
nizes, however,  that  it  may  not  be  possible  or  practical  in  every  in- 
stance for  return  information  to  be  disclosed  in  documentary  form 
{e.g.,  discussions  between  IRS  pereonnel  and  Justice  Department 
attorneys  with  respect  to  a  pending  tax  case  being  handled  by  the 
Justice  Department). 

The  Act  requires  the  IRS  to  maintain  a  standardized  system  of 
permanent  records  on  the  use  and  disclosure  of  returns  and  return 
information.  This  would  include  copies  of  all  requests  for  inspection  or 
disclosure  of  returns  or  return  information  and  a  record  of  all  inspec- 
tions and  disclosures  of  returns  and  return  information.  In  the  case  of 


340 

the  inspection  or  disclosure  of  documentary  information,  such  as  a 
return,  which  the  IRS  retains  in  some  form  in  its  records  either  per- 
manently or  for  a  substantial  period  {e.g.,  10  years),  the  record  of  the 
inspection  or  disclosure  would  include  an  identification  of  the  docu- 
ment, or  part  thereof,  disclosed  or  inspected.  In  the  case  of  inspections 
or  disclosures  of  documents  which  the  IRS  would  not  otherwise  retain 
for  a  substantial  period,  the  record  should  contain  a  copy  of  the 
document. 

The  recordkeeping  requirements  do  not  apply  in  certain  situations, 
including  disclosure  of  returns  and  return  information  open  to  the 
public  generally  (accepted  offers-in-compromise,  the  amounts  of  out- 
standing tax  liens,  information  returns  of  exempt  organizations,  etc.), 
disclosures  to  the  Treasury  or  the  Justice  Department  for  tax  adminis- 
tration and  litigation  purpose^s,  disclosures  to  persons  with  a  material 
interest,  disclosures  to  persons  upon  the  taxpayer's  written  consent, 
disclosures  to  the  media  of  taxpayer  identity  information  and 
disclosures  to  contractors  who  perform  processing,  storage,  transmis- 
sion, reproduction,  programming,  maintenance,  testing,  or  procure- 
ment of  equipment  services  for  the  IRS.  The  Act  also  makes  it  clear 
that  the  IRS  is  not  required  to  disclose  to  taxpayers  under  the  Privacy 
Act  any  disclosures  made  to  the  persons  and  agencies  with  respect  to 
which  the  recordkeeping  requirements  do  not  apply.  In  addition,  the 
Act  makes  it  clear  that  the  recordkeeping  requirements  of  the  Privacy 
Act  cannot  be  utilized  to  resolve  substantive  tax  disputes. 

The  Act  requires  the  IRS  to  establish  one  office  which  would  have 
the  responsibility  for  approving  all  inspections  and  disclosures  of  re- 
turns and  return  information.  However,  upon  approval  of  that  office, 
disclosure  of  tax  returns  may  be  made  by  district  offices  where  appro- 
priate and  to  the  extent  provided  for  in  regulations.  In  addition,  au- 
thority may  be  delegated  to  the  district  offices  on  a  general  basis  with 
respect  to  disclosures  or  inspections  of  returns  and  return  information 
open  to  the  public  generally. 

In  addition  to  the  recordkeeping  requirem.ents  imposed  on  the  IRS, 
the  Act  provides  that  each  Federal  and  State  agency  that  receives  tax 
information  is  required,  pursuant  to  Treasury  regulations,  to  maintain 
a  standardized  system  of  permanent  records  on  the  use  and  disclosure 
of  that  information.  Maintaining  such  records  is  a  prerequisite  to 
obtaining  and  continuing  to  receive  tax  information. 

m.  Safeguards 

Prior  laid 

Except  for  the  general  criminal  penalty  for  unauthorized  disclosure, 
the  tax  law  did  not  provide  rules  for  safeguarding  tax  information 
disclosed  bv  the  IRS  to  other  agencies.  However,  some  of  the  Agree- 
ments on  Coordination  of  Tax  Administration  entered  into  between 
the  Federal  Government  and  the  States  included  provisions  for  safe- 
guarding tax  information. 

The  Privacy  Act  requires  that  each  agency  establish  appropriate 
administrative,  technical,  and  physical  safeguards  to  secure  records 
on  individuals.  This  requirement  applies  to  each  Federal  agency  that 
maintains  a  "system  of  records."  This  provision  does  not  apply  to 
State  or  local  government  agencies  that  receive  Federal  tax  records. 


341 

The  IRS  has  no  authority  under  the  Privacy  Act  to  audit  the  safe- 
guards established  by  other  agencies,  or  to  stop  disclosure  to  other 
agencies  that  do  not  properly  maintain  safeguards. 

Reasons  for  change 
Congress  decided  that,  although  it  is  necessary  to  permit  the  dis- 
closure of  Federal  returns  and  return  information  to  other  Federal 
and  State  agencies  in  certain  situations  for  purposes  other  than  the 
administration  of  the  Federal  tax  laws,  no  such  disclosure  should  1^ 
made  unless  the  recipient  agency  complies  with  a  comprehensive  sys- 
tem of  administrative,  technical,  and  physical  safeguards  designed  to 
protect  the  confidentiality  of  the  returns  and  return  information  and 
to  make  certain  tliat  they  are  not  used  for  purposes  other  than  the 
purposes  for  which  they  were  disclosed. 

Explanation  of  provision 

The  Act  provides  that  no  tax  information  may  be  furnished  by  the 
IKS  to  another  agency  (including  commissions,  States,  etc.)  unless 
the  other  agency  establishes  procedures  satisfactory  to  the  IRS  for 
safeguarding  the  tax  information  it  receives.  Disclosure  of  tax  in- 
formation to  other  agencies  is  conditioned  on  the  recipient  maintain- 
ing a  secure  place  for  storing  the  information,  restricting  access  to 
the  information  to  people  whose  duty  requires  access  and  to  people 
to  whom  disclosure  can  be  made  under  the  law,  providing  other  safe- 
guards necessary  to  keeping  tlie  information  confidential,  and  return- 
ing or  destroying  the  information  when  the  agency  is  finished  with  it. 
The  Act  specifically  authorizes  regulations  allowing  the  IRS  to  carry 
out  these  provisions.  The  IRS  is  to  review,  on  a  regular  basis,  safe- 
guards established  by  other  agencies. 

If  there  are  any  unauthorized  disclosures  by  employees  of  the  other 
agency,  disclosure  of  tax  information  to  that  agency  may  be  discon- 
tinued until  the  IRS  is  satisfied  that  adequate  protective  measures 
have  been  taken  to  prevent  a  repetition  of  the  unauthorized  disclosure. 
In  addition,  the  IRS  may  terminate  disclosur*  to  any  agency  if  the 
IRS  determines  tliat  adequate  safeguards  are  not  being  maintained  by 
the  agency  in  question.  In  this  connection,  the  Act  requires  that  an 
administrative  procedure  be  established  by  regulations  under  which 
the  States  will,  under  appropriate  circumstances,  have  an  opportunity, 
prior  to  the  cut-off  of  returns  and  return  information,  to  contest  a 
preliminary  finding  by  the  IRS  of  inadequate  safeguards  or  unauthor- 
ized disclosures,  or  to  establish  that  steps  had  been  taken  which  would 
prevent  a  repetition  of  the  violation. 

The  authority  of  the  IRS  with  respect  to  safeguarding  the  confiden- 
tiality of  returns  and  return  information  furnished  to  other  agencies 
is  intended  to  be  sufficiently  broad  to  permit  the  IRS  to  take  such  steps, 
pursuant  to  regulations,  as  are  necessary  to  prevent  indirect  disclosures 
of  return  information.  Indirect  disclosures  might  include  disclosures 
by  recipient  agencies  of  information  received  by  the  agency  from 
sources  other  than  the  IRS  which  is  the  same  or  substantiallv  the  same 
as  return  information  furnished  to  that  agency  by  the  IRS,  where 
that  disclosure  would  conflict  with  the  congressional  policy  expressed 
by  this  amendment  of  protecting  the  confidentiality  of  returns  and 
return  information. 


234-120  O  -  77  -  23 


342 

n.  Reports  to  Congress 

Prior  law 
Beginning  in  1971  the  Joint  Committee  on  Taxation  received  from 
the  IRS  a  semi-annual  report  on  disclosure  of  tax  information. 

Reasons  for  change 
Because  the  use  of  returns  and  return  information  for  purposes 
other  than  tax  administration  resulted  in  serious  abuses  of  the  rights 
of  taxpayers  in  the  past,  and  because  the  potential  for  abuse  neces- 
sarily exists  in  any  situation  in  which  returns  and  return  informa- 
tion are  disclosed  by  the  IRS  to  other  Federal  agencies  and  the  States 
for  purposes  other  than  the  administration  of  the  Federal  tax  laws, 
Congress  believes  that  it  must  review  very  closely  the  use  of  returns 
and  return  information  and  the  extent  to  which  taxpayer  privacy  is 
being  protected.  In  order  to  permit  that  review,  Congress  decided  to 
require  that  the  IRS  make  certain  comprehensive  annual  reports  to  the 
Joint  Committee  as  to  the  use  of  returns  and  return  information. 

Explanation  of  provision 

Within  90  days  after  the  end  of  each  calendar  year,  the  IRS  is 
required  to  report  to  the  Joint  Committee  on  Taxation  on  all  requests 
(and  the  reasons  therefor)  received  for  inspection  or  disclosure  of 
returns  or  return  information.  The  report  is  not  to  include,  however, 
a  listing  of  any  requests  by  the  President  for  returns  or  return  in- 
formation with  respect  to  current  employees  of  the  Executive  Branch. 
The  report  will  be  confidential  unless  a  majority  of  the  members  of  the 
Joint  Committee  agree  by  record  vote  to  disclose  all  or  any  portion  of 
the  report.  The  report  is  to  include,  as  a  separate  section  which  will  be 
publicly  disclosed  in  all  oases,  a  listing  of  all  agencies  receiving  tax 
return  information,  the  number  of  cases  in  which  a  tax  return  or  tax 
return  information  was  disclosed  to  them  during  the  j^ear,  and  the 
general  purposes  for  which  the  requests  were  made. 

Included  in  the  report  to  the  Joint  Committee  will  be  a  listing  of 
all  requests  for  tax-checks  of  current  employees  of  the  Executive 
Branch  (other  than  such  requests  made  by  the  President),  and  all 
requests  for  tax-checks  made  by  the  President  or  the  head  of  a  Federal 
agency  with  respect  to  prospective  employees.  The  listing  is  to  set 
forth  the  reasons  for  each  request,  the  taxpayer  involved,  and  the 
particular  returns  and  return  information  disclosed.  This  portion  of 
the  report  will  also  be  confidential  and  is  not  to  be  disclosed  unless  the 
Joint  Committee  determines  that  disclosures  would  be  in  the  national 
interest. 

The  IRS  is  required  to  report  quarterly  to  the  Congressional  tax 
committees  on  the  procedures  established  for  maintaining  the  con- 
fidentiality of  tax  information  disclosed  outside  the  IRS,  on  the 
implementation  of  these  procedures,  and  on  any  problems  that  may 
develop  in  connection  with  these  procedures. 

o.  Enforcement 

Prior  law 
Unauthorized  disclosure  of  a  Federal  income  return,  or  financial 
information  appearing  on  an  income  return  (the  amount  or  source  of 
income,  profits,  losses,  expenditures,  or  any  particular  thereof,  set 


343 

forth  or  disclosed  in  any  income  return),  by  a  Federal  or  State  em- 
ployee was  a  misdemeanor  punishable  by  a  fine  of  up  to  $1,000,  or 
imprisonment  of  up  to  one  year,  or  both  (together  with  the  costs  of 
prosecution).  In  addition.  Federal  oiRcers  or  employees  were  to  be 
dismissed  from  office  or  discharged  from  employment.  It  was  also  a 
misdemeanor  (punishable  in  the  same  manner)  for  any  person  to  print 
or  publish  in  any  manner  not  provided  by  law  an  income  return  or 
financial  information  appearing  therein,  (Sec.  7213(a)  (1)  and  (2)  of 
the  Code:  see  also  18  U.S.C.  §  1905.) 

Shareholders  who  were  permitted  under  section  6103(c)  to  examine 
a  corporate  return  were  guilty  of  a  misdemeanor  (punishable  as 
above)  if  they  disclosed  in  any  manner  not  provided  by  law  the  amount 
of  any  income,  etc.,  shown  on  the  return. 

During  fiscal  years  1973-75,  the  IRS  conducted  investigations  con- 
cerning the  possible  improper  disclosure  of  confidential  information 
as  follows : 


Fiscal 

year- 

1973 

1974 

1975 

Investigations  conducted 

58 
9 
4 

103 
23 
2 

179 

Disciplinary  actions 

23 

Separations  from  employment - - 

5 

There  have  also  been  criminal  prosecutions 
confidential  tax  information,  as  follows : 

for  illegal  disclosure  of 

Fiscal 

year- 

1973 

1974 

1975 

Prosecution  referrals  

Prosecutions  declined 

8 
7 
1 

8 
5 
3 

4 
4 

Convictions 

0 

Two  of  the  four  people  convicted  were  IRS  employees  and  two  were 
private  detectives.  The  two  IRS  employees  were  given  probation  (and 
one  was  fined  $350).  The  two  private  detectives  were  each  fined  $250, 
placed  on  two-year  probation,  and  jailed  for  short  periods  of  time  (i.e, 
24  hours  over  a  period  of  two  days). 

Reasons  for  change 
Congress  decided  that  the  prior  provisions  of  law  dasigned  to  en- 
force the  rules  against  the  improper  use  or  disclosure  of  returns  and 
return  information  were  inadequate.  Congress  decided  that  the  crimi- 
nal penalties  for  an  unauthorized  disclosure  should  be  increased  and 
that  the  situations  to  which  they  apply  should  be  broadened  to  cover 
all  situations  in  which  returns  and  return  information  are  treated 
as  confidential.  It  was  the  opinion  of  Congress  that  in  situations  where 
an  unauthorized  disclosure  is  made  to  a  person  in  exchange  for  an 
offer  by  that  person  of  something  of  material  value,  that  the  person 
actively  soliciting  the  unauthorized  disclosure  is  at  least  equally  re- 
sponsible as  the  person  making  the  disclosure  and  thus  should  be  sub- 
ject to  the  same  punishment.  Congress  also  decided  that,  in  order  to 


344 

redress  any  injury  sustained  and  to  aid  in  the  enforcement  of  the  con- 
fidentiality rules,  a  civil  action  for  damages  should  be  provided  to  any 
person  injured  by  a  willful  or  negligent  disclosure  in  violation  of  the 
Act. 

Explanation  of  provision 

Under  the  Act,  a  criminal  violation  of  the  disclosure  rules  is  a  felony 
rather  than  a  misdemeanor.  The  criminal  penalties  for  an  unauthorized 
disclosure  of  a  return  or  return  information  are  increased  to  a  fine  of 
up  to  $5,000  (instead  of  $1,000)  and  up  to  five  years  imprisonment 
(mstead  of  one  year),  or  both.  Under  prior  law,  criminal  prosecutions 
for  unauthorized  disclosures  were  undertaken  only  where  the  indi- 
vidual made  the  disclosure  knowing  it  to  be  unauthorized.  Congress 
intended  for  this  prosecutorial  standard  to  be  continued,  particularly 
in  view  of  the  increase  of  the  penalty  for  unauthorized  disclosure 
from  a  misdemeanor  to  a  felony. 

The  unauthorized  disclosures  with  respect  to  which  the  criminal 
penalties  apply  are  expanded  beyond  those  subject  to  criminal  penalties 
under  prior  law.  The  penalties  apply  to  any  unauthorized  disclosure 
of  any  return  or  return  information ;  they  do  not,  as  under  prior  law, 
apply  solely  to  unauthorized  disclosures  of  income  returns  and  financial 
information  appearing  on  income  returns.  As  under  prior  law,  the 
criminal  penalties  apply  to  unlawful  disclosures  by  any  Federal  of- 
ficers or  employee,  by  any  officer,  employee,  or  agent  or  any  State 
or  political  subdivision,  or  by  any  one-percent  shareholder  allowed  to 
inspect  the  returns  of  a  corporation.  In  addition,  the  criminal  sanc- 
tions apply  to  former  Federal  and  State  officers  and  to  officers  and 
employees  of  contractors  having  access  to  returns  and  return  informa- 
tion in  connection  with  the  processing,  storage,  transmission,  and  re- 
production of  such  returns  and  return  information,  and  the  program- 
ming, maintenance,  etc.,  of  equipment.  The  criminal  penalties  also 
apply  to  any  person  who  prints  or  publishes  any  return  or  return 
information  which  he  knows  was  disclosed  to  him  in  violation  of  the 
law  (as  contrasted  with  prior  law  under  which  the  criminal  penalties 
only  applied  to  the  unauthorized  printing  or  publishing  of  income 
returns  or  certain  financial  information  appearing  thereon). 

The  Act  also  makes  it  a  felony,  subject  to  the  same  penalties,  for 
any  person  willfully  to  receive  returns  or  return  information  as  the 
result  of  a  solicitation  of  the  returns  or  return  information.  The  crimi- 
nal penalties  only  apply  if  the  person  making  the  solicitation  knows 
that  the  disclosure  to  him  of  the  returns  or  return  information  is 
unlawful.  For  this  purpose,  a  solicitation  means  an  offer  to  exchange 
an  item  of  material  value  in  return  for  the  unauthorized  disclosure 
of  the  returns  or  return  information.  Thus,  the  criminal  penalties  do 
not  apply  to  the  receipt  of  returns  or  return  information  as  the  result 
of  a  request  if  the  person  making  the  request  does  not  offer  to  exchange 
an  item  of  material  value  for  the  disclosure,  even  where  that  person 
knows  that  the  disclosure  to  him  is  in  violation  of  the  law. 

Congress  also  decided  to  establish  a  civil  remedy  for  any  taxpayer 
damaged  by  an  unlawful  disclosure  of  returns  or  return  information. 
The  cause  of  action  extends  to  any  disclosure  of  return  or  return  in- 
formation which  is  made  in  violation  of  section  6103.  Under  the  Act, 
any  person  who  willfully  or  negligently  discloses  returns  or  return 
information  in  violation  of  the  law  is  liable  to  any  taxpayer  for  actual 


345 

damages  sustained  plus  court  costs.  Punitive  damages  are  also  author- 
ized in  situations  where  the  unlawful  disclosure  is  willful  or  is  the 
result  of  gross  negligence.  Because  of  the  difficulty  in  establishing  in 
monetary  terms  the  damages  sustained  by  a  taxpayer  as  the  result  of 
the  invasion  of  his  privacy  caused  by  an  unlawful  disclosure  of  his 
returns  or  return  information,  the  Act  provides  that  these  damages 
are,  in  no  event,  to  be  less  than  liquidated  damages  of  $1,000  for  each 
disclosure.  Congress  does  not  intend  that  a  disclosure  of  returns  or 
return  information  made  pursuant  to  a  good  faith,  but  erroneous,  in- 
terpretation of  the  confidentiality  rules  w^ould  constitute  an  actionable 
disclosure.  Instead,  disclosures  which  would  give  rise  to  civil  liability 
are  limited  to  those  situations  where  the  unauthorized  disclosure  re- 
sults from  a  willful  or  negligent  failure  of  the  person  to  comply  with 
the  procedures  and  safeguards  provided  for  in  the  Act  and  in  regula- 
tions interpreting  the  Act. 

Eifective  date 
This  provision  applies  to  disclosures  of  tax  returns  and  tax  return  in- 
formation made  after  December  31,  1976.  With  respect  to  disclosures 
by  the  IRS  of  returns  and  return  information  to  Federal  agencies  un- 
der prior  law,  Congress  intended  that  such  recipient  Federal  agencies 
be  permitted,  with  one  exception,  to  use  such  returns  and  return  infor- 
mation for  purposes  specifically  authorized  by  prior  law.  The  excep- 
tion to  this  rule  is  the  use  of  the  returns  and  return  information  in 
administrative  or  judicial  proceedings.  In  such  cases,  the  statutory 
limitations  on  such  use  imposed  bj'^  the  Act  are  to  be  applicable  on  and 
after  January  1, 1977. 

3.  Income  Tax  Return  Preparers  (sec.  1203  of  the  Act  and  sees. 
6060, 6103, 6107, 6109, 6503-6504, 6511, 6694-96, 7407-08, 7427-28, 
and  7701  of  the  Code) 

Prior  law 

The  Internal  Revenue  Code  formerly  contained  few  provisions 
which  related  to  the  conduct  of  persons  who  prepare  the  tax  returns  of 
other  persons  for  a  fee.  The  tax  return  forms  generally  required  that 
any  person  preparing  a  return  for  another  person  sign  the  return,  but 
the  law  provided  no  penalty  in  cases  of  failure  to  sign.  No  otlier  Code 
provisions  required  that  an  income  tax  return  preparer  disclose  to 
the  IRS  whether  he  was  in  the  business  of  preparing  returns  or  what 
returns  he  had  prepared. 

In  addition,  most  penalties  set  out  in  the  Internal  Revenue  Code  for 
improperly  prepared  returns  were  penalties  which  related  to  im- 
proper tax  return  preparation  by  the  taxpaver  himself  and  not  by  a 
paid  preparer.  Under  these  provisions,  which  continue  to  apply  to  in- 
dividual taxpayers,  taxpayers  may  be  subject  to  criminal  fraud  pen- 
alties of  up  to  $10,000  in  fines  and  imprisonment  for  not  more  than  five 
years  for  willful  attempt  to  evade  tax  (sec.  7201).  Taxpayers  are  also 
subject  to  civil  fraud  penalties  of  up  to  50  percent  of  the  amount  of  any 
underpayment  of  tax  as  well  as  penalties  for  negligence  or  intentional 
disregard  of  rules  and  regulations  in  an  amount  equal  to  5  percent  of 
any  underpayment  of  tax  (sec.  6653) . 

By  contrast,  persons  who  prepared  returns  of  others  for  a  fee  were 
only  subject  to  criminal  fraud  penalties  for  willfully  aiding  or  assist- 


346 

ing  in  the  preparation  of  a  fraudulent  return.  This  crime  was  punish- 
able by  fines  of  up  to  $5,000  and  imprisonment  for  not  more  than  three 
years  (sec.  7206). 

Reasons  for  change 

The  past  few  years  have  seen  a  substantial  increase  in  the  number 
of  persons  whose  business  is  to  prepare  income  tax  returns  for  indi- 
viduals and  families  of  moderate  income.  The  Internal  Revenue  Serv- 
ice estimates  that  for  the  year  1972,  35  million  taxpayers,  or  one-half 
of  all  those  who  filed  income  tax  returns,  sought  some  form  of  profes- 
sional or  commercial  tax  advice  in  preparing  their  returns.  The  Inter- 
nal Revenue  Service  also  estimates  that  in  1972  approximately  250,000 
persons  were  engaged  in  the  business  of  preparing  income  tax  returns. 

The  rapid  growth  of  the  business  of  professional  and  commercial 
preparation  of  tax  returns  has  led  to  a  number  of  problems  for  the 
Internal  Revenue  Service.  Some  abuses  have  arisen  in  the  preparation 
of  wage  earners'  returns  for  a  relatively  small  fee.  In  some  of  these 
cases,  return  preparers  have  made  guarantees  that  individuals  would 
obtain  a  refund  because  of  the  tax  expertise  of  the  preparer.  In  other 
cases,  return  preparers  have  suggested  that  a  taxpayer  sign  a  blank 
return  (i.e.,  before  it  was  prepared) .  Thus,  the  taxpayer  did  not  look  at 
the  return  or  review  it  before  it  was  filed.  In  some  of  these  cases,  the 
preparer  either  claimed  fictitious  deductions  or  increased  the  number 
of  exemptions  claimed  in  order  to  achieve  the  refund  or  tax  liability 
which  was  promised  to  the  taxpayer. 

In  1972  and  again  in  1973,  the  IRS  conducted  surveys  of  preparers 
suspected  of  engaging  in  these  types  of  conduct.  For  1972,  the  IRS 
discovered  that  about  60  percent  of  the  returns  surveyed  (or  over 
3,000  returns)  showed  significant  fraud  potential.  In  the  1973  survey, 
which  was  based  on  a  more  random  selection  of  preparers  than  those 
checked  in  1972, 22.3  percent  of  the  returns  ( 1,112  returns)  prepared  by 
preparers  showed  fraud  potential.  The  sizable  number  of  returns 
with  fraud  potential  was  partly  attributable  to  the  fact  that  the  IRS 
focused  on  preparers  suspected  of  improper  conduct.  Nonetheless,  the 
surveys  indicate  that  a  significant  number  of  preparers  in  those  years 
had  engaged  in  abusive  practices. 

Under  prior  law,  it  was  difficult  for  the  IRS  to  detect  any  individual 
case  of  improper  preparation  because  the  tax  return  preparer  was  not 
required  to  sign  the  return.  Thus,  the  IRS  had  no  way  of  knowing 
whether  the  return  was  prepared  by  the  taxpayer  or  by  a  preparer 
who  could  be  engaging  in  abusive  practices  involving  a  number  of 
returns. 

Furthermore,  even  if  the  IRS  could  trace  the  improper  prepara- 
tion of  tax  returns  to  an  individual  tax  return  preparer,  the  only 
sanctions  available  against  such  preparers  were  the  criminal  penalties 
of  the  tax  law.  Such  criminal  penalties  were  often  inappropriate, 
cumbersome,  and  ineffective  deterrents  because  of  the  cost  and  length 
of  time  involved  in  trying  these  cases  in  court.  Because  these  criminal 
penalties  were  difficult  to  apply  under  prior  law,  ih^  IRS  generally 
proceeded  against  only  the  most  flagrantly  fraudulent  cases  involving 
income  tax  return  preparers. 


347 

At  the  request  of  the  Joint  Committee  on  Taxation,  the  General 
Accoimting  Office  conducted  a  study  of  tax  return  prepara- 
tion by  all  types  of  tax  return  preparers.  The  GAO  report,  issued 
December  8,  1975,  indicates  that  commercial  preparers  (i.e.  non- 
professional preparers)  on  the  average  have  not  had  a  significantly 
greater  tendency  to  make  mistakes  in  preparing  returns  than  have 
other  types  of  preparers.  For  example,  the  GAO  studied  the  22,000 
tax  returns  which  were  audited  in  depth  for  the  year  1971  under  the 
IRS  Taxpayer  Compliance  Measurement  Program.  The  GAO  dis- 
covered that  for  all  returns  (excluding  1040A  short  form  returns) 
with  adjusted  gross  incomes  of  $10,000  and  under,  and  for  nonbusiness 
returns  with  adjusted  gross  incomes  between  $10,000  and  $50,000,  the 
percentage  of  tax  adjustment  determined  from  the  IRS  audits  aver- 
aged 10.9  percent  for  returns  prepared  by  commercial  preparers 
and  10.2  percent  for  returns  prepared  by  professional  preparers. 
Other  parts  of  the  study  indicate  also  that  commercial  preparers  are 
no  more  likely  to  make  more  or  larger  mistakes  on  the  returns  they 
prepare  than  are  professional  preparers.  This  result  probably  occurs 
because  most  commercial  preparers  are  generally  involved  only  with 
those  returns  which  are  relatively  simple  to  prepare,  while  profes- 
sional preparers  are  generally  involved  with  more  complex  returns. 

It  should  be  noted  that  the  errors  did  not  necessarily  result  from 
the  types  of  abuses  described  above  but  may  have  resulted  from  dif- 
ferences of  interpretation  or  other  similar  mistakes.  Nevertheless, 
where  the  IRS  determines  that  a  certain  return  preparer  has  made 
erroneous  interpretations  of  the  tax  law,  regulation  of  all  preparers 
would  allow  the  IRS  to  correct  these  errors  on  all  the  returns  pre- 
pared by  that  preparer.  The  fact  that  all  types  of  preparers  are  about 
equally  likely  to  make  errors  in  preparing  tax  returns  led  the  GAO 
to  recommend  that  any  regulation  of  tax  return  preparers  apply 
equally  to  all  preparers. 

To  aid  the  Internal  Revenue  Service  in  detecting  incorrect  returns 
prepared  by  tax  return  preparers,  and  to  deter  preparers  from  engag- 
ing in  improper  conduct,  the  Act  includes  a  number  of  provisions  re- 
quiring tax  return  preparers  to  disclose  to  the  IRS  certain  informa- 
tion and  subj  ting  preparers  to  penalties  for  failure  to  comply  with 
the  information  requirements  and  for  improper  conduct  in  the  prep- 
aration of  returns. 

Explanation  of  provision 

The  Act  provides  disclosure  requirements  and  standards  of  conduct 
which  are  applicable  to  income  tax  return  preparers.  It  gives  the  Sec- 
retary^ of  the  Treasury  the  power  to  impose  penalties  or  to  seek  injunc- 
tions against  preparers  because  of  certain  specified  prohibited  prac- 
tices. 

Dcii7iition  of  income  tax  preparer. — The  Act  applies  to  any  person 
who  is  a  tax  return  preparer,  regardless  of  the  educational  qualifica- 
tions or  professional  status  of  the  person.  An  income  tax  return  pre- 
parer means  any  person  who  prepares,  for  compensation,  all  or  a 
substantial  portion  of  a  tax  return  or  claim  for  refund.  Whether  or 
not  a  portion  of  a  return  constitutes  a  substantial  portion  is  to  be  de- 
termined by  examining  both  the  length  and  complexity  of  that  par- 
ticular portion  of  the  return  and  the  amount  of  tax  liability  involved. 


348 

Generally,  'filling  out  a  single  schedule  of  a  tax  return  would  not  be 
considered  preparing  a  substantial  portion  of  that  return  unless  that 
particular  schedule  was  the  dominant  portion  of  the  entire  tax  return. 

A  person  who  prepares  a  return  for  compensation  may  be  an  income 
tax  return  preparer  even  though  that  person  does  not  actually  place 
the  figures  on  the  lines  of  the  taxpayer's  final  tax  return.  A  person 
who  supplies  to  a  taxpayer  sufficient  information  and  advice  so  that 
filling  out  the  final  tax  return  becomes  merely  a  mechanical  or  clerical 
matter  is  to  be  considered  an  income  tax  return  preparer.  However, 
an  individual  who  gives  advice  on  particular  issues  of  law  or  IRS 
policy  relating  to  particular  deductions  or  items  of  income  will  not 
have  prepared  a  return  with  respect  to  those  issues  if  the  advice  does 
not  directly  relate  to  any  specific  amounts  which  are  placed  on  the 
return  of  the  taxpayer. 

The  definition  of  income  tax  return  preparer  includes  only  persons 
who  prepare  the  returns  of  others  for  compensation.  A  person  who  fills 
out  a  return  gratuitously  for  a  friend  or  a  relative,  for  example,  is  not 
considered  an  income  tax  return  preparer.  In  addition,  a  person  who 
fills  out  a  return  for  a  friend  or  neighbor  with  no  explicit  or  implicit 
agreement  for  compensation  is  not  considered  to  have  prepared  the 
return  for  compensation  even  though  that  person  receives  an  expres- 
sion of  gratitude  (such  as  an  invitation  to  dinner  or  a  returned  favoi 
from  the  taxpayer).  Also,  IRS  employees  who  provide  taxpayer 
assistance  are  not  tax  return  preparers  with  respect  to  that  activity. 

The  term  "income  tax  return  preparer"  includes  the  employer  of 
persons  who  prepare  the  returns  of  others  for  compensation  as  well  as 
the  persons  actually  preparing  returns.^  In  cases  where  more  than  one 
person  aids  in  filling  out  a  single  return  imder  one  employer,  the  in- 
'iividual  who  has  the  primary  responsibility  for  the  preparation  of 
the  entire  return  or  of  a  substantial  portion  of  the  return  is  usually 
an  income  tax  preparer,  while  those  persons  involved  only  with  indi- 
vidual portions  of  the  return  are  not  usually  income  tax  return  pre- 
parers. The  fact  that  a  person  who  prepares  an  entire  return  or  a  sub- 
stantial portion  of  the  return  has  his  work  reviewed  by  a  more  senior 
employee  does  not  by  itself  mean  that  the  person  preparing  the  return 
is  not  an  income  tax  return  preparer. 

The  Act  provides  four  specific  exceptions  to  the  definition  of  an 
income  tax  return  preparer.  First,  a  person  is  not  considered  a  pre- 
parer merely  because  that  person  furnishes  typing,  reproducing,  or 
other  mechanical  assistance  in  preparing  the  return.  Thus,  a  person 
who  provides  a  computerized  service  for  filling  out  returns  from  in- 
formation supplied  by  the  taxpayers  or  advisore  of  the  taxpayer  is  not 
considered  an  income  tax  return  preparer  if  the  processing  done  by 
such  pei'son  is  limited  to  mechanical  calculations  and  processing.  Sec- 
ond, an  employee  is  not  a  tax  return  preparer  merely  because  he  pre- 
pares the  return  or  a  claim  for  refimd  for  his  employer  or  for  em- 
ployees of  the  employer.  However,  such  an  individual  must  be  a  regu- 
lar and  continuous  employee  of  the  employer  and  not  an  independ- 
ent contractor.  For  example,  an  individual  who  maintains  his  own 

^  A  person  who  retains  one  or  more  persons  to  prepare  the  Income  tax  returns  of 
others  Is  an  income  tax  return  preparer  whether  or  not  the  persons  retained  are  technically 
considered  employees  or  agents.  The  fact  that  the  persons  retained  are  not  considered 
employees  for  purposes  of  other  federal  laws  does  not  mean  that,  for  purposes  of  this 
provision,  the  person  retaining  the  income  tax  preparers  is  not  also  an  income  tax  preparer. 


a49 

accounting  practice,  but  who  every  year,  ait  the  appropriate  time  for 
filing  returns,  is  hired  by  an  employer  to  prepare  that  employer's  re- 
turns or  the  individual  returns  of  officers  or  employees  of  that  em- 
ployer, is  considered  an  income  tax  return  preparer.  Third,  the  Act 
provides  that  a  pereon  is  not  an  income  tax  return  preparer  merely  be- 
cause he  prepares  a  return  or  a  claim  for  refund  for  any  trust  or  estate 
of  which  that  person  is  a  fiduciary.  Fourth,  under  the  Act,  a  pei-son 
will  not  be  considered  a  tax  return  preparer  merely  because  he  pre- 
pares a  refund  claim  which  is  filed  as  a  result  of  an  Internal  Revenue 
Service  audit.  The  fouith  exception  includes  preparere  of  refmid 
claims  in  three  specific  types  of  situations.  The  first  situation  arises 
when  a  taxpayer's  income  tax  return  for  a  year  has  been  audited,  a 
deficiency  assessed  and  collected,  or  a  notice  of  deficiency  issued,  or  a 
waiver  of  restriction  on  assessment  and  collection  issued  after  the 
commencement  of  the  audit,  and  the  taxpayer  elects  to  challenge  the 
Service's  determination  of  his  liability  for  that  tax  year  by  filing  a 
claim  for  refund  in  order  to  perfect  his  right  to  a  judicial  resolution 
of  the  controversy.  The  second  situation  arises  where  determinations 
made  in  the  course  of  an  audit  of  a  taxpayer  for  one  tax  year  can 
affect  his  liability  in  another  year.  The  preparation  of  a  claim  for 
refimd  for  the  affected  year  will  not  by  itself  cause  the  preparer  of 
the  refund  claim  to  be  an  income  tax  return  preparer  under  this  pro- 
vision of  the  Act.  Similarly,  in  the  third  case,  merely  preparing  a  re- 
fund claim  for  a  taxpayer  whose  tax  liability  has  been  affected  di- 
rectly or  indirectly  by  a  determination  made  in  the  audit  of  another 
taxpayer  does  not  render  the  pereon  preparing  the  claim  for  refund 
an  income  tax  return  preparer  under  this  provision. 

The  definition  of  a  tax  return  preparer  relates  only  to  returns  of 
taxes  imposed  by  subtitle  A  of  the  Internal  Revenue  Code  and  to  claims 
for  refund  of  taxes  imposed  by  subtitle  A. 

Disclosure  requirem-ents  and  lyenaUies  for  failure  to  make  reports. — 
The  Act  requires  that  any  person  preparing  an  income  tax  return  state 
on  that  return  his  identification  number,  the  identification  number  of 
his  employer,  or  both,  in  the  manner  prescribed  by  the  Secretary.  In 
cases  of  returns  prepared  by  more  than  one  return  preparer,  the  Secre- 
tary may  also  establish  rules  determining  which  preparer  or  preparers 
are  required  to  place  their  identification  number  on  the  return.  The 
Act  establishes  a  $25  penalty  for  each  failure  to  furnish  a  proper 
identification  number  on  a  return  unless  a  failure  is  due  to  reasonable 
cause  and  not  due  to  willful  neglect.  In  conjunction  with  this  identifi- 
cation requirement,  a  failure  by  a  return  preparer  to  sign  any  return  if 
required  to  do  so  under  regulations  prescribed  by  the  Secetary.  will 
result  in  a  $25  penalty.  However,  the  Act  does  not  change  prior  law 
with  respect  to  the  Secretary's  authority  to  require  that  the  name  of 
any  income  tax  return  preparer  appear  on  any  return. 

The  Act  also  requires  that  any  income  tax  return  preparer  retain  a 
copy  of  all  returns  prepared  by  him,  or  alternatively  retain  a  list 
vyith  respect  to  each  taxable  year  of  all  taxpayers  and  their  iden- 
tification numbers  for  whom  returns  were  prepared.  The  copies  of 
the  return  or  the  list  of  returns  prepared  are  to  be  kept  by  the 
preparer  for  three  years.  This  provision,  in  addition  to  the  require- 
ment that  the  preparer  place  his  identification  number  on  the  re- 
turn itself,  is  to  enable  the  IRS  to  identify  all  returns  prepared  by 


350 

a  specific  individual  in  cases  where  the  IRS  has  discovered  some  re- 
turns improperly  prepared  by  that  individual.  The  Act  provides  for  a 
$50  penalty  for  each  failure  to  keep  a  return  or  to  include  a  return  on 
a  list  of  prepared  returns.  The  maximum  penalty  under  this  provision 
is  $25,000  with  respect  to  any  person  for  any  return  period.  This 
penalty  applies  unless  the  failure  is  due  to  reasonable  cause  and  not  to 
willful  neglect. 

The  Act  also  requires  that  employers  of  income  tax  return  preparers 
make  an  annual  report  to  the  IRS  listing;  the  name,  taxpayer  identifi- 
cation number,  and  place  of  work  of  each  tax  return  preparer  em- 
ployed durinjj  the  year.  For  purposes  of  this  requirement,  an  individ- 
ual who  is  self-employed  as  an  income  tax  return  preparer,  or  wlio  acts 
as  an  independent  contractor  (other  than  as  an  agent  of  another  tax 
return  preparer  who  files  an  information  return  which  includes  the 
agent),  is  required  to  file  his  own  information  report.  The  IRS  may 
provide  regulations  permitting  a  parent  cor]:)oration  to  file  a  single 
consolidated  annual  report  for  all  of  its  subsidiaries  and  franchises. 
The  Act,  however,  provides  that  if  it  is  determined  that  the  informa- 
tion generally  required  on  an  annual  report  is  available  to  the  Service 
from  sources  other  than  such  a  report,  the  Secretary  may  approve  al- 
ternative compliance  methods  including,  for  example,  guarantees  of 
access  t_o  records  which  provide  the  information  required  by  the  Secre- 
tary without  filinff  a  report,  or  permitting  a  summary-tvne  report, 
provided  the  employer  keeps  more  detailed  records  available  and 
accessible  to  the  Service. 

Failure  of  an  employe)-  nroperly  to  file  an  annual  report  or  to  com- 
ply with  altornativo  compliance  procedures  will  result  in  a  penalty  of 
$100  for  each  report  which  is  not  pronerlv  filed  or  is  not  made  avail- 
able to  the  Service,  plus  $5  for  each  omitted  }tem  which  should  have 
been  included  on  any  report  or  made  available  to  the  Service.  Thus,  an 
individual  avIio  files  an  incomplete  report  will  incur  a  penalty  of  $5  for 
each  item  improperly  excluded:  an  individual  who  files  uo  report  will 
be  assessed  $100  plus  $5  for  each  item  which  would  have  been  included 
on  a  properly-filed  report.  The  maximum  penalty  under  this  provision 
is  $20,000  with  respect  to  any  person  for  any  report  period. 

The  Act  also  requires  that  a  tax  return  preparer  furnish  a  completed 
copy  of  any  return  prepared  by  him  to  the  taxpayer  either  prior  to  or 
at  the  same  time  as  the  return  is  presented  to  the  taxpayer  for  his  sig- 
nature. This  provision  is  intended  to  insure  that  the  taxpayer  receives 
a  copy  of  the  completed  return  to  review  its  accuracy,  and  to  insure 
that  the  final  return  is  not  signed  by  the  taxpayer  prior  to  its  comple- 
tion. A  tax  return  preparer  who  fails  to  provide  a  completed  copy  of 
the  return  to  the  taxpayer  at  the  appropriate  time  is  subject  to  a  pen- 
alty of  $25  for  each  such  failure  unless  due  to  reasonable  cause  and 
not  to  willful  neglect. 

The  Act  also  requires  that  in  the  case  of  an  individual,  the  taxpayer 
identification  number  required  on  any  return  is  to  be  the  individual's 
social  security  account  number.  This  provision  applies  both  to  tax  re- 
turn preparers  and  to  individual  taxpayers. 

Another  section  of  the  Act  ^  provides  in  relation  to  this  provision 
that  States  or  local  governing  bodies  charged  with  the  administration 

2  Sec.  6103(k)  (5)  of  the  Code,  as  amended  by  sec.  1202  of  this  Act. 


351 

of  any  tax  law  in  their  jurisdiction  may  obtain  the  social  security 
account  number  or  employer  identification  number  assigned  to  any 
taxpayer  upon  application  to  the  Secretary  for  use  in  fulfilling  their 
tax  administration  responsibilities.  This  disclosure  provision  permits 
the  IKS  to  give  to  State  or  local  governing  bodies  charged  with  licens- 
ing, registering  or  regulating  income  tax  preparers  information  con- 
tained on  the  annual  information  reports  submitted  to  the  Internal 
Revenue  Service  which  identifies  tax  return  preparers  or  which  indi- 
cates any  penalties  which  have  been  assessed.  However,  such  informa- 
tion may  be  furnished  only  upon  written  request  by  the  Governor  or 
Chief  Executive  Officer  of  the  State  in  which  the  governing  body  is 
located.  The  request  must  designate  the  body  to  which  such  information 
is  to  be  furnished.  The  information  furnished  may  be  used  by  the  State 
or  local  governing  body  only  for  the  purposes  of  licensing,  registering 
or  regulating  income  tax  return  preparers.  (State  employees  who  make 
an  unauthorized  disclosure  of  any  information  furnished  by  the  IRS 
may  be  subject  to  misdemeanor  penalties  or  imprisonment  for  up  to 
one  year  and  penalties  of  up  to  $1,000  (sec.  7214(b) ) .) 

Penalties  for  negligent  or  fraudulent  preparation. — In  addition  to 
the  penalties  provided  for  failure  to  comply  with  the  disclosure  and 
information  return  requirements,  the  Act  establishes  new  penalties 
for  certain  negligent  or  willfull  attempts  to  understate  a  taxpayer's  tax 
liability.  These  penalties  are  primarily  aimed  at  detering  income  tax 
return  preparers  who  prepare  a  large  number  of  returns  from  engag- 
ing in  negligent  or  fraudulent  practices  designed  to  understate  a  tax- 
payer's liability. 

The  Act  establishes  a  penalty  of  $100  for  each  return  on  which  an 
understatement  of  tax  liability  is  caused  by  negligent  or  intentional 
disregard  of  the  Federal  tax  law  or  rulings  and  regulations  by  an 
income  return  preparer.  The  rules  and  regulations  to  which  this  pro- 
vision applies  include  the  Treasury  regulations  and  IRS  rulings.  The 
penalty  applies  generally  to  every  negligent  or  intentional  disregard 
of  such  regulations  and  rulings  except  that  a  good  faith  dispute  by  an 
income  tax  return  preparer  about  an  interpretation  of  a  statute  (ex- 
pressed in  regulations  or  rulings)  is  not  considered  a  negligent  or 
intentional  disregard  of  rulings  and  regulations.  The  provision  is  thus 
to  be  interpreted  in  a  manner  similar  to  the  interpretation  given  the 
provision  under  present  law  (sec.  6653(a))  relating  to  the  disregard 
of  rules  and  regulations  by  taxpayers  on  their  own  returns.  While 
there  may  l>e  instances  in  which  some  form  of  disclosure  on  a  return 
revealing  the  legal  theory  or  basis  for  the  return  preparer's  position 
would  be  necessary  to  avoid  penalties  under  section  6694(a),  that 
would  depend  on  all  the  relevant  facts  and  circumstances  in  the  par- 
ticular case,  as  is  true  under  section  6653(a). 

The  negligence  penalty  applies  to  the  specific  income  tax  return 
preparer  Avho  negligently  or  intentionally  disregards  rules  or  regu- 
lations. The  penaltv  is  not  to  be  imputed  to  an  emplover  of  a  tax 
return  preparer  solelv  by  reason  of  the  emplovment  relationship;  the 
emplover  or  one  or  more  of  its  chief  officers  also  must  have  negligently 
or  intentionally  disregarded  the  rules  or  regulations  if  the  emplover  is 
to  be  penalized.  For  example,  if  an  emplover  or  another  employee 
supervises  the  preparation  of  a  return  by  an  income  tax  preparer,  any 


352 

negligent  or  intentional  disregard  of  rules  and  regulations  which 
occurs  in  connection  with  that  return  may  be  attributable  to  the  person 
supervising  the  preparation  of  the  return  if  that  person  had  responsi- 
bility for  determining  whether  or  not  the  rules  and  regulations  were 
followed,  or  if  that  person  in  fact  knew  that  the  rules  or  regulations 
were  not  followed. 

The  Act  provides  a  second  penalty  of  $500  for  each  return  on  which 
any  understatement  of  liability  results  from  a  willful  attempt  to 
understate  tax  liability  by  a  tax  return  preparer.  A  willful  under- 
statement of  tax  liability  includes  situations  where  an  income  tax 
return  preparer  disregards  facts  supplied  to  him  by  the  taxpayer  (or 
othei-s)  in  an  attempt  to  reduce  the  taxpayer's  liability.  For  example, 
if  a  taxpayer  states  to  the  return  preparer  that  he  has  only  two  depend- 
ents, and  the  preparer,  with  full  knowledge  of  that  statement,  reports 
six  dependents  on  the  tax  return,  a  willful  attempt  to  understate  tax 
liability  has  occurred.  A  willful  attempt  also  occurs  generally  where 
an  income  tax  return  preparer  disregards  certain  items  of  income  given 
to  him  by  the  taxpayer  or  other  persons.  While  the  three-year  statute 
of  limitations  is  to  apply  to  the  assessment  of  the  penalty  for  negligent 
or  intentional  disregard  of  rules  and  regulations,  no  statute  of  limita- 
tions is  to  apply  to  the  willful  understatement  penalty. 

A  willful  understatement  of  tax  liability  can  also  include  an  inten- 
tional disregard  of  rules  and  regulations.  For  example,  an  income 
tax  return  preparer  who  deducts  all  of  a  taxpayer's  medical  expenses, 
intentionally  disregarding  the  percent  of  adjusted  gross  income  lim- 
itation, may  have  both  intentionally  disregarded  rules  and  regula- 
tions and  willfully  understated  tax  liability.  In  such  a  case,  the  In- 
ternal Revenue  Service  can  assess  either  or  both  penalties  against  the 
income  tax  return  preparer.  However,  the  total  amount  collected  by 
reason  of  imj^osing  both  penalties  cannot  exceed  $500  per  return.  Thus, 
the  IRS  could  in  this  and  in  other  cases  first  assess  the  neorligent 
or  intentional  disregard  of  rules  and  regulations  penalty,  and  then 
at  a  later  date,  assess  the  penalty  for  the  willful  understatement  of 
tax  liability.  Rut  if  the  first  penalty  of  $100  is  collected,  the  later  as- 
sessment for  willful  understatement  of  tax  liability  would  be  limited 
to  ^400  per  tax  return. 

The  negligence  and  willful  understatement  peralties  apply  only  to 
eases  where  there  is  an  understatement  of  tax  liabilitv.  An  understate- 
ment of  tax  liability  occurs  when  any  net  amount  payable  with  respect 
to  any  tax  imposed  by  subtitle  A  of  the  Internal  Revenue  Code  is 
understated  or  when  any  net  amount  of  such  tax  which  is  refundable 
or  creditable  against  future  taxes  is  overstated.  Xo  final  administra- 
tive or  judicial  determination  with  respect  to  anv  taxpaver  is  required 
as  a  condition  of  an  understatement  of  tax  liabilitv.  An  understate- 
m.ent  of  tax  can  exist  if  it  is  shown  in  fact  to  exist  in  the  proceeding 
against  the  return  preparer  regardless  of  what  actions,  if  any,  the 
Internal  Revenue  Service  has  taken  airainst  the  taxpayer  involved. 

Both  the  negligent  or  intentional  disregard  of  rules  and  regula- 
tions penalty  and  the  willful  understatement  of  liability  penalty  are 
assessed  independently  of  any  taxpayer  deficiencies  asserted  against 
the  income  tax  return  preparer  (and  the  other  assessable  penalties 


353 

which  have  been  discussed  in  connection  with  the  disclosure  require- 
ments). Under  normal  IRS  procedures,  an  investigation  will  be  made 
before  the  assessment.  A  revenue  agent's  report  will  be  filed,  followed 
by  a  thirty-day  letter  to  the  income  tax  preparer  notifying  him  of  the 
proposed  penalty  and  giving  him  an  opportunity  to  pursue  administra- 
tive remedies  prior  to  the  assessment  of  the  penalty.  After  these  appeals 
are  exhausted,  if  the  IRS  assesses  the  penalty,  it  must  make  a  statement 
of  notice  and  demand  (separate  from  any  taxpayer  notice  of  defi- 
ciency) to  the  income  tax  return  preparer.  The  penalty  is  payable  upon 
assessment. 

An  income  tax  return  preparer  can  appeal  the  assessment  of  the 
penalty  by  paying  the  amount  assessed  and  filing  a  claim  for  a  refund.^ 
If  the  refund  claim  is  denied  by  the  Internal  Revenue  Service,  the 
income  tax  return  preparer  can  appeal  that  denial  to  the  courts. 

In  addition  to  this  refund  procedure,  the  Act  provides  that  an  in- 
come tax  return  preparer  can  appeal  an  assessment  of  the  penalty  if 
he  pays  15  percent  of  any  penalty  within  thirty  days  of  the  notice  of 
assessment  and  files  a  claim  for  a  refund  at  that  time.  During  the 
period  when  the  claim  for  refund  or  appeal  of  any  refusal  to  refund  is 
jjending,  the  Internal  Revenue  Service  may  not  proceed  to  collect  any 
part  of  the  remaining  85  percent  of  the  penalty.  However,  with  respect 
to  any  penalty  for  which  the  15  percent  amount  is  not  paid,  the  Inter- 
nal Revenue  Service  is  free  to  pursue  collection. 

If  the  Internal  Revenue  Service  denies  a  claim  for  refund  of  the  15 
percent  of  the  penalty  assessed,  the  income  tax  return  prej^arer  may 
appeal  the  matter  to  the  appropriate  U.S.  district  court  within  thirty 
days  and  avoid  any  further  IRS  collection  of  the  remaining  85  percent 
of  the  penalty.  If  the  IRS  does  not  rule  on  a  claim  for  refund  by  the 
end  of  six  months  after  the  time  the  claim  is  presented,  the  preparer 
can  sue  in  tlie  appropriate  U.S.  district  court  within  thirty  days  after 
the  end  of  the  six-month  period.  In  such  a  suit,  the  Internal  Revenue 
Service  need  not  file  a  counterclaim  for  the  remaining  85  percent  of 
outstanding  penalties  because  any  court  decision  with  regard  to  the 
refund  of  15  percent  of  the  penalty  will  apply  equally  to  the  remaining 
85  percent.  If  the  preparer  does  not  begin  a  suit  within  the  thirty-day 
period,  the  IRS  can  proceed  with  collection  of  the  remaining  85  per- 
cent of  the  penalties. 

In  any  trial  on  the  merits  of  assessed  penalties,  the  IRS  bears  the 
burden  of  proof  if  the  penalty  assessed  is  for  willful  understatement 
of  tax  liability.  If  the  penalty  is  for  intentional  or  negligent  disregard 
of  Internal  Revenue  Code  rules  or  regulations,  the  preparer  bears  the 
burden  of  proof.  However,  if  a  preparer  can  show  that  his  normal  prac- 
tice with  respect  to  the  treatment  of  a  particular  income  or  deduction 
item  was  not  negligent  and  if  there  is  evidence  that  his  normal  practice 
was  followed,  the  preparer  will  be  considered  to  have  met  his  burden  of 
proof  miless  the  Service  presents  contrary  evidence.  For  example,  if 
a  tax  return  preparer  prepared  returns  for  10  years  based  on  a  revenue 
rulin.qr  which  the  Service  revoked  during  the  fifth  year,  the  preparer 
would  be  considered  negligent  at  least  with  regard  to  returns  prepared 


'  If  the  income  tax  return  preparer  pays  the  entire  amount  of  the  penalty,  a  claim  for 
refund  can  be  filed  at  any  time  within  three  years  after  the  time  the  penalty  Is  paid. 


354 

in  accord  with  the  ruling  for  the  sixth,  seventh,  eiglith,  ninth  and  tenth 
years,  and  (depending  upon  the  facts  and  circumstances)  perhaps  also 
for  the  fifth  year. 

In  the  case  of  any  claim  for  refund  based  on  the  lo-percent  payment, 
the  IRS  may  resume  its  collection  activities  only  upon  final  resolution 
of  the  matter.  Final  resolution  includes  any  settlement  betM'een  the 
Internal  Revenue  Service  and  the  income  tax  return  preparer,  or  any 
final  decision  by  a  court,  and  includes  the  types  of  detorminations  pro- 
vided under  existing  law  (sec.  1313(a) )  relating  to  taxpayer  deficien- 
cies. During  any  pei'iod  of  appeal  of  any  assessed  i)enalty  for  which 
the  IRS  is  prevented  from  pui-suing  collection  of  the  remainder  of  the 
penalty,  the  running  of  the  statute  of  limitations  for  collection  is 
susj^ended. 

Regardless  of  whether  or  not  the  penalties  assessed  are  appealed  by 
the  income  tax  preparer,  any  payment  of  such  penalties  will  Ix*  re- 
funded to  the  income  tax  return  preparer  if  it  is  determined  by  final 
administrative  or  judicial  action  involving  the  taxpayer  that  there  was 
no  understatement  of  liability  in  the  case  of  the  ret\irn  for  which  the 
penalty  was  assessed.  For  example,  if  an  income  tax  return  preparer 
pays  the  penalty  with  resj^ect  to  a  s})ecific  return  and  at  a  later  date 
the  taxpayer  obtains  an  administrative  or  judicial  determination  to 
the  etl'ect  that  no  understatement  of  tax  existed  on  his  i-eturn,  a  refund 
of  the  ix'nalty  shall  be  automatically  provided  to  the  income  tax  return 
pi-eparer.  The  Internal  Revenue  Service  is  to  make  this  refund  to  the 
income  tax  i-eturn  ju-eparer  whether  or  not  a  request  for  the  refund  is 
made  by  the  preparer  and  regardless  of  the  rmming  of  any  statute  of 
limitations. 

In  addition,  the  Act  establishes  a  civil  penalty  of  $500  against  any 
income  tax  return  or  claim  for  refund  preparer  who  endorses  or  other- 
wise negotiates  (directly  or  through  an  agent)  any  check  which  is 
issued  with  respect  to  any  return  which  he  has  prepared  with  regard 
to  taxes  imposed  by  subtitle  A  of  the  Internal  Revenue  Code  and  which 
is  issued  to  a  taxpayer  other  than  the  income  tax  return  preparer. 
The  provision  is  to  apply  to  enilorsements  (such  as  forgeries)  or  other 
negotiations  which  were  illegal  under  prior  law  (and  which  continue 
to  be  illegal)  as  well  as  to  ])i-eviously  legal  transactions  where  a  return 
preparer  endorses  or  negotiates  a  check  issued  to  another  taxpayer  (for 
example,  by  reason  of  a  }X)wer  of  attorney  or  because  of  a  specific  or 
bearer  endorsement  by  the  taxpayer) .  This  penalty  applies  whether  or 
not  the  return  preparer  endorses  or  negotiates  the  check  directly  or 
through  some  other  person  (other  than  the  taxpayer)  as  agent  on  his 
behalf.  However,  the  penalty  is  not  intended  to  a]>ply  to  subsequent 
endorsements  made  as  pait  of  the  check  clearing  process  through  the 
financial  system,  ]")rovided  the  check's  initial  endorsement  or  nego- 
tion  was  propei-.  i.e.,  pi-ovided  the  check  was  not  endorsed  or  nego- 
tiated by  a  taxpayer  who  was  an  income  tax  return  preparer  ^rith 
respect  to  the  return  or  claim  for  which  the  Service  issued  the  check. 

Paicrr  to  seoJc  injunrfJotis. — The  Act  grants  the  Secretary  the  power 
to  seek  an  injunction  prohibiting  an  income  tax  return  preparer  from 
engaging  in  specific  ]>ractices  or  from  actinsr  as  an  income  tax  return 
preparer.  The  Secretary  may  bring  suit  in  the  TTnited  States  District 
(^ourt  for  the  district  in  which  the  preparer  resides,  or  in  the  district 


355 

in  which  the  taxpayer's  principal  place  of  business  is  located,  or  the 
district  in  which  the  taxpayer  whose  return  is  the  basis  for  the 
action  resides. 

An  injunction  may  be  sought  whenever  the  Secretary  believes  that 
an  income  tax  return  preparer  has  engaged  in  conduct  subject  to  mone- 
tary penalties  under  the  ])rovisions  of  the  Act,  has  engaged  in  conduct 
subject  to  criminal  penalties  under  the  Internal  Kevenue  Code,  has  mis- 
represented his  eligibility  to  practice  before  the  Internal  Revenue 
Service,  has  misrepresented  his  experience  and  education  as  an  income 
tax  return  preparer,  has  guaranteed  the  payment  of  any  tax  refund  or 
the  allowance  of  any  tax  credit,  or  has  engaged  in  any  other  fraudulent 
or  deceptive  conduct  similar  in  nature  to  the  above  types  of  conduct 
which  substantially  interferes  with  the  proper  administration  of  the 
internal  revenue  laws.  If  the  court  believes  injunctive  relief  is  appro- 
priate, it  may  enjoin  an  income  tax  return  preparer  from  continuing 
to  engage  in  such  conduct.  If  the  court  determines  that  a  preparer  has 
continually  or  repeatedly  engaged  in  any  such  conduct  and  that  an  in- 
junction prohibiting  only  the  specific  type  of  conduct  would  not  suffice 
to  prevent  interference  with  tax  administration,  the  court  may  enjoin 
the  preparer  from  engaging  in  business  as  a  tax  return  preparer. 

The  Secretary  may  seek  such  an  injunction  without  regard  to 
whether  or  not  penalties  have  been  or  may  be  aSvSe.ssed  against  any 
income  tax  return  preparer.  Thus,  it  is  permissible  for  the  Secretary 
both  to  assess  penalties  against  a  taxpayer  for  certain  acts  and  to  seek 
an  injunction  prohibiting  the  tax  return  preparer  from  engaging 
further  in  such  conduct  or  from  acting  as  an  income  tax  return 
preparer. 

The  injmictive  relief  sought  by  the  Secretaiy  must  be  commensurate 
with  the  conduct  which  led  to  the  seeking  of  the  injunction.  For  ex- 
ample, if  an  income  tax  return  preparer,  who  is  only  experienced  in 
preparing  individuals'  returns,  overstates  his  qualifications  as  a  pre- 
parer by  claiming  expertise  in  the  preparation  of  corporate  returns, 
it  is  anticipated  that  any  injunction  would  be  directed  toward  the 
misrepresentation  itself  or  the  preparation  of  corporate  returns  and 
not  toward  preventing  the  preparer  from  preparing  any  returns  at  all. 
Furthermore,  if  some  of  an  employer's  employee-preparers  have  en- 
gaged in  conduct  leading  to  a  request  for  an  injunction  against  the 
further  preparation  of  returns,  tlie  injunction  sought  is  to  apply  only 
against  those  preparers  and  not  the  employer  (or  other  employees), 
unless  the  employer  (or  other  employees)  is  actively  involved  in  the 
improper  conduct.  Nothing  in  this  provision  alters  the  inherent  au- 
thority of  the  courts  to  limit  the  scope  and  duration  of  any  injunction 
as  is  deemed  appropriate  with  respect  to  the  actions  leading  to  the 
request  for  injunctive  relief. 

To  the  extent  permitted  under  the  Federal  Rules  of  Civil  Procedure, 
the  Secretary  may  seek  a  temporaiy  restraining  order  on  an  ex  parte 
basis  under  this  provision.  However,  the  Secretary  is  to  seek  such 
an  order  only  in  those  extreme  cases  where  the  administration  of  the 
tax  laws  would  be  irreparably  lianned  by  the  continuation  of  the  con- 
duct against  which  the  restraining  order  is  sought. 

An  income  tax  return  iireparer  may,  however,  prevent  the  Secretary 
from  initiating  or  pursuing  an  injunctive  action  based  on  the  penalties 


356 

provided  for  in  this  Act  if  the  preparer  files  with  the  Secretary  a  bond 
of  $50,000  as  surety  for  the  payment  of  any  of  the  penalties  which 
nii^ht  be  assessed.  The  bond  need  not  be  continued  if  the  penalties 
which  gave  rise  to  the  injunctive  action  have  been  assessed  and  paid. 

Effective  date 
This  provision  applies  to  documents  prepared  after  December  31, 
1976. 

Revenue  effect 
This  provision  will  not  have  any  revenue  impact. 

4.  Jeopardy  and  Termination  Assessments  (sec.  1204  of  the  Act 
and  sees.  68.51,  6863,  and  7429  of  the  Code) 

Prior  laio 

Under  normal  assessment  procedure,  there  is  generally  a  consider- 
able lapse  of  time  between  a  taxpayer's  first  notice  that  the  Internal 
Revenue  Service  is  seeking  to  collect  taxes  from  him  and  the  actual 
enforced  collection  of  those  taxes.  For  example,  a  taxpayer  who  does 
not  agree  with  a  proposed  assessment  of  income  taxes  may  pursue 
administrative  appeals  within  the  Service,  and,  if  no  agreement  is 
reached,  the  taxpayer  may  petition  the  Tax  Court  after  tlie  Service 
has  issued  a  notice  of  deficiency,  all  without  paying  the  tax  allegedly 
due.  On  the  other  hand,  when  the  Service  deteruiines  that  the  collec- 
tion of  a  tax  may  be  in  jeopardy,  it  may  forgo  the  normal  time- 
consuming  assessment  and  collection  procedures  and  immediately 
assess  and  collect  the  tax.  For  this  purpose,  there  are  two  basic  types 
of  special  assessments — jeopardy  assessments  and  termination  assess- 
ments.^ 

Jeopardy  assessments  are  of  two  different  types  depending  on 
whether  the  taxes  involved  are  (1)  income,  estate,  gift,  or  certain 
excise  taxes  (those  taxes  that  are  normally  dealt  with  under  the  notice 
of  deficiency  procedures)  or  (2)  other  taxes  (such  as  employjuent  taxes 
and  wagering  taxes). 

Use  of  jeopardy  assessments  related  to  income,  etc.,  taxes. — If  the 
Service  determines  that  the  collection  of  incouie,  estate,  gift,  or  certain 
excise  taxes  is  in  jeopardy,  a  jeopardy  assessment  may  be  made  under 
section  6861  of  the  Code.  Under  such  an  assessment,  the  Service  deter- 
mines that  a  deficiency  exists  and  that  its  assessuient  or  collection 
would  be  jeopardized  by  the  delay.  The  Service  is  then  authorized 
immediately  to  (1)  assess  the  tax,  (2)  send  a  notice  and  demand  for 
payment,  and  (3)  levy  upon  the  taxpayer's  property  for  its  collection. 
The  10-day  waiting  period  normally  required  between  demand  for 
payment  and  seizure  of  the  taxpayer's  property  does  not  apply  in  this 
case.  However,  if  the  jeopardy  assessment  is  made  before  the  statutory 
notice  of  deficiency  is  sent  to  the  taxpayer,  the  Service  is  required  to 
send  the  notice  within  60  days  after  the  jeopardy  assessment  is  made. 

The  judicial  remedies  available  to  a  taxpayer  who  has  been  subject 

1  The  Internal  Revenue  Manual  states  that  a  jeopardy  or  termination  assessment 
should  not  be  made  unless  at  least  one  of  the  following  three  conditions  Is  met : 

(.1)  The  taxpayer  Is  or  appears  to  be  designing  quickly  to  deitart  from  the  United 
States  or  to  conceal  himself  ; 

(2)  The  taxpayer  Is  or  appears  to  be  designing  quickly  to  place  his  property  beyond 
the  reach  of  the  Government  either  by  removing  It  from  the  United  States,  or  bycon- 
cealing    it.    or    by    transferring    it    to    other    persons,    or    by    dissipating    It ;    or 

(3)  The  taxpayer's  financjal  solvency  appears  to  be  imperiled. 


357 

to  a  section  6861  jeopardy  assessment  are  identical  to  the  remedies 
available  for  a  normal  assessment.  Upon  receiving  a  notice  of  defi- 
ciency, the  taxpayer  may  file  a  petition  for  redetermination  in  the  Tax 
Court.^  Alternatively,  tlie  taxpayer  may  pay  the  full  amount  of  the 
deficiency,  file  a  claim  for  refund  with  the  Service,  wait  6  months 
(unless  the  claim  is  denied  by  the  Service  sooner),  and  then  file  a 
refund  action  in  a  Federal  district  court  or  the  Court  of  Claims. 

Under  prior  law,  the  taxpayer  who  had  been  subjected  to  a  jeopardy 
assessment,  however,  did  not  have  all  the  protection  aflforded  the 
ordinary  taxpayer  during  the  judicial  review.  In  the  normal  deficiency 
case,  the  Service  has  been  prohibited  from  making  an  assessment  and 
taking  collection  action  against  a  taxpayer's  property  prior  to  the 
time  allowed  for  filing  a  petition  for  redetermination  and  during  the 
time  litigation  is  pending  in  the  Tax  Court.  Although  the  Service  has 
generally  been  precluded  from  selling  any  property  seized  prior  to  or 
during  Tax  Court  litigation,  the  jeopardy  taxpayer — unlike  the  ordi- 
nary taxpayer— lost  the  use  of  whatever  property  had  been  seized  by 
the  Service  while  relief  was  being  sought  in  the  Tax  Court. 

Use  of  jeopardy  assessments  relating  to  other  taxes. — If  the  Service 
determines  that  collection  of  any  tax  liability  relating  to  a  tax  other 
than  an  income,  estate,  gift,  or  certain  excise  tax  is  in  jeopardy,  the 
Service  may  make  a  jeopardy  assessment  under  section  6862.  This 
type  of  jeopardy  assessment  differs  from  a  jeopardy  assessment 
under  section  6861  in  that  the  taxpayer  does  not  have  the  right  to 
appeal  the  Service's  determination  to  the  Tax  Court  because  the  Tax 
Court  has  no  jurisdiction  in  cases  involving  the  types  of  taxes  covered 
by  section  6862. 

As  in  the  case  of  a  section  6861  jeopardy  assessment,  if  the  Service 
determines  that  a  tax  is  due  and  that  the  assessment  or  collection  of 
the  tax  would  be  jeopardized  by  delay,  the  Service  is  authorized 
to  immediately  assess  and  levy  upon  the  taxpayer's  property.  How- 
ever, under  prior  law,  unlike  the  prohibition  that  prevented  the  Service 
from  selling  any  propei'ty  seized  under  a  section  6861  jeopardy  assess- 
ment before  Tax  Court  appeal  rights  were  exhausted,  property  seized 
as  a  result  of  a  section  6862  jeopardy  assessment  (since  the  case  cannot 
be  taken  to  the  Tax  Court)  can  be  sold  before  the  taxpayer  has  a 
right  to  contest  the  tax  liability. 

The  appeal  rights  for  a  taxpayer  who  has  been  subject  to  a  section 
6862  jeopardy  assessment  begin  after  payment  of  the  tax  and  filing 
of  a  claim  for  refund  with  the  Service.  The  taxpayer  must  wait  6 
months — unle^^s  the  Service  denies  the  claim  sooner — and  then  either 
the  Federal  district  court  or  Court  of  Claims  will  consider  a  refund 
suit  by  the  taxpayer. 

Use  of  termination  assessments. — The  two  types  of  jeopardy  assess- 
ment discussed  np  to  this  point  are  used  only  where  the  deficiency  is 
determined  after  the  end  of  the  tnxnble  vear  to  which  it  relates.  A  ter- 
mination assessmen  (sec.  6851  of  the  Code'^  mav  be  m;^de  wlien  the  col- 
lection of  an  income  tax  is  in  jeopardy  before  the  end  of  a  taxpayer's 
normal  tax  year  or  Ix^fore  the  statuton'  date  the  taxpayer  is  required 
to  file  a  return  and  pay  the  tax.  Under  a  termination  assessment, 

^  The  notice  is  a  jurisdictional  prerequisite  to  litigation  In  the  Tax  Court. 


234-120  O  -  77  -  24 


358 

which  may  be  made  only  to  collect  income  taxes,  if  the  Semce  finds 
that  the  collection  of  a  tax  is  in  jeopardy,  it  is  authorized  to : 

(1)  serve  notice  on  the  taxpayer  of  the  tennination  of  his 
taxable  period ; 

(2)  demand  immediate  payment  of  any  tax  determined  to  be 
due  for  the  terminated  period ;  and 

(3)  if  payment  is  not  received,  immediately  levy  upon  the 
taxpayer's  property. 

Any  amount  collected  as  a  result  of  the  termination  assessment  is 
credited  ajrainst  the  tax  finally  determined  to  be  due  for  the  tax- 
payer's full  year  liabilitv.  The  10-day  Avaitinj?  period  normally  re- 
quired between  demand  for  payment  and  seizure  of  the  taxpayer's 
property  does  not  apply  when  a  termination  assessment  is  made. 

In  recent  years  tliore  has  been  considei-ablo  litio-ation  and  confusion 
concerning  the  judicial  remedies  of  taxpayers  Avho  were  subject 
to  termination  assessments  under  prior  law.  It  has  been  the  Service's 
position,  in  the  case  of  termination  assessments,  that  its  autlioritv  to 
assess  has  not  been  limited  by  requirements  (such  as  found  in  section 
6861)  that  the  Service  must  send  to  the  taxpaver  a  deficiency  notice 
within  60  days  after  assessment.  Thus,  under  tlie  Service's  position,  a 
taxpayer  who  liad  been  subject  to  a  termination  assessment  could  have 
contested  the  assessment  only  bv  (1)  paying  the  assessed  tax,  (2)  filing 
a  claim  for  refund  with  the  Service,  and  (3)  after  6  months,  unless 
the  refund  claim  was  denied  sooner,  filing  a  refund  action  with  the 
Federal  district  court  or  Court  of  Claims.  Since  it  also  has  been  the 
Service's  practice  not  to  consider  a  refund  claim  until  after  the  end  of 
the  taxpayer's  normal  tax  year,  there  could  liave  l^en  in  some  cases  a 
considerable  delav  until  the  taxpayer  could  obtain  judicial  review  of 
his  case,  and  during  this  delay  the  taxjiaver  was  depi'ived  of  the  use 
of  any  refund  to  Avhich  he  would  be  entitled.  Before  the  La'ing  deci- 
sion (see  footnote  3,  below),  some  courts  had  sustained  the  Service's 
position,  and  other  courts  had  rejected  it. 

On  January  13,  1976  (after  H.R.  10612  was  ])assed  by  the  House), 
the  Supreme  Court  held  ^  that  when  a  taxpayer  has  been  subjected  to 
a  termination  assessment,  the  Service  was  required  to  send  the  tax- 
payer a  notice  of  deficiency  within  60  davs  after  assessment  (see  foot- 
note 2,  above).  In  addition,  the  Court  held  that  the  Service  had  no 
authoritv  to  sell  property  seized  pursuant  to  a  termination  assessment 
before  the  taxpayer  has  had  an  opportunity  for  judicial  review  of  the 
tax  liabilitv  in  tlie  Tax  Court. 

In  recent  years,  most  taxpayers  who  have  been  subject  to  termina- 
tion assessments  have  been  suspected  of  dealing  in  narcotics.  Particu- 
larly during  1972  and  1973,  a  concerted  eff'ort  was  made  to  utilize 
termination  assessments  to  "reduce  the  profitabilitv"  of  dealing  in 
illegal  drugs.  In  1974,  however,  the  Service  revised  its  guidelines  to 
emphasize  that  termination  assessments  (and  jeopardy  assessments) 
were  to  be  utilized  to  achieve  maximum  comi)liance  with  tlie  internal 
I'evenue  laws  rather  than  to  attempt  to  disrupt  the  distribution  of 
narcotics. 


3  Laing  v.  United  States,  423  U.S.  161,  96  S.  Ct.  473,  76-1  USTC  par.  9164,  37  AFTR  2d 
76-530    (1976). 


359 

Reasons  for  change 

As  a  result  of  concern  in  this  area,  the  Joint  Committee  on 
Taxation,  on  December  27,  1974,  requested  the  General  Account- 
ing Office  to  act  as  its  agent  in  reviewing  the  procedures  followed 
by  the  Internal  Revenue  Service  in  making  jeopardy  assessments.  The 
review  was  to  include  how  the  Service  uses  these  enforcement  tools, 
how  often  they  are  used,  and  whether  their  use  varies  significantly 
from  district  to  district.  Because  of  the  time  schedule  of  Congressional 
tax  reform  consideration,  the  GAO  expedited  its  review  and  therefore 
limited  its  work  to  two  IRS  districts.  The  GAO  has  recently  submitted 
its  report  to  the  Joint  Committee.* 

The  GAO  report  indicated  that  most  jeopardy  assessments  and  ter- 
mination assessments  were  utilized  against  taxpayers  allegedly  en- 
gaged in  illegal  activities,  although  some  of  the  jeopardy  assessments 
under  section  6862  were  utilized  to  collect  penalty  taxes  from  persons 
who  had  failed  to  collect,  or  pay  over,  employment  taxes.  Although 
the  GAO  generally  concluded  that  these  types  of  assessments  had  not 
been  misused,  it  did  note  that  the  termination  assessments  were  gen- 
erally unproductive  from  a  tax  collection  viewpoint,  since  in  40  cases 
which  had  been  completed  as  of  March  1976,  $1,254,233  was  assessed 
but  the  total  tax  deficiency  after  audit  was  only  $220,677  (17.6  percent 
of  the  assessments).  The  GAO  also  noted  that,  in  at  least  one  case 
where  a  section  6862  jeopardy  assessment  was  used  to  collect  penalty 
taxes  resulting  from  a  corporation's  failure  to  pay  employment  taxes, 
it  was  at  least  possible  that  the  taxpayer  was  not  liable  for  payment  of 
the  penalty  tax. 

The  jeopardy  and  termination  assessment  jewel's  granted  to  the 
Internal  Revenue  Service  are  generally  considered  valuable  enforce- 
ment tools  which  the  Service  can  effectively  utilize  in  unusual  circum- 
stances to  prevent  taxpayers  from  avoiding  the  payment  of  taxes.  How- 
ever, a  taxpayer  who  has  been  subjected  to  such  an  assessment  may 
suffer  considerable  hardship  from  the  suddenness  with  which  action 
may  be  taken. 

Hardship  may  also  result  because  of  the  requirement  that,  if  the 
assessment  is  made  under  section  6862  (jeopardy  assessment  for  other 
than  income,  estate,  or  gift  tax,  or  certain  excise  taxes),  the  taxpayer 
must  pav  the  tax,  file  a  claim  for  refund,  and  then  wait  six  months 
before  filing  a  suit  for  refund.  In  addition,  property  seized  following 
a  jeopardy  assessment  under  section  6862  can  be  sold  before  the  tax- 
payer can  contest  the  tax  liability. 

Since  a  taxpayer  subjected  to  a  section  6851  termination  assessment 
or  a  section  6861  jeopardy  assessment  must  be  mailed  a  deficiency 
notice  within  60  days  after  the  assessment,  the  prol)lem  is  less  acute 
in  this  case  than  in  the  case  of  a  taxpa^'er  subjected  to  a  section  6862 
assessment.  However,  since,  even  in  the  case  of  a  temiination  assess- 
ment or  a  section  6861  jeopardy  assessment,  a  taxpayer  may  have  to 
wait  at  least  60  days  to  petition  the  Tax  Court  and  then  his  case  will 
be  placed  on  the  regular  docket  of  the  Tax  Court,  his  judicial  remedy 
(considered  in  the  light  of  the  fact  that  substantially  all  of  his  assets 


*  "TTse  of  .Teonardy  and  Termination  Assessments  by  tlie  Internal  Revenue  Service." 
submitted  July  16.  1976.  (GAO  had  submitted  a  draft  of  it<!  renort  to  the  House  Tommittee 
on  Ways  and  Means  during  its  marlcup  of  the  reform  legislation  in  September  1975.) 


360 

may  have  been  seized)  is  not  sufficiently  speedy  to  avoid  undue  hard- 
ship in  cases  where  the  assessment  may  have  been  inappropriate. 

Furthermore,  some  have  argued  that  under  prior  law  a  taxpayer's 
rights  for  review  of  the  Service's  action  M^ere  constitutionally  inade- 
quate. That  argument  was  based  on  the  premise  that,  in  view  of  the 
hardship  that  could  have  been  suffered  by  a  taxpayer  who  was  the 
subject  of  a  jeopardy  or  termination  assessment,  it  was  not  sufficient 
to  provide  that  within  60  days  a  taxpayer  could  have  filed  a  petition 
with  the  Tax  Court  which  generally  could  be  expected  to  render  an 
opinion  within  12  to  30  months  after  the  petition  was  filed. 

On  March  8,  1976,  the  Supreme  Court  decided  the  case  of  CommAs- 
fihner  v.  Shapiro  424  U.S.  614-761  USTC  par.  9266,  37  AFTR  2d 
76-959  (1976),  involving  an  interpretation  of  the  Anti-Injunction  Act 
(section  7421  of  the  Code)  with  respect  to  a  taxpayer  against  whom 
a  jeopardy  assessment  had  been  made.  In  this  case,  the  Supreme  Court 
rejected  the  Commissioner's  position  that  he  "has  absolutely  no  obli- 
gation to  prove  that  the  seizure  has  any  basis  in  fact  no  matter  how 
severe  or  irreparable  the  injury  to  the  taxpayer  and  no  matter  how 
inadequate  his  eventual  remedy  in  the  Tax  Court."  (424  U.S.  at  630.) 
The  Supreme  Court  also  indicated  that,  at  least  in  certain  circum- 
stances, a  taxpayer  may  be  constitutionally  entitled  to  a  more  rapid 
judicial  or  administrative  review  of  the  Service's  basis  for  a  seizure 
of  assets  pursuant  to  a  jeopardy  asessment  than  is  provided  by  his 
right  to  petition  the  Tax  Court  under  the  normal  Tax  Court  proce- 
dures. In  its  opinion  (at  footnote  12),  the  Supreme  Court  also  stated: 
"Nothing  we  hold  today,  of  course,  would  prevent  the  Gov- 
ernment from  providing  an  administrative  or  other  forum 
outside  the  Art.  Ill  judicial  system  for  whatever  preliminary 
inquiry  is  to  be  made  as  the  basis  for  a  jeopardy  assessment 
and  levy." 
Under  the  circumstances.  Congress  felt  that  a  taxpayer  should  be 
able  to  obtain  judicial  review  of  the  propriety  of  a  jeopardy  assess- 
ment or  a  termination  assessment  on  an  expedited  basis  and  also  that 
assets  levied  on  by  reason  of  any  jeopardy  assessment  or  termination 
assessment  should  not  be  sold  prior  to  or  during  the  pendency  of  this 
judicial  review.  Also,  Congress  believed  that  the  niles  relating  to  the 
possible  creation  of  multiple  short  taxable  years  by  i-eason  of  termina- 
tion assessments  needed  to  be  revised. 

Explanation  of  provisions 
The  Act  adds  a  new  provision  (sec.  7429)  which  provides  for  expe- 
dited administrative  and  judicial  review  of  jeopardy  and  termination 
assessments.  Under  this  new  procedure,  within  five  days  after  the 
date  on  which  a  jeopardy  or  termination  assessment  is  made,  the  Serv- 
ice is  required  to  give  the  taxpayer  a  written  statement  of  the  infor- 
mation upon  which  the  Service  relies  in  making  the  assessment. 
Within  30  days  after  the  statement  is  furnished  (or  required  to  be 
furnished),  the  taxpayer  may  request  the  Service  to  review  the  pro- 
priety of  the  jeopardy  or  tennination  assessment.  After  such  a  request 
is  made,  the  Service  is  to  detennine  (1)  whether  the  making  of  the 
jeopardy  or  termination  assessment  is  reasonable  under  the  circum- 
stances and  (2)  whether  the  amount  assessed  is  appropriate  under  the 
circumstances.  In  making  these  determinations,  the  Service  is  to  take 


361 

into  account  not  only  infonnation  available  at  the  time  the  assess- 
ment is  made  but  also  information  which  subsequently  becomes  avail- 
able.^ If  the  Service  finds  that  the  assessment  is  inappropriate  or  ex- 
cessive in  amount,  it  may  abate  the  assessment  in  whole  or  in  part.*^ 

If  the  taxpayer  is  not  satisfied  with  the  results  of  the  administrative 
review,  he  may,  within  30  days  after  the  Service  makes  a  determina- 
tion on  his  request  (or,  if  earlier,  within  30  days  after  the  16th  day 
after  the  request  for  administrative  review  was  made) ,  bring  an  action 
in  the  United  States  District  Court  for  the  district  in  which  he  resides. 
Within  20  daj's  after  the  commencement  of  this  action,  the  district 
court  is  to  make  independent,  de  novo  determinations  as  to  (1)  whether 
the  maldng  of  the  jeopardy  or  termination  assessment  is  reasonable 
under  the  circumstances,  and  (2)  whether  the  amount  assessed  or  de- 
manded is  api>ropriate  under  the  circumstances.  In  making  these  de- 
terminations, the  court  is  to  take  into  account  not  only  information 
available  to  the  Service  at  the  time  of  the  assessment  but  also  any  other 
information  which  bears  on  these  issues.  The  court  has  autho^'ity  to 
effectuate  its  determination  by  ordering,  where  appropriate,  the  abate- 
ment of  the  assessment  (in  whole  or  in  part)  or  by  other  appropriate 
relief.  The  20-day  period  may  be  extended  by  not  more  than  40  addi- 
tional days  at  the  request  of  the  taxpayer,  but  may  not  be  extended  at 
the  request  of  the  Treasury  Department  or  the  court.  It  is  further  pro- 
vided that  a  determination  by  the  district  court  may  not  be  appealed  to 
or  reviewed  by  any  other  court. 

In  this  court  proceeding,  the  Treasury  Department  has  the  burden 
of  proof  as  to  whether  the  making  of  the  jeopardy  or  termination 
assessment  is  reasonable."  If  an  issue  is  raised  as  to  the  reasonableness 
of  the  amount  assessed,  the  Treasury  Department  is  required  to  pro- 
vide a  written  statement  (such  as  in  its  answer  to  the  taxpayer's  peti- 
tion) setting  forth  its  basis  for  determining  the  amount  assessed,  but 
the  taxpayer  is  required  to  bear  the  burden  of  proof.  This  is  similar 
to  the  division  of  burden  of  proof  in  civil  fraud  cases.  The  burden  of 
proof  as  to  the  reasonableness  of  making  a  jeopardy  or  termination  as- 
sessment is  placed  on  the  Treasury  Department  because  the  making  of  a 
jeopardy  or  termination  assessment  involves  more  severe  consequences 
to  the  taxpayer  than  a  normal  assessment,  and  the  imposition  of 
these  consequences  differs  substantially  from  normal  assessment  and 
collection  procedure.  However,  the  Treasury  Department  is  not  re- 
quired to  carry  its  burden  of  proof  in  the  court  review  of  a  jeopardy  or 
termination  assessment  under  the  special  evidentiary  standard  of  proof 
applicable  to  proving  civil  fraud,  i.e.,  "clear  and  convincing  evidence." 
Rather,  the  usual  standard  is  to  apply,  as  it  does  where  the  govern- 
ment is  given  the  burden  of  proof  in  a  deficiency  case  on  a  tax  issue 
it  failed  to  raise  in  its  notice  of  deficiency. 


s  Since  the  Service  (and  the  court)  may  rely  on  information  which  becomei?  available 
after  the  makiner  of  the  assessment,  the  ai'atement  (in  whole  or  in  part)  of  a  jeopardy 
or  termination  assessment  does  not  necessarily  Imply  that  the  Service  acted  improperly 
in  makin?  the  assessment. 

*  Bntli  the  Serv'ce  and  the  court  nre  intended  to  have  d'scre+ion  to  abate  an  assess- 
ment (in  whole  or  in  ]iart)  even  if  the  assessment  is  not  found  to  be  inaporopriate  or 
excessive    if  there  is  a  findine  that  the  taxpayer  would  suffer  unusual  hardship. 

■J The  Congress  believes  that  the  general  standards  set  forth  in  the  Internal  Revenue 
Manual  relatinp  to  the  conditions  which  must  exist  before  a  jeopardy  or  termination 
assessment  is  made  are  reasonable.  (See  footnote  1,  above,  for  the  standards  provided  In 
the  manual.) 


362 

In  determining  whether  the  amount  assessed  is  appropriate  under 
tlie  circumstances,  the  court  is  not  expected  to  attempt  to  determine 
uUimate  tax  liability.  Rather,  the  issue  to  be  determined  is  whether, 
based  on  the.  information  then  available,  the  amount  of  the  assessment 
is  reasonable.  Thus,  for  example,  in  the  absence  of  other  evidence  made 
available  to  the  Internal  Revenue  Service  before  the  proceeding  or 
during  the  proceeding,  an  assessment  of  an  estimate  of  the  taxpayer's 
liability  to  date  based  on  information  in  fact  available  to  the  Internal 
Revenue  Service  will  be  presumed  to  be  reasonable. 

A  determination  made  under  new  section  7429  will  have  no  effect 
upon  the  determination  of  the  correct  tax  liability  in  a  subsequent  pro- 
ceeding. The  proceeding  under  the  new  provision  is  to  be  a  separate 
proceeding  which  is  unrelated,  substantively  and  procedurally,  to  any 
subsequent  proceeding  to  determine  the  correct  tax  liability,  either  by 
action  for  refund  in  a  Federal  district  court  or  the  Court  of  Claims  or 
by  a  proceeding  in  the  Tax  Court. 

The  requirement  that  the  Service  give  the  taxpayer  a  written  state- 
ment of  the  information  upon  which  it  relied  in  making  the  jeopardy 
or  termination  assessment  and  the  provision  for  administrative  review 
are  provided  because  Congress  believed  that  this  statement  to  the  tax- 
payer and  an  opportunity  for  administrative  review  will  allow  the 
taxpayer  and  the  Service  to  exchange  information  and,  in  most  cases, 
either  to  work  out  a  solution  satisfactory  to  both  parties  or  at  least  to 
facilitate  the  court  proceeding.  These  provisions  could  delay  court 
review  for  only  20  days,  and,  in  the  judgment  of  Congress,  the  delay 
appears  to  be  more  than  counterbalanced  by  the  likelihood  that  the 
court  proceedings  would  be  facilitated  by  the  exchange  of  information 
and  that  some  court  proceedings  could  be  avoided  entirely. 

The  Act  provides  for  expedited  review  of  jeopardy  and  termination 
assessments  by  the  district  court  because  it  is  contemplated  that  tax- 
payer would  find  it  easier  and  more  convenient  to  bring  an  action  in 
the  district  courts  rather  than  in  the  Tax  Court.  In  addition,  since  the 
Tax  Court  does  not  have  permanent  facilities  (or  judges  or  commis- 
sioners sitting)  throughout  the  country,  review  of  these  procedures  is 
likely  to  be  less  of  a  burden  if  placed  in  the  district  courts. 

The  Act  also  provides  that,  during  the  period  necessary  to  complete 
administrative  review,  and,  if  administrative  review  is  sought,  during 
the  period  necessary  to  seek  judicial  review,  property  seized  pureuant 
to  a  jeopardy  or  termination  assessment  may  not  be  sold  unless  (1) 
it  is  perishable.  (2)  the  taxpayer  consents,  or  (3)  the  expenses  of  con- 
servation or  maintenance  would  greatly  reduce  the  net  proceeds.  AVliere 
judicial  review  is  sought,  these  restrictions  also  apply  during  the  pe- 
riod until  a  jud'cial  determination  is  made. 

The  Supreme  Court  in  the  Laing  case  held  that,  since  restraints  on 
section  6861  also  applied  to  assessments  under  6851,  property  seized 
pureuant  to  a  termination  assessment  could  not  be  sold  ])rior  to  an  op- 
portunity for  Tax  Court  review  of  the  amount  of  tax  liability,  and  if 
a  petition  is  filed  in  the  Tax  Court,  prior  to  the  completion  of  the  action 
on  the  tax  liability.  The  Act  follows  this  decision  in  this  respect  ex- 
cept that  the  restrictions  on  sale  expire  on  the  due  date  of  the  return 
(taking  into  account  any  extensions)  if  no  return  is  filed  by  that  date. 


363 

Since  the  Act  provides  this  special  proceeding  whereby  the  tax- 
payer can  have  both  administrative  and  judicial  review  of  the  appro- 
priateness of  the  jeopardy  or  termination  assessment  within  as  few 
as  40  days  after  the  makino;  of  such  assessment,  Congress  believed  it 
is  appropriate  to  provide  that  the  making  of  a  termination  assessment 
does  not  terminate  a  taxable  year,  create  a  deficiency,  or  require  the 
Service  to  give  the  taxpayer  a  notice  of  deficiency  within  60  days  of  a 
termination  assessment.  The  decision  in  the  Lahig  case  interprets  prior 
law  to  require  such  a  notice  within  60  days  of  the  making  of  the  termi- 
nation assessment  since  it  regai'ds  the  amount  assessed  pursuant  to 
such  an  assessment  as  a  deficiency.  This  approach,  however,  would 
have  the  effect  of  requiring  courts  to  make  a  determination  of  tax 
liability  based  upon  less  than  a  full  taxable  year.  Such  a  determination 
appears  to  be  inconsistent  with  the  provisions  of  section  6851(b) 
(prior  to  its  amendment)  allowing  the  taxable  year  to  be  reopened 
after  termination  until  its  normal  end  if  the  taxpayer  has  income  after 
the  tei'mination.  The  requirement  of  multiple  short  taxable  years 
could  not  only  create  administrative  problems  for  the  Service,  but 
also  could  result  in  detriment  to  the  taxpayer  whose  income  tax 
liability  might  be  greater  because  of  the  multiple  years.* 

Therefore,  the  Act  revises  section  6851  to  provide  that  a  termina- 
tion assessment  does  not  end  the  taxable  year  for  any  purpose  other 
than  the  computation  of  the  amount  of  tax  to  be  assessed  and  collected. 
Also,  the  language  relating  to  reopening  of  a  taxable  year  is  elimi- 
nated. This  has  the  general  effect  of  treating  amounts  assessed  and 
collected  pursuant  to  termination  assessments  in  a  manner  similar  to 
the  collection  of  estimated  taxes.  Such  an  enforced  collection,  however, 
is  subject  to  the  administrative  and  judicial  review  described  above, 
but  it  does  not  have  the  effect  of  terminating  the  taxpayer's  taxable 
year.  Rather,  such  taxable  year  continues  until  its  normal  end. 

Congress  believes  it  is  appropriate  to  allow  a  taxpayer  who  has  been 
subjected  to  a  termination  assessment  to  contest  the  ultimate  issue  of 
his  tax  liability  in  the  Tax  Court  in  the  same  manner  as  is  provided 
with  respect  to  a  taxpayer  who  has  been  subjected  to  a  jeopardy  assess- 
ment. Consequently,  the  Act  provides  that  within  60  days  after  the 
later  of  the  due  date  of  the  taxpayer's  return  for  the  full  taxable  year 
or  the  date  on  which  the  return  is  actually  filed,  the  Service  must  send 
the  taxpayer  a  notice  of  deficiency.^ 


8  Thus,  for  instance,  gambling  winnings  can  be  offset  by  gambling  losses  only  within 
the  same  taxable  year.  Consequently,  if  a  gambler  were  the  subject  of  a  termination 
assessment,  he  might  well  be  worse  off  with  two  short  taxable  years  than  a  full  taxable 
year.  Also,  a  number  of  complicated  issues  might  well  have  to  be  faced,  such  as  ad.lust- 
Ing  limitations  on  the  number  of  taxable  years  for  carryovers  and  carrybacks  (such  as 
those  for  net  operating  losses  and  the  investment  credit)  and  problems  relating  to  an- 
nualization  of  the  taxpayer's  Income. 

»  The  Act  also  makes  a  number  of  technical  changes  to  the  code  to  conform  to  the  revi- 
sions of  section  68ol(a)  and  (b)  and  to  clarify  the  manner  In  which  the  tax  is  computed 
both  where  there  is  one  termination  assessment  in  a  taxable  year  and  vhere  there  are 
multiple  terminations.  Thus,  for  instance,  it  is  provided  that  certain  rules  relating  to  jeop- 
ardy assessments  also  apply  to  termination  assessments,  including  provisions  Indicating 
that  the  Service  has  discretionary  authority  to  abate  where  jeopardy  is  not  shown  to 
exist  (even  without  regard  to  the  review  process  described  above).  The  renuirement  of  a 
return  for  the  short  period  from  the  beginning  of  the  taxable  year  until  the  date  of  ter- 
mination assessment  is  repealed,  and  section  6091  is  amended  to  specifically  allow  the 
Service  to  designate  tlie  place  for  taxpavers  who  have  been  subjected  to  termination  as- 
sessments. Section  6211(b)(1)  is  amended  to  provide  that  the  amounts  collected  nur- 
suant  to  a  termination  assessment  are  not  treated  as  nayments  which  would  be  utilized 
in  determining  whether  there  is  a  deficiency.  Further,  the  rules  relating  to  a  bond  to  stay 
collection  of  a  termination  assessment  have  been  integrated  with  those  relating  to  jeopardy 
assessments  in  section  6863(a). 


364 

Effective  date 
Under  the  Act,  these  provisions  were  to  apply  to  jeopardy  and  termi- 
nation assessments  where  the  notice  and  demand  takes  phice  after 
December  31,  1976.  However,  Public  Law  9^528  delayed  the  effective 
date  of  these  provisions  to  apply  to  jeopardy  and  termination  assess- 
ments where  the  notice  and  demand  takes  place  after  February  28, 1977. 

Revenue  effect 
These  provisions  do  not  have  any  revenue  impact. 

5.  Administrative  Summons  (sec.  1205  of  the  Act  and  sees.  7609 
and  7610  of  the  Code) 

Prioi'  law 

Under  the  tax  law,  the  IRS  is  given  authority,  during  the  course  of 
an  investigation  to  determine  the  tax  liability  of  a  person,  "to  examine 
any  books,  papers,  records,  or  other  data  which  may  be  relevant  or 
material"  to  the  investigation.  This  includes  not  only  the  right  to 
examine  records  in  the  possession  of  the  taxpayer  but  also  the  a\ithority 
to  issue  a  summons  to  "any  person"  having  possession  or  custody  of 
records  "relating  to  the  business  of  the  person  liable  for  tax"  as  well 
as  the  authority  to  take  the  testimony  of  any  such  person  under  oath 
(sec.  7602).  In  certain  cases,  where  the  Service  has  reason  to  believe 
that  certain  transactions  have  occurred  which  may  affect  the  tax  liabil- 
ity of  some  taxpayer,  but  is  unable  for  some  leason  to  determine  the 
specific  taxpayer  who  may  be  involved,  the  Service  may  serve  a  so- 
called  "John  Doe"  summons,  which  means  that  books  and  records  relat- 
ing to  certain  transactions  are  requested,  although  the  name  of  the  tax- 
payer involved  is  not  specified  ( United  States  v.  Bisceglm,  420  U.S.  141 
(1975)).  The  summonses  served  by  the  Internal  Revenue  Service, 
which  may  be  referred  to  as  administrative  summonses,  may  be  en- 
forced where  necessary  by  appropriate  court  procedure. 

Under  prior  law,  where  the  summons  was  served  on  a  person  Avho  was 
not  the  taxpayer  (i.e.,  a  third-party  summons),  the  party  sunnnoned 
could  challenge  the  summons  for  procedural  defects  (i.e.,  on  grounds 
that  the  summons  was  not  validly  served  or  was  ambiguous,  vague  or 
otherwise  deficient  in  describing  the  material  requested),  on  grounds 
of  the  attorney-client  privilege  (wliere  applicable)  and  on  other 
grounds,  such  as  an  assertion  that  the  material  subject  to  summons 
was  not  relevant  to  a  lawful  investigation,  or  that  it  was  not  possible 
for  the  witness  to  comply  (as  where  the  records  were  not  in  his  pos- 
session). However,  there  was  no  legal  requirement  that  the  taxpayer 
(or  other  party)  to  whose  business  or  transactions  the  summoned  rec- 
ords related  be  informed  that  a  third-party  summons  had  been  served.' 
obtain  records,  etc.,  without  an  advance  showing  of  probable  cause 

Reasons  for  cJiange 
The  use  of  the  administrative  summons,  including  the  third-party 
summons,  is  a  necessary  tool  for  the  IRS  in  conducting  many  legiti- 
mate investigations  concerning  the  projjer  determination  of  tax.  The 
administration  of  the  tax  laws  requires  that  the  Service  be  entitled  to 

-In  United  States  v.  Miller,  decided  on  April  21,  1976,  the  Supreme  Court  lield  that 
a  taxpayer  had  no  protectable  Fourth  amendment  interest  in  certain  bank  records  main- 
tained pursuant  to  the  Banl^  Secrecy  Act  of  1970. 


365 

obtain  records,  etc.,  without  an  advance  showing  of  probable  cause 
or  other  standards  which  usually  are  involved  in  the  issuance  of  a 
search  warrant.  On  the  other  hand,  the  use  of  this  important  investi- 
gative tool  should  not  unreasonably  infringe  on  the  civil  rights  of 
taxpayers,  including  the  right  to  privacy. 

Even  prior  to  the  enactment  of  this  provision,  the  Service  had  insti- 
tuted an  administrative  policy  designed  to  establish  certain  safeguards 
in  this  area.  Under  this  policy,  IRS  representatives  were  instructed 
to  obtain  information  from  taxpayers  and  third  parties  on  a  volun- 
tary basis  where  possible.  Where  a  third-party  summons  is  served, 
advance  supervisory  approval  was  required.  In  the  case  of  a  John 
Doe  summons,  the  advance  supervisory  approval  was  required  to 
be  obtained  on  a  high  level  basis.  The  Congress  decided,  however,  that 
these  administrative  changes,  while  commendable,  do  not  fully  provide 
all  of  the  safeguards  which  might  be  desirable  in  terms  of  protecting 
the  right  of  privacy. 

The  Congress  believes  that  many  of  the  problems  in  this  area  can 
be  cured  if  the  parties  to  whom  the  records  pertain  are  advised  of  the 
service  of  a  third-party  summons,  and  are  afforded  a  reasonable  and 
speedy  means  to  challenge  the  summons  where  appropriate.  "NVliile  the 
third-party  witness  also  had  this  right  of  challenge,  even  under  prior 
law,  the  interest  of  the  third-party  witness  in  protecting  the  privacy 
of  the  records  in  question  is  frequently  far  less  intense  than  that  of  the 
persons  to  whom  the  records  pertain. 

In  the  case  of  a  Jolin  Doe  summons,  advance  notice  to  the  taxpayer 
is  obviously  not  possible.  Here  the  Congress  decided  that  the  IRS 
agent  should  be  required  to  show  adequate  grounds  for  serving  the 
summons  in  an  independent  review  process  before  a  court  before  any 
such  summons  can  be  served. 

Explanation  of  provisions 

Under  the  Act,  new  requirements  are  imposed  where  an  admin- 
istrative summons  is  served  on  a  third-party  record  keeper.  This  cate- 
gory is  limited  to  attorneys,  accountants,  banks,  trust  companies, 
credit  unions,  savings  and  loan  institutions,  credit  reporting  agencies, 
issuers  of  credit  cards,  and  brokers  in  stock  or  other  securities.  For 
purposes  of  these  rules,  a  third-party  record  keeper  within  this  cate- 
gory must  be  a  person  engaged  in  making  or  keeping  the  records 
involving  transactions  of  other  persons.  For  example,  an  administra- 
tive summons  served  on  a  partnership,  with  respect  to  records  of  the 
partnership's  own  transactions,  would  not  be  subject  to  these  rules. 

Under  the  Act,  the  Service  is  to  be  required  to  send  notice  of  the 
summons  by  registered  or  certified  mail  to  the  person  (or  persons) 
v/ho  is  identified  in  the  description  of  the  books  and  records  contained 
in  the  summons  as  the  person  relating  to  whose  business  or  transactions 
the  books  or  records  are  kent.'  For  example,  if  the  Service  summons  a 
bank  to  furnish  records  with  respect  to  all  deposits  and  withdrawals 
of  the  X  corporation  for  the  year  1976,  the  X  corporation  is  to  receive 
notice  of  the  summons,  because  it  is  the  records  concerning  the  trans- 


*  Snch  notice  Is  to  bp  sent  to  the  last  kno^'n  business  or  residential  address  of  the 
person  or  persons  so  identified.  (If  no  address  is  known,  the  notice  may  be  left  with  the 
third-party  record  keeper. ) 


366 

actions  of  the  X  corporation  which  are  being  examined.^  Where  more 
than  one  person  is  identified  in  the  description  of  the  records  as  a  per- 
son the  records  of  whose  transactions  are  to  be  inspected,  then  all 
such  persons  are  to  ha\e  the  right  to  receive  notice  under  these  pro- 
visions, and  are  also  to  have  the  right  to  challenge  the  summons,  as 
discussed  below. 

The  notice  required  under  these  rules  is  to  be  mailed  not  later  than 
3  days  after  the  administrative  summons  is  served  on  the  third-party 
record  keeper. 

The  Congress  also  expects  that  the  Service  will  prepare  a  summary 
of  the  noticee's  rights  under  these  provisions,  in  layman's  language, 
and  that  a  copy  of  this  summary  will  be  enclosed  with  each  copy  of 
the  certified  notice,  so  that  taxpayers  and  other  noticees  will  not  lose 
their  right  to  intervention  due  to  inadvertance  or  ignorance  of  their 
rights. 

Under  the  Act,  the  Service  is  not  to  attempt  to  obtain  the  records 
covered  under  the  summons  until  the  expiration  of  a  l-t-day  period 
from  the  date  of  the  mailing  of  tlie  notice  to  the  taxpayer  or  other 
noticee.  This  is  to  give  the  taxpayer  (or  other  noticee)  *  a  14-day 
period  in  which  to  notify  the  bank  or  other  third-party  witness  not  to 
comply  with  the  summons.  This  notification  may  be  in  the  form  of  a 
letter  sent  by  certified  or  registered  mail,  A  copy  of  this  notice  is  to  be 
similarly  mailed  within  this  same  14-day  period  to  the  IRS  officer 
designated  in  the  notice  which  the  taxpayer  receives.  The  notification 
by  the  taxpayer  or  other  noticee  is  to  be  treated  as  timely  (within  the 
meaning  of  sec.  7502)  if  such  notification  is  mailed  within  the  14-day 
period.  Where  the  copy  of  tlie  notification  lias  not  been  received  by  the 
Service  within  3  days  from  the  close  of  the  14-day  period,  the  IRS 
would  be  permitted  to  presume  that  the  notification  had  not  been  time- 
ly mailed. 

Of  course,  where  the  noticee  does  not  request  tlie  third-party  witness 
not  to  comply  at  this  stage,  he  would  still  be  permitted  to  assert  such 
defenses  as  may  be  available  to  him  with  respect  to  any  evidence  ob- 
tained pursuant  to  the  summons  in  any  later  court  action  in  which 
the  noticee  was  directly  involved  (i.e.,  affecting  his  tax  liability  or  any 
criminal  charges  which  might  be  brought)  to  the  same  extent  that 
he  had  this  right  under  prior  law. 

In  cases  where  noticees  do  exercise  their  right  to  request  noncom- 
pliance by  notifying  the  third-party  record  keeper  and  tlie  IRS,  as 
outlined  above,  the  Service  is  not  to  seek  to  inspect  the  books  or  rec- 
ords subject  to  the  summons  unless  the  Service  goes  into  court  and 
obtains  an  order,  against  the  third-party  record  keeper,  for  enforce- 
ment of  its  summons.  Both  the  third-party  record  keeper  and  the 
noticee  are  to  be  served  with  notice  that  an  action  for  enforcement  has 
been  instituted.^  The  third-party  record  keeper  could  (if  it  chose  to 


3  Of  course,  thp  Service  woiild  not  be  required  to  send  a  notice  to  eacti  person  to  whom 
the  X  corporation  wrote  a  checlc  during  the  period  under  examination  ;  not  only  would 
this  he  impossible  administratively,  but  the  identity  of  these  persons  would  not  even  be 
known  by  the  Service  until  the  records  bnd  been  examined. 

*  Under  the  Act,  the  protection  of  these  rules  extends  even  if  the  person  Identified  in 
the  summons  (I.e.,  the  noticee)  is  not  a  taxpayer  whose  tax  liability  Is  under  current 
investigation. 

5  Generally,  the  third-party  witness  would  be  served  with  process.  The  taxpayer  or  other 
noticee  would  be  entitled  to  receive  notice  by  certified  or  registered  mail. 


367 

oppose  enforcement  of  the  order)  assert  such  defenses  as  may  be  avail- 
able to  it,  just  as  under  prior  law. 

The  noticee  could  also  intervene  in  the  action  to  enforce  the  sum- 
mons and  assert  defenses  to  enforcement  of  summons  which  were  avail- 
able under  prior  law.  In  addition,  the  Congress  intends  that  the 
noticee  would  have  standing  to  raise  other  issues  which  could  be  as- 
serted by  the  third-party  record  keeper,  such  as  asserting  that  the  sum- 
mons is  ambiguous,  vague  or  otherwise  deficient  in  describing  the  ma- 
terial requested,  or  that  the  material  requested  is  not  relevant  to  a  law- 
ful investigation.  In  other  words,  the  Congress  intends  that  the  noticee 
will  be  allowed  to  stand  in  the  shoes  of  the  third-party  record  keeper 
and  assert  certain  defenses  to  enforcement  which  witnesses  are  tradi- 
tionally allowed  to  claim,  but  which  might  not  have  been  available  to 
intervenors  (under  many  court  decisions)  on  ground  of  standing. 

At  the  same  time,  it  should  be  made  clear  that  the  purpose  of  this 
procedure  is  to  facilitate  the  opportunity  of  the  noticee  to  raise  defenses 
which  are  already  available  under  the  law  (either  to  the  noticee  or  to 
the  third-party  witness)  and  that  these  provisions  are  not  intended  to 
expand  the  substantive  rights  of  these  parties.  Also,  of  course,  the 
noticee  will  not  be  permitted  to  assert  as  defenses  to  enforcement  issues 
which  only  affect  the  interests  of  the  third-party  record  keeper,  such 
as  the  defense  that  the  third-party  record  keeper  was  not  properly 
served  with  the  summons  (i.e.,  wrong  address)  or  that  it  will  be 
unduely  burdensome  for  the  third-party  record  keeper  to  comply  with 
the  summons. 

The  Congress  does  not  wish  these  procedures  to  so  delay  tax  inves- 
tigations by  the  Service  that  they  produce  a  problem  for  sound  tax 
administration  greater  than  the  one  they  seek  to  solve.  Accordingly, 
the  Act  provides  that  the  disposition  of  any  court  actions  involved  be 
heard  on  as  expeditious  a  schedule  as  possible. 

Also,  to  prevent  the  use  of  this  procedure  by  a  taxpayer  purely 
for  the  purpose  of  delay,  the  Act  provides  that  in  cases  where 
the  noticee  is  also  the  taxpayer  whose  tax  liability  is  under  in- 
vestigation in  connection  with  the  summons,  tlie  statute  of  lim- 
itations for  assess'nent  of  the  taxpayer's  liability  for  the  period 
with  respect  to  which  the  summons  relates,  as  well  as  the  crimi- 
nal statute  of  limitations,  is  to  be  suspended  during  the  period  of  any 
court  action  by  the  Service  to  enforce  the  summons.*'  Of  course,  this 
rule  only  applies  where  the  noticee  (who  is  also  the  taxpayer  involved) 
has  mailed  notice  to  the  third-party  witness  not  to  comply  w^th  the 
summons  or  intervenes  in  the  court  action.  No  suspension  of  the  statute 
occurs  where  enforcement  of  the  summons  is  onlv  contested  by  the 
third-party  record  keeper.  However,  the  statute  of  limitations  would 
Ije  suspended  if  the  noticee  staying  compliance  with  the  summons  (or 
intervening  in  the  court  action)  Avere  the  taxpayer's  nominee  or  agent, 
or  another  person  actually  under  the  direction  or  control  of  the  tax- 


"  Of  course,  closed  years  would  not  be  rpopened  under  these  rules.  The  Congress  expects 
thnt  in  thp  summary  of  rljrhts  which  the  Service  is  to  send  to  taxpayers  (and  other 
noticees).  the  Service  will  include  a  description  of  the  rules  relatine  to  the  suspension  of 
the  s-tatutp  of  limitations,  includine  the  snecific  years  which  will  be  affected  If  the 
taxpayer  requests  third-party  noncompliance  with  the  summons  and  the  Service  sub- 
seouentlv  seel^s  enforcement  of  Its  summons.  Where  the  noticee  Is  not  the  taxpayer  under 
Investigation  the  statute  of  limitations  is  not  to  be  suspended,  and  the  summary  of  rights 
is  to  indicate  this  fact. 


368 

payer.  A  corporation  controlled  by  the  taxpayer,  for  example,  is  cov- 
ered under  this  rule.  On  the  other  hand,  if  the  third-party  record 
keeper  (attorney,  accountant,  bank,  etc.)  protested  enforcement  of  the 
summons,  this  would  not  suspend  the  statute  of  limitations  with  respect 
to  the  taxpayer  because  the  third-party  record  keeper  is  not  the  notice. 
(Also,  these  persons  ordinarily  would  not  be  under  the  actual  direc- 
tion or  control  of  the  taxpayer.) 

In  general,  these  rules  apply  in  the  case  of  a  summons  issued  under 
paragraph  (2)  of  section  7602  (general  examination  of  books  and 
records)  as  well  as  the  specific  summonses  available  in  connection  with 
certain  credits.'  These  rules  also  apply  in  connection  with  testimony 
to  be  taken  under  summons  from  the  third-party  witness  relating  to 
these  books  and  records. 

However,  this  procedure  will  not  apply  in  the  case  of  a  summons  used 
solely  for  purposes  of  collection.  Also,  this  procedure  would  not  apply 
in  cases  where  the  only  information  requested  by  the  Service  was 
whether  or  not  the  third-party  record  keeper  had  records  with  respect 
to  a  particular  person  ( without  requesting  any  information  contamed 
in  those  records) . 

Thus,  where  the  Service  has  made  an  assessment  or  obtained  a  judg- 
ment against  a  taxpayer  and  ser^'es  a  summons  on  a  bank,  for  exampie, 
in  order  to  determine  whether  the  taxpayer  has  an  account  in  that 
bank,  and  whether  the  assets  in  that  account  ai'e  sufficient  to  cover  the 
tax  liability  which  has  been  assessed,  the  Service  is  nut  required,  under 
the  Act,  to  give  notice  to  the  taxpayer  whose  account  is  involved. 
Also,  notice  is  not  required  where  the  Service  is  attempting  to  en- 
force fiduciary  or  transferee  liability  for  a  tax  which  has  been 
assessed.  (Otherwise,  there  might  be  a  possibility  that  the  taxpayer, 
transferee  or  fiduciary  would  use  the  14-day  grace  period,  which  is 
provided  under  the  provisions  outlined  above,  to  withdraw  the  money 
in  his  accomit,  thus  frustrating  the  collection  activity  of  the  Service.) 
However,  this  exception  does  not  apply  where  the  Service  is  attempting 
to  obtain  information  concerning  the  taxpayer's  account  for  purposes 
other  than  collection  as,  for  example,  where  the  iService  is  attempting 
to  compute  the  taxpayer's  taxable  income  by  use  of  the  ''net  worth'' 
method. 

The  Act  also  provides  an  exception  to  the  general  rule  that  the 
Service  is  to  furnish  notice  whenever  it  examines  records  of  the 
taxpayer  which  are  maintained  by  a  third  party  to  cover  the  sit- 
uation where  the  Service  can  demonstrate  to  a  court  that  compliance 
with  the  notice  requirement  creates  a  substantial  possibility  that  the 
noticee  may  flee,  engage  in  the  destruction  of  records  (including  those 
in  his  own  hands)  or  engage  in  collusion  with  or  the  intimidation  of 
witnesses.  This  provision  is  intended  to  enable  the  Service  to  avoid 
material  interference  with  an  investigation  where  it  reasonably  be- 
lieves that  this  might  occur;  however,  petitions  by  the  Service  are  not 
to  be  granted  automatically  by  the  coui-ts  and  the  petitions  (and  sup- 
porting affidavits)  must  show  reasonable  cause.  The  Congress  con- 
templates that  this  will  be  a  relatively  unusual  procedure,  but  believes 


'These  Include  section  6420(e)(2)  (credit  for  gasoline  used  on  farms),  section 
6421(f)(2)  (credit  for  gasoline  used  for  nonhighway  purposes  by  local  transit  systems), 
section  6424(d)(2)  (credit  for  lubricating  oil  used  in  nonhighway  motor  vehicles),  and 
section  6427(e)  (2)  (credit  for  fuels  not  used  for  taxable  purposes). 


369 

this  device  should  be  available  for  use  by  the  Service  in  cases  where 
it  can  be  demonstrated,  to  the  satisfaction  of  a  court,  that  there  is  a 
significant  possibility  that  there  may  be  a  material  interference  with 
the  lawful  course  of  an  investigation  if  the  taxpayer  is  informed  that 
his  records  are  under  examination. 

In  the  case  of  a  "John  Doe"  situation,  where  the  Service  has  knowl- 
edge of  a  particular  transaction  or  transactions  which  may  affect  tax 
liability,  but  does  not  know  the  identity  of  the  person  involved,  it  is 
obviously  not  possible  to  comply  with  the  notice  rules  outlined  above. 
Typically,  when  cases  like  this  have  arisen  in  the  past,  the  Service 
has  issued  a  "John  Doe"  summons  to  the  third-party  record  keeper,  in 
which  the  record  keeper  is  requested  to  supply  all  information  in  its 
possession  relating  to  such  transactions  (including  any  information 
which  the  third  party  may  have  concerning  the  identity  of  the  tax- 
payer). 

Recognizing  that  issues  of  privacy  are  involved  in  connection  with 
the  John  Doe  summons,  the  Service  has  made  sparing  use  of  this  in- 
vestigative tool.  Nonetheless,  there  are  cases  where  the  facts  of  a  par- 
ticular case  are  so  suggestive  of  possible  tax  liability  that  the  Service 
could  be  remiss  in  its  duty  of  collection  and  enforcement  of  the  Internal 
Revenue  laws  if  it  did  not  investigate.  In  some  such  circumstances, 
the  John  Doe  summons  is  the  only  practical  investigative  tool  which  is 
available. 

Under  the  Act,  the  Service  would  be  authorized  to  serve  a  John  Doe 
summons  following  a  court  proceeding  in  which  the  Service  estab- 
lished, to  the  satisfaction  of  the  court  that  ( 1 )  the  summons  relates  to 
the  investigation  of  a  particular  person  or  group,  (2)  there  is  a  reason- 
able basis  for  believing  that  this  person  or  group  has  failed  (or  may 
fail,  in  the  case  of  an  investigation  of  a  current  transaction)  to  comply 
with  the  internal  revenue  laws,  and  (3)  the  information  sought  under 
the  summons  is  not  readily  available  from  other  sources  and  informa- 
tion concerning  the  identity  of  the  pereon  or  group  involved  is  likewise 
not  readily  available. 

In  one  reported  case  in  this  area,  for  example,  the  Service  discovered 
that  a  number  of  verv  old  bills  had  been  deposited  in  a  bank,  although 
the  identity  of  the  depositor  was  not  known  to  the  Service  (United 
S fates  V.  Bisceglia,  420  U.S.  141  (1975^-  The  Service  has  also  used 
the  John  Doe  summons  to  obtain  the  identity  of  the  taxpayer  where, 
for  example,  an  accountant  has  filed  a  "John  and  Mary  Doe"  tax  re- 
turn. In  another  case,  the  Service  used  the  John  Doe  summons  to  obtain 
the  names  of  corporate  shareholders  involved  in  a  taxable  reorganiza- 
tion which  had  been  characterized  by  the  corporation  (in  a  letter  to  its 
shareholders)  as  a  nontaxable  transaction.  In  these,  and  similar  situa- 
tions, where  there  are  unusual  (or  possibly  suspicious)  circumstances, 
and  the  Service  needs  to  learn  more  details  of  the  situation  in  order 
to  determine  whether  tax  liabilitv  should  be  assessed  against  some 
person  (as  well  as  the  identity  of  the  person  who  may  be  liable  for 
tax") .  use  of  the  John  Doe  summons  may  be  appropriate. 

"\^niile  the  Congress  believes  it  is  important  to  presence  the  John  Doe 
summons  as  an  investigative  tool  which  may  be  used  in  appropriate 
circumstances,  at  the  same  time,  the  Congress  does  not  intend  that  the 
John  Doe  summons  is  to  be  available  for  purposes  of  enabling  the 
Service  to  engage  in  a  possible  "fishing  expedition."  For  this  reason, 


370 

the  Congress  intends  that  when  the  Service  does  seek  court  authoriza- 
tion to  service  this  type  of  summons,  it  will  have  specific  facts  con- 
cerning a  specific  situation  to  present  to  the  court. 

On  the  other  hand,  the  Congress  does  not  intend  to  impose  an  undue 
burden  on  the  Service  in  connection  with  obtaining  a  court  authoriza- 
tion to  serve  this  type  of  summons.  For  example,  the  Service  is  not  re- 
quired to  show  that  there  is  "probable  cause"  (within  the  meaning  of 
the  criminal  laws  relating  to  the  issuance  of  a  search  warrant)  to 
believe  that  a  criminal  act  has  occurred,  or  even  that  civil  fraud  has 
occurred,  or  might  be  involved.  It  is  enough  for  the  Service  to  reveal 
to  the  court  evidence  that  a  transaction  has  occurred,  or  may  have  oc- 
curred, and  that  the  transaction  (in  the  context  of  such  facts  as  may  be 
known  to  the  Service  at  that  time)  is  of  such  a  nature  as  to  be  reason- 
ably suggestive  of  the  pr  sibility  that  the  correct  tax  liability  with 
respect  to  that  transaction  may  not  have  been  reported  (or  might  not  be 
reported  in  the  case  of  a  current  year  transaction,  with  respect  to  which 
a  return  is  not  yet  due).  Also  the  Service  must  convince  the  court  that 
it  has  made  a  good  faith,  reasonable  effort  to  explore  other  methods  of 
investigation,  and  that  use  of  the  John  Doe  summons  is  the  only  prac- 
tical means  of  obtaining  the  information  contained  in  the  records  de- 
scribed in  the  summons.  ' 

In  such  circumstances,  issuance  of  a  court  order  authorizing  use  of 
the  summons  would  be  appropriate.  Of  course,  the  summons,  when 
served,  is  to  describe  the  particular  information  needed  by  the  Service 
with  respect  to  that  transaction  with  as  great  a  specificity  as  possi- 
ble, in  order  to  minimize  the  burden  on  the  third-party  record  keeper. 

The  Congress  contemplates  that  the  court  will  review  each  John 
Doe  summons  to  be  sure  that  the  material  requested  is  reasonably  re- 
lated to  the  investigation,  and  that  the  summons  is  not  overly  broad 
in  terms  of  the  records  requested. 

The  Act  provides  that  the  Service  is  not  required  to  give  notice 
or  to  follow  the  "John  Doe"  procedure  where  the  purpose  of  the  in- 
quiry is  simply  to  learn  the  identity  of  the  person  maintaining  a  num- 
bered bank  account  (or  similar  arrangement).  For  purposes  of  these 
rules,  a  numbered  bank  account  (or  similar  arrangement)  is  an  account 
through  which  a  person  may  authorize  transactions  solely  through  the 
use  of  a  number,  symbol,  code  name  or  other  device  not  involving  the 
disclosure  of  his  identity.  A  person  maintaining  the  account  includes 
the  person  who  established  it  and  any  }>er'Son  authorized  to  use  the 
account  or  to  receive  records  or  statements  concerning  the  account. 

The  Act  also  contains  a  provision  which  would  authorize  the  Serv- 
ice to  reimburse  witnesses  for  the  costs  of  complying  with  administra- 
tive summonses.  ITnder  these  provisions  the  Service  is  required  to  pay 
per  diem  and  mileage  costs  wlien  a  witness  is  required  to  appear  in 
response  to  a  summons  and  would  authorize  the  Service  to  reimburee 
a  summoned  party  (other  than  the  taxpayer  or  his  representatives) 
for  reasonably  necessary  direct  costs  incurred  in  locating,  copying  and 
transporting  any  summoned  records  (other  than  records  in  which  the 
taxpayer  has  a  proprietary  interest).  Such  payments  and  reimburse- 
ments are  to  be  at  rates,  and  subject  to  such  conditions,  as  may  be 
prescribed  in  regulations. 


371 

Ejfcctive  date 
Under  the  Act  these  provisions  were  to  apply  to  summonses  issued 
after  December  31,  1976.  However,  Public  Law  94-528  delayed  the 
effective  date  of  tliese  provisions  to  apply  to  summonses  issued  after 
February  28,  1977. 

Revenue  e-ffect 
These  provisions  do  not  have  any  revenue  impact. 

6.  Assessments  in  Case  of  Mathematical  or  Clerical  Errors  (sec. 
1206  of  the  Act  and  sec.  6213  of  the  Code) 

Prior  law 
In  general,  the  Internal  Revenue  Service  is  required  to  send  the  tax- 
payer a  notice  of  deficiency  and  provide  an  opportunity  to  petition 
the  Tax  Court  before  the  Service  can  assess  a  deficiency  of  income, 
estate,  or  gift  tax  or  of  an  excise  tax  imposed  under  the  private  founda- 
tions provisions  (chapter  42)  or  under  the  provisions  relating  to  quali- 
fied pension,  etc.,  plans  (chapter  43).  An  exception  imder  prior  law 
permitted  the  Service  summarily  to  assess  any  additional  tax  resulting 
from  correction  of  "a  mathematical  error  appearing  on  the  return" 
(sec.  6213(b)  (1) ) .  In  such  a  case,  the  Service  was  not  required  to  send 
a  notice  of  deficiency  to  the  taxpayer,  nor  did  the  taxpayer  have  a 
right  to  judicial  review  (through  a  Tax  Court  petition)  before  being 
required  to  pay  the  tax. 

Where  the  Internal  Revenue  Service  determined  that  a  mathe- 
matical error  had  been  made  and,  as  a  result,  the  taxpayer  owed  addi- 
tional tax,  an  assessment  was  summarily  made,  and  a  notice  of  mathe- 
matical error  which  described  the  error  was  sent  to  the  taxpayer.  Under 
the  Service's  policy,  before  it  began  to  collect  the  individual  tax  due  on 
account  of  the  apparent  error,  the  Service  permitted  the  taxpayer  to 
explain  why  he  or  she  believed  there  was  no  error.  If  the  taxpayer 
substantiated  the  claim,  the  Service's  policy  was  to  abate  any  assess- 
ment which  it  may  have  made  or  refund  any  additional  tax  which  the 
taxpayer  may  have  paid.  Under  prior  law,  however,  a  taxpayer  had 
no  right  to  claim  abatement  of  any  income,  estate  or  gift  tax  (sec. 
6404(b)). 

The  term  "mathematical  error"  had  been  interpreted  by  the  Service 
to  include  several  types  of  error  which  were  broader  in  nature  than 
literal  errors  of  arithmetic.  The  Service  position  had  been  that  mathe- 
matical error  included  the  following:  errors  in  arithmetic  (such  as 
2  +  2  =  5)  ;  errors  in  transferring  amounts  correctly  calculated  on  a 
schedule  form,  or  another  page  of  Form  1040,  to  either  page  1  or  page  2 
of  Form  1040;  missing  schedules,  forms,  or  other  substantiating  in- 
formation required  for  inclusion  with  Form  1040 ;  inconsistent  entries 
and  computations  (such  as  cases  where  total  exemptions  claimed  do 
not  agree  with  the  total  used  in  computing  the  tax)  ;  and  errors  where 
the  entry  exceeds  a  stiitutorv  numerical  or  percentage  limitation  (such 
as  a  standard  deduction  claimed  in  excess  of  the  maximum  allowed  by 
the  Code). 

Court  opinions,  however,  generally  had  limited  the  scope  of  the 
term,  mathematical  error,  to  arithmetic  errors  involving  numbers 
which  were  themselves  correct. 


372 

Reasons  for  change 

Questions  had  been  raised  as  to  whether  the  Service  had  used  its 
mathematical  errors  summary  assessment  powers  in  cases  where  their 
use  was  not  authorized  by  the  statute.  The  Service  maintained  that  it 
properly  used  this  procedure  in  categories  of  cases  where  most  tax- 
payers did  not  dispute  the  Service's  conclusions,  thereby  substantially 
reducing  administrative  and  other  costs. 

The  Service  had  stated  that  the  deficiency  notice  procedure  was  sig- 
nificantly more  costly  than  the  mathematical  error  procedure,  both  in 
terms  of  personnel  and  processing  costs  and  in  terms  of  the  cost  to 
the  Government  of  delays  in  collection  of  taxes.  On  the  other  hand, 
Congress  has  concluded  that  the  Service  should  not  be  able  to  proceed 
summarily  where  it  may  have  erred  in  its  determination. 

In  balancing  these  considerations,  Congress  decided  (1)  to  provide 
greater  protection  for  taxpayers  who  wish  to  contest  Internal  Revenue 
Service  summary  assessments  in  mathematical  error  cases  by  restrict- 
ing the  Service's  powers  in  such  cases  and  (2)  to  clarify  the  kinds  of 
cases  in  which  the  Service  could  use  this  restricted  summary  assess- 
ment authority. 

Explanatimi  of  provision 

The  Act  provides  that  when  the  Internal  Revenue  Service  uses  the 
summary  assessment  procedure  for  mathematical  or  clerical  errors, 
the  taxpayer  must  be  given  an  explanation  of  the  asserted  error  (sec. 
6213(b)  (1) )  and  a  period  of  time  to  require  the  Service  to  abate  its 
assessment  (sec.  6213(b)  (2)  (A) ),  and  the  Service  is  not  to  proceed  to 
collect  on  the  assessment  until  the  taxpayer  has  agreed  to  it  or  has 
allowed  the  time  for  objecting  to  expire  (sec.  6213(b)  (2)  (B) ). 

Deiinition. — The  Act  defines  the  term  "mathematical  or  clerical 
error"  (sec.  6213(f)  (2) )  to  mean— 

(1)  an  error  in  addition,  subtraction,  multiplication,  or  divi- 
sion shown  on  the  return ; 

(2)  an  incorrect  use  of  an  Internal  Revenue  Service  table  if  the 
error  is  apparent  from  the  existence  of  other  inform.ation  on  the 
return ; 

(3)  inconsistent  entries  on  the  return ; 

(4)  an  omission  of  information  required  to  be  supplied  on  the 
return  in  order  to  substantiate  an  item  on  that  return;  and 

(5)  entry  of  a  deduction  or  credit  item  in  an  amount  which 
exceeds  a  statutory  limit  which  is  either  (a)  a  specified  monetary 
amount  or  (b)  a  percentage,  ratio,  or  fraction — if  the  items  enter- 
ing into  the  application  of  that  limit  appear  on  that  return. 

Arithmetic  errors. — Examples  of  errors  in  addition,  subtraction, 
etc.,  include  2  +  2  =  5  and  7  —  0  =  0.  In  the  usual  case,  such  an  error  Avill 
be  apparent  and  the  correct  answer  will  be  obvious.  However,  care 
should  be  taken  to  be  sure  that  what  appears  to  be  an  error  in  addition 
or  subtraction  is  not  in  reality  an  error  in  transcribing  a  number  from 
a  work  sheet,  with  the  final  figure  being  correct  even  though  an  inter- 
mediate arithmetical  step  on  the  return  appears  to  be  wrong.  It  is 
expected  that  the  Service  will  check  such  possible  sources  of  apparent 
arithmetical  errors  before  instituting  the  summary  assessment 
procedures. 


373 

Use  of  tahles. — An  example  of  an  incorrect  use  of  a  table  is  the  use 
of  a  tax  rate  schedule  X  (single  taxpayei-s)  by  a  person  who  has 
checked  line  3  of  the  1975  Form  1040,  indicating  that  the  taxpayer  is 
"married  filing  separately."  Sucli  a  person  should  use  the  generally 
higher  tax  figures  in  the  right-hand  poi-tion  of  tax  rate  schedule  Y. 
In  such  a  case,  it  is  expected  that  the  notification  to  the  taxpayer  will 
indicate  that  the  taxpayer  used  the  single  person's  rate  schedule,  that 
the  taxpayer  who  checked  line  3  on  the  Form  1040  should  have  used 
the  married  pei*sons  filing  separately  schedule,  and  the  notification 
should  show  the  amount  of  the  difference  in  tax  (indicating  the 
amount  from  the  married  persons  filing  separatel}^  schedule  minus  the 
amount  from  the  single  persons  schedule).  The  notice  to  the  taxpayer 
is  also  to  inquire  whether  tlie  taxpayer  is  in  fact  married  and  is  to  in- 
quire as  to  sucli  other  information  which  might  enable  the  taxpayer 
to  determine  whether  he  or  she  might  be  eligible  for  a  more  favorable 
tax  status  even  though  married.  For  exam.ple,  a.  person  legally  sep- 
arated from  his  or  her  spouse  may  be  treated  as  not  being  married 
for  purposes  of  the  Internal  Revenue  Code  (sec.  2(c))  and  therefore 
may  be  entitled  to  use  the  single  jjcrson's  schedule  or  the  even  more 
favorable  head-of-household  schedule  (schedule  Z). 

Inconsistent  cnti'/cs. — This  category  is  intended  to  encompass  those 
cases  where  it  is  apparent  which  of  the  inconsistent  entries  on  the 
returns  is  correct  and  which  is  incorrect.  For  example,  if  the  tax- 
paj'er's  entries  as  to  personal  exemptions  on  lines  6a,  b,  c,  d,  and  e  of 
Form  1040  add  up  to  the  total  stated  on  line  6f  (for  example,  assume 
that  the  total  is  "6,''  correctly  added),  but  the  taxpayer  on  line  46  of 
Form  1040  multiplies  $750  by  a  different  number  (for  example,  "7"), 
then  the  Service  is  justified  in  regarding  this  as  an  error  and  correcting 
the  error  by  multiplying  the  $750  for  each  exemption  by,  in  the  case 
cited  above,  "6."  Even  in  this  case,  however.  Congress  expects  that 
the  Service  will  so  phrase  its  notification  to  the  taxpayer  as  to  include 
questions  designed  to  show  whether  the  taxpayer  indeed  is  entitled 
to  the  greater  number  of  exemptions  indicated  on  line  46  rather  than 
the  lesser  number  of  exemptions  indicated  on  line  7. 

However,  the  srnnmary  assessment  procedure  is  not  to  be  used  where 
it  is  not  clear  which  of  the  inconsistent  entries  is  the  correct  one.  For 
example,  line  6b  of  the  Form  1040  requires  the  taxpayer  to  list,  "First 
names  of  your  dependent  children  who  lived  with  you''  and  then  to 
enter  the  number  of  those  dependent  children  in  a  column  for  pereonal 
exemptions.  If  a  taxpayer  lists  three  names  on  line  6b  but  then  enters 
"4"  in  the  column,  it  is  not  clear  whether  the  taxpayer  miscounted 
(in  which  case  the  taxpayer  should  have  written  "3''  in  the  column) 
or  whether  the  taxpayer  eiToneously  omitted  the  name  of  one  of  the 
dependent  children  (in  which  case  the  taxpayer's  column  entry  of 
"4"  would  be  correct).  In  this  case,  the  Service  should,  of  course,  take 
steps  to  determine  which  entry  is  correct,  and  the  taxpayer  has  the 
obligation  of  showing  that  he  or  she  is  entitled  to  the  number  of  ex- 
emptions claimed.  However,  this  summary  assessment  procedure  is 
not  to  be  used  where  the  Service  is  merely  resolving  an  uncertainty 
against  the  taxpayer. 

Omissimis  of  supporting  schedules. — The  next  category  is  "an  omis- 
sion of  information  which  is  required  to  be  supplied  on  the  return  to 


234-120  O  -  77  -  25 


374 

substantiate  an  entry  on  the  rieturn".  The  intent  of  this  provision  is  to 
deal  with  situations  where  items  should  be  supported  by  schedules 
which  are  part  of  the  return.  For  example,  if  deductions  are  itemized, 
Schedule  A  should  be  included  with  the  return.  Similarly,  Schedule  G 
should  be  included  if  the  taxpayer  claims  the  benefits  oi  income  aver- 
aging. Also,  Form  4726  should  be  included  if  the  taxpayer  claims  the 
benefits  of  the  maximum  tax.  Where  the  necessary  supporting  schedule 
is  omitted  from  the  return,  then  the  Service  may  proceed  under  this 
provision  by  disallowing  the  beneficial  treatment — unless  the  taxpayer 
supplies  the  necessary  schedule.  Here,  too,  the  notification  by  the  Serv- 
ice should  be  so  designed  as  to  encourage  the  taxpayer  to  supply  the 
omitted  schedule.  If  the  taxpayer  supplies  the  omitted  schedule,  then 
this  justification  for  use  of  the  summary  assessment  procedure  is  no 
longer  applicable,  and  the  supplying  of  the  schedule  is  to  be  treated 
as  a  request  for  an  abatement  of  the  summary  assessment.  If  the 
omitted  schedule  itself  presents  other  mathematical  or  clerical  errors 
(such  as  errors  in  addition  or  inconsistent  entries) ,  then  this  may  be 
a  justification  for  initiating  a  new  summary  assessment  procedure 
based  on  those  asserted  errors. 

Exceeding  statutory  limits. — The  fifth  category  deals  with  deduc- 
tion or  credit  items  that  exceed  the  statutory  limit,  where  this  is  ap- 
parent from  the  return.  This  category  of  error  occurs,  for  example, 
where  a  taxpayer  (other  than  a  married  taxpayer  filing  a  joint  return) 
takes  a  dividend  exclusion  of  more  than  $100  ($200  for  joint  returns) 
or  more  than  the  amount  of  the  otherwise  taxable  dividends  (sec.  116) . 
However,  this  category  of  mathematical  or  clerical  erroi-  does  not  ex- 
tend to  a  dispute  as  to  whether  a  given  dividend  qualifies  for  the  ex- 
clusion (e.g.,  the  exclusion  does  not  apply  to  dividends  from  foreign 
corporations,  real  estate  investment  trusts,  etc.).  Another  example  of 
an  error  that  falls  into  this  fifth  category  is  the  claiming  of  a  standard 
deduction  greater  than  the  dollar  or  percentage  limits  applicable  to 
that  taxpayer.  (See  the  percentage  standard  deduction  and  low  income 
allowance  provisions  of  sec.  141.) 

In  the  categories  of  cases  that  Congress  has  dealt  with  in  this  Act, 
not  only  is  the  error  apparent  from  the  face  of  the  return,  but  the 
correct  amount  is  determinable  with  a  high  degree  of  probability 
from  the  information  that  appears  on  the  return.^ 

Abatement. — The  Act  (new  sec.  6213(b)(2))  provides  that  a  tax- 
payer who  receives  notice  of  an  assessment  for  additional  tax  has  60 
days  (from  the  date  the  notice  was  sent)  to  file  a  requesit  for  an  abate- 
ment of  the  assessment  stating  the  disagreement  with  the  amount  of 
the  assessment. 

If  the  taxpayer  sends  such  a  requesit  to  the  Service  within  the  pre- 
scribed time  limit,  the  Service  must  abate  the  assessment.  During  this 
60-day  period,  the  Service  is  not  to  proceed  to  collect  upon  this  sum- 
mary assessment.  Of  coui-se,  if  the  assessment  is  abated,  then  it  never 
will  be  collected  upon. 

1  It  may  be  argued  that  the  category  of  omissions  of  supporting  schedules  departs  from 
this  general  approach.  As  indicated  above,  the  summary  assessment  in  such  a  case  Is  to  be 
abated  when  the  omitted  schedule  is  supplied  by  the  taxpayer ;  disputes  as  to  the 
adequacy  of  the  schedule  that  the  taxpayer  submits  are  to  be  dealt  with  under  normal 
administrative  procedures  and  not  by  use  of  the  extraordinary  summary  assessment 
procedure  (unless  one  of  the  other  "mathematical  or  clerical  errors"  categories  applies). 


375 

Effective  date 
The  new  summary  assessment  rules,  together  with  the  rights  of 
taxpayers  to  require  abatement  of  ?n\y  assessments  made  under  those 
rules,  are  to  apply  to  income,  estate,  gift,  private  fomidation,  and 
pension  tax  returns  filed  after  December  31, 1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  have  no  revenue  effect. 

7.  Withholding  Tax  Provisions 

CL  Withholding  of  State  and  District  Income  Taxes  for  Military 
Personnel  (sec.  1207  of  the  Act  and  sees.  5516  and  5517  of 
titlc5,U.S.C.) 

Prior  laio 
The  Sexiretary  of  the  Treasurj^  is  required  to  enter  into  agreements 
with  States  which  re^juest  it  to  withhold  State  income  tax  from 
Federal  employees.  ITnder  prior  law,  however,  these  agreements  could 
not  apply  to  membere  of  the  Armed  Forces. 

Reasons  for  change 

The  absence  of  withholding  has  created  problems  for  servicemen 
who  may  not  know  that  they  are  subject  to  State  income  tax  and  may 
be  assessed  with  a  large  deficiency  wlien  they  return  from  active  duty. 
In  addition,  in  the  absence  of  withholding,  many  members  of  the 
Armed  Service,  have  had  difficulty  making  the  lump  sum  payments  re- 
quired when  complying  with  the  State  tax  on  an  annual  basis.  There 
was  considerable  suppor't  among  servicemen  and  other  concerned 
groups  for  providing  withholding  of  State  income  taxes  for  members 
of  the  Armed  Forces. 

In  June  1974,  the  National  Association  of  Tax  Administrators 
(NATA)  unanimously  decided  to  advise  the  Federal  Government  of 
the  States'  desire  for  withholding  of  State  incomes  taxes  from  military 
pay.  In  1975,  the  General  Accounting  Office  (GAO)  reported  on  this 
question  to  the  Congress  ("A  Case  for  Providing  Pay-as- You-Go 
Privileges  to  Military  Personnel  for  State  Income  Taxes")  ;  and 
pointed  out  that,  on  the  basis  of  a  limited  study  of  compliance  with 
State  income  tax  by  military  personnel  in  the  Washington  metropoli- 
tan area  (covering  the  income  taxes  of  all  three  jurisdictions),  the 
compliance  with  these  income  taxes  by  legal  residents  of  these  juris- 
dictions was  inadequate.  The  report  stated  in  part : 

"Tlie  Congress  should  ena  ct  legislation  to  provide  military  personnel 
with  pay-as-you-go  privileges  for  State  income  taxes.  Laws  which 
permit  these  taxes  to  be  withheld  from  Federal  civilian  pay  prohibit 
such  withholding  on  military  pay 

"DOD  cited  administrative  difficulties  and  costs  of  accomplishing 
withholding  as  its  principal  objections.  GAO  recognizes  it  would  cost 
the  Federal  Government  to  withhold  State  income  taxes  from  mili- 
tary pay  but  similar  withholding  is  being  done  with  respect  to  civilian 
employees  of  Federal  agencies  and  by  private  firms  having  operations 
national  in  scope." 

In  November  1975,  the  Advisory  Commission  on  Intergovernmental 
Relations  recommended  a  change  in  the  law  to  provide  mandatory 


376 

withholding  of  State  income  taxes  from  military  personnel.  As  pointed 
out  in  the  October  staff  report  on  which  this  recommendation  was 
based,  the  compliance  with  State  income  tax  by  military  personnel 
is  not  good.  As  the  report  noted,  "The  absence  of  tax  withholding 
contributes  to  the  military  member's  uncertainty  about  his  income  tax 
obligation;  it  also  makes  payment  of  taxes  more  difficult  and  increases 
the  temptation  not  to  file  a  tax  return."  The  report  further  pointed  out 
"The  absence  of  withholding  also  complicates  the  enforcement  process 
for  States  and  local  governments."  The  report  indicated  that  even 
under  the  arrangement  whereby  the  military  reports  payroll  infonna- 
tion  for  military  personnel  to  the  States,  compliance  is  poor  and  the 
information  is  not  adequate.  The  commission's  final  report  (issued  in 
July  1976),  further  noted  that  if  withholding  were  adopted,  it  would 
impose  additional  costs  on  the  military  (but  no  more  than  any  private 
employer)  and,  accepting  the  military's  estimate  of  $1.7  million  an- 
nually to  operate  the  system,  this  is  only  about  $1  per  serviceman  per 
year.  As  the  report  points  out,  this  compares  to  the  estimated  revenue 
loss  to  the  States  of  $94  million  from  incomplete  tax  compliance  by 
the  military,  a  substantial  portion  of  which  the  States  would  obtain 
if  withholding  were  required. 

The  Office  of  Management  and  Budget  (OMB)  also  expressed  ap- 
proval of  State  income  tax  withholding  for  military  personnel  as  indi- 
cated in  its  August  12,  1975  letter  to  the  GAO,  which  said  in  part : 

There  is  no  question  that  the  present  system  of  withholding  state  and  local 
taxes  from  pay  of  Federal  civilian  employees  has  proved  to  be  beneficial  both 
to  the  employee  and  to  the  states  and  local  municipalities.  This  system  makes  it 
easier  for  individuals  to  meet  their  tax  obligations  and  it  also  facilitates  the 
receipt  of  revenues  that  appropriately  belong  to  the  affected  states.  We  believe 
similar  benefits  would  be  forthcoming  if  such  a  withholding  system  was  applied 
to  military  pay  and  that  the  Federal  Government  should  provide  whatever 
assistance  is  necessary  to  assure  that  such  a  system  is  developed  and  imple- 
mented. 

As  a  result  of  these  concerns,  the  Congress  believed  it  appropriate 
to  provide  for  the  withholding  of  State  income  taxes  for  members 
of  the  Armed  Forces. 

Explanation  of  provision 

The  Act  amends  section  5516  and  5517  of  title  5  of  the  U.S.C.  to 
eliminate  the  prohibition  against  the  Secretary  of  the  Treasury  enter- 
ing into  agreements  with  States  and  the  District  of  Coluiiibia  to  with- 
hold State  incom.e  taxes  from  members  of  the  Armed  Services.  Thus, 
the  Secretary  of  the  Treasury  will  be  required  to  enter  into  agree- 
ments to  withhold  State  and  District  income  taxes  from  membei's  of 
the  Armed  Forces  when  the  States  or  the  District  request  such  with- 
holding from  military  personnel  who  are  liable  for  such  tax. 

The  Congress  expects  that  the  Secretary  of  the  Treasury  will  con- 
sult with  the  Department  of  Defense  and  other  concerned  agencies 
in  designing  such  agreements  in  view  of  the  fact  that  DOD  will  do 
the  actual  withholding  since  it,  not  the  Treasury,  is  the  paying  agent 
and  in  view  of  the  special  problems  that  are  involved  in  establishinff 
the  residence  for  tax  purposes  of  military  personnel. 

These  changes  do  not  in  any  way  affect,  or  imply  any  change  in,  the 
existing  rules  which  determine  the  situs  for  State  income  tax  purposes 
of  a  member  of  the  Armed  Forces.  They  do  not  in  any  way  imply  that 


377 

a  State  in  which  a  member  of  the  Armed  Forces  is  stationed  but  of 
which  he  is  not  a  resident  for  tax  purposes  may  assert  jurisdiction  over 
such  person.  In  other  words,  the  existing  rules  for  liability  for  State 
income  tax  of  members  of  the  Armed  Forces  are  left  unchanged  but 
withholding  from  individuals  who  are  members  of  the  Armed  Forces 
and  liable  for  these  income  taxes  is  provided. 

The  Congress  expects  that  the  Department  of  Defense  will  con- 
tribute to  the  effective  implementation  of  this  provision  by  making  a 
greater  effort  to  instruct  members  of  the  Araied  Forces  in  their  possi- 
ble liability  for  State  income  taxes  and  the  requirements  of  withhold- 
ing in  cases  where  they  are  liable  for  such  tax. 

The  Congress  also  expects  that  the  Secretaiy  of  the  Treasury 
and  the  Department  of  Defense  will  develop  procedures  for  deter- 
mining the  residence  for  tax  purposes  of  military  personnel  within 
the  context  of  agreements  the  Secretary  of  the  Treasury  enters  into 
with  the  States. 

The  burden  imposed  on  the  military  by  the  withholding  require- 
ment is  not  regarded  as  being  more  burdensome  than  that  imposed 
on  private  employers.  Once  the  sy&iem  is  established  for  the  military 
withholding,  its  operaton  should  not  be  significantly  more  burden- 
some to  the  militarj^  than  the  rules  applicable  to  private  employers. 
The  purpose  of  the  requirement  that  the  burden  on  the  Federal  Gov- 
ernment be  no  greater  than  that  imposed  on  private  employers  is 
to  prevent  discrimination  against  the  United  States  (as  to  employees) 
by  the  States.  The  Congress  believes  that  this  withholding  is  a  burden 
which  the  United  States  should  assiune,  both  for  the  States  and  for 
the  military  and  their  families.  Therefore,  any  difference  in  burdens 
is  not  one  which  comes  within  the  purview  of  the  requirement. 

Effective  date 
This  provision  contains  its  own  effective  date  in  that  sections  5516 
and  5517  (5  U.S.C.)  require  the  Secretary  to  enter  into  a  withholding 
agreement  120  days  after  the  request  from  the  proper  State  official 
and  such  request  cannot  be  made  until  after  the  date  of  enactment  of 
the  Act. 

Revenue  effect 
This  provision  has  no  effect  on  the  Federal  revenues,  but  is  expected 
to  improve  the  effectiveness  of  individual  income  tax  collection  by 
the  States  and  the  District  of  Columbia. 

6.  Withholding  State  and  City  Income  Taxes  From  the  Com- 
pensation of  Members  of  the  National  Guard  or  the  Ready 
Reserve  (sec.  1207  of  the  Act  and  sees.  5516  and  5517  of  title  5, 
US.C.) 

Prior  law 
The  Secretary  of  the  Treasury  is  required  to  enter  into  agreements 
with  States  and  cities  to  withhold  State  and  city  income  taxes  from 
the  compensation  of  Federal  employees.  However,  under  prior  law 
the  agreement  could  not  apply  to  pay  for  service  as  a  member  of  the 
Armed  Forces. 

Reasons  for  change 
In  the  case  of  members  of  the  National  Guard  or  Ready  Reserve  who 
are  serving  in  this  status  within  the  State  of  which  they  are  a  resident, 


a78 

the  inability  of  the  Federal  Government  to  withhold  State  income  tax 
from  their  compensation  often  meant  they  were  faced  either  with 
large  lump-sum  payments  at  the  time  of  filing  or  they  had  to  make  a 
declaration  of  estimated  tax  and  pay  the  tax  quarterly.  This  is  the 
same  problem  which  led  to  the  adoption  of  the  Federal  withholding 
of  State  income  tax  for  nonmilitary  Federal  employees  in  the  first 
instance. 

Explanation  of  provision 
The  Act  extends  the  provision  under  prior  law  requiring  the  Treas- 
ury to  enter  into  agreements  with  States,  the  District  of  Columbia 
and  cities  to  withhold  income  taxes  from  Federal  employees  to  mem- 
bers of  the  National  Guard  and  Ready  Reserve  when  they  are  paid  for 
perfonning  regular  training. 

Effective  date 
The  prior  law  provision  which  is  amended  by  this  amendment  con- 
tains its  own  effective  date  in  that  section  5517  (5  U.S.C.)  requires 
the  Secretary  to  enter  into  a  withholding  agreement  120  days  after  the 
request  from  the  proper  State  official  and  such  request  cannot  be  made 
until  after  the  date  of  enactment  of  the  Act. 

Revenue  effect 
This  provision  has  no  effect  on  Federal  revenues. 

c.  Voluntary  Withholding  of  State  Income  Taxes  From  the  Com- 
pensation of  Federal  Employees  (sec.  1207  of  the  Act  and  sec. 
5517,  title  5,  UJS.C.) 

Prior  law 
The  Secretary  of  the  Treasury  is  required  to  enter  an  agreement 
with  a  State  to  withhold  State  income  tax  from  Federal  employees 
in  the  State  only  if  withholding  State  income  tax  is  generally  required 
of  employees.  The  Secretary  cannot  enter  such  agreements  in  States 
where  the  withholding  is  voluntary. 

Reasons  for  change 
The  prohibition  against  the  Secretary  of  the  Treasury  entering  into 
withholding  agreements  with  States  unless  the  requirement  is  imposed 
generally  was  designed  to  prevent  States  from  imposing  more  strin- 
gent requirements  on  the  Federal  Government  than  they  imposed  on 
other  employers  who  operated  in  the  State.  If  withholding  is  volun- 
tary in  the  case  of  both  private  employere  and  the  Federal  Govern- 
ment, no  discrimination  between  them  exists  and  the  Congress  sees 
no  reason  to  prohibit  the  Federal  Government  from  withholding  State 
income  tax  from  its  employees. 

Explanation  of  provision 
The  Act  requires  the  Secretary  of  the  Treasury  to  enter  into  agree- 
ments with  States  to  withhold  State  income  taxes  from  Federal  em- 
ployees in  those  States  where  such  withholding  is  voluntary. 

Effective  date 
The  prior  law  provision  which  is  amended  by  this  amendment  con- 
tains its  own  effective  date  in  that  section  5517  (5  U.S.C.)  requires 
the  Secretary  to  enter  into  a  withholding  agreement  120  days  after  the 


379 

request  from  the  proper  State  official  and  such  request  cannot  be  made 
until  after  the  date  of  enactment  of  the  Act. 

Revenue  ejfect 
This  provision  has  no  effect  on  Federal  revenues. 

d.  Withholding  Tax  on  Certain  Gambling  Winnings  (sec.  1207  of 
the  Act  and  sec.  3402  of  the  Code) 

Prior  law 

Under  prior  law,  withholding  on  racetrack  winnings  was  not  re- 
quired althf  ;^h  payouts  to  winners  of  the  daily  double,  Exacta,  Per- 
fecta  and  similar  type  pools  are  reportable  on  Form  1099  information 
retui'ns  if  the  payout  is  $600  or  more  and  is  based  on  betting  odds  of 
300  to  one  or  higher.  Nor  was  withholding  required  for  State-con- 
ducted lottery  winnings. 

In  addition,  Nevada  gambling  casinos  were  required  to  report  cer- 
tain large  winnings  from  Keno  and  bingo  games  on  Form  1099  to  the 
Internal  Revenue  Service  depending  on  the  price  of  tickets  as  well  as 
the  amount  won. 

Reasons  for  change 
Although  most  wagering  transactions  have  no  tax  significance  since 
the  majority  of  bettors  end  up  the  year  with  no  net  wagering  gains,  the 
special  types  of  wagers  mentioned  above  in  many  cases  represent 
unique  and  occasional  windfalls  that  generally  produce  a  significant 
tax  liability.  Even  with  the  information  reporting  requirements,  many 
taxpayei-s  do  not.  report  these  winnings  on  their  income  tax  returns. 
One  source  of  this  nonreporting  of  income  is,  for  example,  the  use  of 
the  so-called  "10  percenters"  at  the  racetrack.  A  10  percenter  is  a  per- 
son hired  by  the  winner  to  cash  his  ticket  for  10  percent  of  the  win- 
nings and  provide  fictitious  identification  so  that  the  reporting  on 
Form  109!)  is  provided  in  a  name  other  than  that  of  the  actual  winner. 
These  10  percenters  themselves  seldom  pay  any  income  tax. 

Explanation  of  provision 

To  deal  with  the  underreporting  of  gambling  winnings,  the  Act 
supplements  t\\(^  information  reporting  requirement  with  a  provision 
for  withliolding  on  certain  winnings  at  a  20-percent  withholding  rate. 
The  Act  imposes  withholding  at  a  20-percent  rate  on  winnings  of  more 
than  $1,000  from  sweepstakes,  wagering  pools,  and  lotteries  and  from 
other  types  of  gambling  if  the  odds  are  300  to  1  or  more,  with  certain 
exceptions. 

First,  tl-'C  witliholding  does  not  apply  to  winnings  from  slot  ma- 
chines, keno,  and  bingo. 

Second,  in  the  case  of  State-conducted  lotteries,  withholding  applies 
only  to  winnings  of  more  than  $5,000.  State-conducted  sweepstakes 
and  wagering  pools  are  not  included  in  the  $5,000  exemption,  but 
rather  are  treated  the  same  as  piivately-conducted  sweepstakes  and 
wagering  pools  (and  tlius  are  subject  to  withholding  on  any  net  win- 
nings exceeding  $1,000).  The  withholding  applies  to  the  entire  amount 
of  wimiings  once  the  tests  aie  met,  not  just  the  excess  over  $1,000  or 
$5,000.  Under  the  Act,  Congress  intends  that  the  term  "wagering 
pools"  is  to  include  all  paii-mutuel  betting  pools,  including  on-  and  off'- 
track  racing  pools,  and  similar  types  of  betting  pools. 


380 

Withholding  applies  to  winnings  net  of  the  ticket  price,  taking  into 
ac<Jount  all  tickets  for  identical  wagers.  For  example,  if  one  $100 
bet  and  two  $50  bets  are  placed  on  a  single  horse  to  win  a  single  race, 
any  winnings  from  the  three  tickets  must  be  added  together  and  the 
ticket  prices  of  all  three  tickets  must  be  deducted  to  deteiTnine  net 
winnings.  However,  if  the  bets  are  placed  on  different  horses  or  on 
different  events,  the  net  winnings  are  to  be  determined  separately  for 
each  ticket. 

In  addition,  the  Internal  Revenue  Service  is  to  report,  prior  to  1979, 
to  the  House  Committee  on  Ways  and  Means  and  the  Senate  Com- 
mittee on  Finance  on  the  operation  of  the  present  reporting  system 
(IRS  Form  1099)  as  applied  to  winnings  from  keno,  bingo,  and  slot 
machines,  and  is  to  make  a  recommendation  whether  or  not  such  win- 
nings should  be  subject  to  withholding.  In  the  interim,  the  Internal 
Revenue  Service  is  to  modify  the  reporting  requirements  (on  IRS 
Form  1099)  with  respect  to  winnings  from  these  sources.  This  modi- 
fication should  include  a  lower  threshold  for  the  requirement  that  the 
payor  report  payments  to  the  Internal  Revenue  Service  to  the  extent 
that  current  reporting  practices  differ  from  that  set  out  in  the  Internal 
Revenue  Code  (sec.  6041). 

Ejfective  date 
The  withholding  provisions  apply  to  payments  of  winnings  made 
after  the  90th  day  after  the  date  of  enactment  (October  4,  1976). 

Revenue  ejfect 
This  provision  will  increase  budget  receipts  by  $101  million  in  fiscal 
year  1977,  $68  million  in  fiscal  year  1978,  and  $68  million  in  fiscal 
year  1981. 

€.  Withholding  of  Federal  Taxes  on  Certain  Individuals  Engaged 
in  Fishing  (sec.  1207(e)  of  the  Act  and  3121(b)  (20)  of  the 
Code) 

Prior  law 
Under  prior  law,  the  Internal  Revenue  Service  frequently  treated 
individuals  employed  on  fishing  boats,  or  on  boats  engaged  in  taking 
other  forms  of  aquatic  animal  life,  as  regular  employees.  As  a  result, 
operators  of  the  boats  had  to  witlihold  taxes  from  the  wages  of  crew- 
men, and  also  had  to  deduct  and  pay  the  taxes  on  employees  under  the 
Federal  Insurance  Contributions  Act  (the  social  security  taxes). 

Reasons  for  change 

The  crews  that  work  on  boats  used  in  fishing  and  similar  pursuits, 
such  as  taking  shrimp  and  lobsters,  are  frequently  "pickup"  crews 
composed  of  individuals  who  may  work  for  only  a  few  voyages,  and 
sometimes  even  for  only  one  voyage.  In  some  cases,  the  boat  operator 
may  select  his  crew  from  individuals  found  waiting  on  the  dock  in  the 
morning.  In  still  other  cases,  small  boats  may  be  operated  by  relatives, 
no  one  of  whom  is  considered  the  boat  operator,  "captain,"  or  even  the 
crew's  leader.  Thus,  the  voyage  partakes  more  of  the  nature  of  a  joint 
venture  than  it  does  of  an  employment  situation. 

Under  these  circumstances,  it  is  difficult  and  impractical  for  the 
boat  operator  to  keep  the  necessary  records  to  calculate  his  tax  obliga- 
tions as  an  employer,  and  it  is  equally  difficult  for  him  to  withhold  the 


381 

appropriate  taxes  for  payment.  Often  these  boats  operate  with  small 
crews,  and  the  boat  operator  himself  is  likely  to  be  an  individual  who 
has  worked  as  a  fisherman  throughout  his  career,  and  who  is  unac- 
customed to  keeping  records  of  any  type,  especially  the  type  required 
under  the  tax  rules  for  employers. 

Another  factor  cxDntributing  to  tlie  difficulty  in  which  such  boat  oper- 
ators find  themselves  is  the  nature  of  the  remuneration  paid  to  their 
crewmen.  In  many  cases,  the  crewmen  are  paid  no  regular  salary,  but 
instead  receive  a  portion  of  the  catch  or  a  portion  of  the  proceeds  of 
the  catch.  In  practice,  the  catch  is  often  sold  upon  return  to  shore, 
usually  by  the  boat  operator,  and  each  crewman  is  immediately  paid 
a  percentage  of  the  proceeds  of  the  catch  that  is  equivalent  to  the  por- 
tion of  the  catch  for  which  he  agreed  to  work.  In  view  of  the  basic 
informality  of  these  arrangements,  and  the  consequent  difficulty  in 
adhering  to  the  obligations  required  of  employers  by  the  Internal 
Revenue  Code,  Congress  believes  it  appropriate  to  remove  these  obli- 
gations from  certain  small  boat  operators  by  treating  their  crewmen 
as  self-employed  individuals.  Congress  l)e]ie\^es  that  this  will  recognize 
the  basic  nature  of  the  arrangement  between  the  boat  operators  and 
the  crewmen  since  the  crewmen,  under  these  arrangements,  should  find 
it  much  simpler  and  more  convenient  to  calculate  and  report  their  own 
income  for  tax  purposes  than  do  the  boat  operators. 

In  treating  these  situations  as  instances  of  emplojrment  of  crewmen 
by  boat  operators,  the  Internal  Revenue  Service  has  not  only  required 
current  payment  of  employment  taxes  by  the  boat  operators,  but  has 
also  assessed  these  taxes  retroactively  for  all  tax  years  still  open  under 
the  statute  of  limitations.  As  a  result  of  possibly  sizable  assessments, 
many  boat  operators  may  face  bankruptcy.  Given  this  possibility.  Con- 
gress believes  it  is  appropriate  to  extend  this  provision  to  certain  prior 
years  in  cases  where  fishermen  were  not  treated  as  emploj^ees  by  the 
boat  operator  or  owner. 

Explanatian  of  provision 

Under  the  Act,  crewmen  on  boats  engaged  in  taking  fish  or  other 
aquatic  animal  life  with  an  operating  crow  of  fewer  than  ten  are  to  be 
treated  as  self-employed  for  Federal  tax  purposes  if  their  remu- 
neration is  a  share  of  the  boat's  catch  (or  a  share  of  the  proceeds  of  the 
catch) ,  or,  in  the  case  of  an  operation  involving  more  than  one  boat,  a 
share  of  the  entire  fleet's  catch  or  its  proceeds. 

Crewmen  described,  in  this  provision  are  to  be  treated  as  self-em- 
ployed for  purposes  of  income  tax  withholding  from  wages,  the  self- 
employment  tax,  the  Federal  Insurance  Contributions  Act  (FICA) 
taxes,  and  the  social  security  laws.  They  are  to  be  treated  as  self- 
employed  only  if  the  operating  crew  of  the  boat  normally  consists  of 
fewer  than  ten  individuals  (including  the  captain).  Of  course,  a  crew- 
man who  is  self-employed  by  virtue  of  this  provision  for  one  voyage 
may  work  as  a  regular  employee  in  a  subsequent  voyage  during  the 
same  tax  period  on  another  boat,  or  conceivably  even  on  the  same  boat. 
Therefore,  such  an  individual  may  be  both  self-employed  and,  a  regular 
employee  in  his  occupation  as  a  fisherman  (or  in  such  a  similar  pur- 
suit as  taking  lobsters  or  shrimp)  during  the  same  tax  period. 

The  provision  amends  the  definitions  of  employment  (sec.  3121(b) 
of  the  Code),  the  definition  of  a  trade  or  business  (sec.  1402(c) ),  and 
the  definition  of  wages  for  purposes  of  withholding  (sec.  3401(a)). 


382 

In  addition,  amendments  are  made  to  the  definitions  of  employment 
and  of  a  trade  or  business  in  the  parallel  social  security  statutes. 

This  provision  alleviates  many  of  the  recordkeeping  requirements 
of  the  small  boat  operatore.  However,  in  order  to  permit  the  Internal 
Revenue  Service* to  maintain  a  method  of  insuring  that  the  crewmen 
to  be  treated  as  self-employed  correctly  report  their  income  to  the  IRS, 
the  amendment  also  requires  boat  operators  to  report  the  identity  of 
the  self-employed  individuals  serving  as  crewmen,  the  weight  and  type 
of  the  catoh  distributed  to  each  crewmen,  or,  in  cases  of  distributions 
of  proceeds  of  the  catch,  the  dollar  amount  distributed  to  each  crew- 
man. The  operator  is  also  to  rejxyrt.  the  percentage  of  each  crewman's 
share  of  the  catch,  as  well  as  his  own  percentage.  Furthermore,  such 
a  boat  operator  is  also  to  provide  each  of  the  self-employed  crewmen 
a  written  statement  on  or  before  January  31  of  the  succeeding  year 
showing  the  information  reported  by  the  boat  operator  with  respect 
to  each  crewman  for  the  calendar  year. 

The  designation  of  fishermen  as  self-employed,  as  provided  'by  this 
provision  of  the  Act,  is  for  the  indicated  tax  purpose  only  and  is  not 
intended  to  affect  their  rights  to  bargain  collectively  or  their  status 
under  the  antitrust,  admiralty,  or  other  laws. 

Because  the  status  of  individuals  as  independent  contractors  or 
employees  for  Federal  tax  purposes  presents  an  increasingly  impor- 
tant problem  of  tax  administration,  the  Congress  joins  in  the  request 
of  the  Senate  Finance  Committee  (S.  Rept.  9^938,  p.  604)  that  the 
staff  of  the  Joint  Committee  on  Taxation  make  a  study  of  this  general 
area  in  all  industries  in  which  this  problem  arises. 

Effective  date 

The  classification  of  self-employed  individuals  for  crewmen  who 
meet  the  criteria  provided  by  the  Act  is  to  be  effective  as  to  services 
performed  after  December  31,  1971.  However,  this  retroactive  date 
is  not  to  result  in  requiring  crewmen  who  have  been  treated  as  ordinary 
employees  to  pay  the  higher  rate  of  social  security  tax  required  of 
self-employed  individuals,  nor  are  refunds  of  the  employer's  share 
of  social  security  taxes  to  be  made  to  boat  operators  in  such  cases.  As 
a  result,  this  provision  will  be  principally  effective  in  barring  future 
deficiency  assessments  for  past  years  which  are  still  open  under  the 
statute  of  limitations.  Treatment  of  a  crewman  as  a  regular  employee 
(or,  to  be  precise,  treatment  of  his  compensation  as  a  regular  em- 
ployee's compensation)  is  to  include  either  payment  of  the  employ- 
ment taxes,  or  some  part  of  them,  or  withholding  taxes  from  the  crew- 
man (with  or  without  subsequent  payment  to  the  Internal  Revenue 
Service).  In  addition,  it  is  to  be  immaterial  whether  treatment  of  the 
crewman  as  a  regular  employee  was  caused  or  influenced  by  litigation 
or  administrative  procedure. 

The  necessary  changes  in  the  definitions  of  "trade  or  business"  and 
"wages"  are  effective  for  taxable  years  ending  after  December  31,  1971. 
The  new  requirements  for  reporting  to  be  made  by  boat  operators  with 
respect  to  payments  to  crewmen  who  are  self-employed  pursuant  to 
this  section  of  the  Act  are  effective  for  calendar  year  1977  and  sub- 
sequent calendar  years. 


383 

Revenue  ejfect 
Enactment  of  this  provision  is  expected  to  result  in  a  revenue  loss  of 
approximately  $13  million  annually  beginning  in  fiscal  1977. 

8.  State-Conducted  Lotteries  (sec.  1208  of  the  Act  and  sees  4402 
and  4462(b)  of  the  Code) 

Prior  laio 
Under  prior  law,  each  person  engaged  in  the  business  of  accepting 
wagers  was  subject  to  an  excise  tax  of  2  percent  on  the  amount  of  wagers 
placed  with  that  pereon  (sec.  4401).  The  excise  tax  on  wagers  generally 
applied  to  any  person  who  conducts  a  lottery.  In  addition,  a  related 
occupational  tax  of  $500  per  year  was  imposed  on  each  person  who  was 
liable  for  the  tax  on  wagers  (or  who  was  engaged  in  the  business  of 
receiving  wagers  for  or  on  behalf  of  a  person  who  was  in  turn,  liable 
to  pay  the  excise  tax  on  wagere)  (sec.  4411).  Also,  a  special  occupa- 
tional tax  of  $250  per  year  was  imposed  on  the  operation  of  coin-oper- 
ated gaming  devices,  including  a  vending  machine  which  dispenses 
tickets  on  lotteries  (sec.  4461).  An  exemption  ivora  the  wagering  tax 
was  provided  for  sweepstakes  or  lotteries  conducted  by  an  agency  of  a 
State  and  in  which  the  ultimate  winners  are  determined  by  the  results 
of  a  horse  race. 

Reasons  for  change 

In  1963,  New^  Hampshire  became  the  first  State  in  recent  history  to 
establish  a  State  lottery.  The  lottery  was  similar  in  operation  to  the 
Irish  Sweepstakes,  so  that  the  lottery's  ultimate  winners  were  deter- 
mined by  the  results  of  a  designated  horse  race,  which  was  run  follow- 
ing a  preliminary  selection  of  the  prospective  winners  by  lot.  The 
lottery,  when  established,  was  subject  to  the  Federal  tax  on  wagering. 
In  1965,  however,  Congress  provided  an  exemption  from  this  tax  in 
the  case  of  State-conducted  sweepstakes,  wagering  pools,  or  lotteries. 
The  exemption  was  specifically  based  upon  the  New  Hampshire-type 
of  lottery  and  had  two  basic  requirements :  (1)  the  sweepstakes,  wager- 
ing pool,  or  lottery  must  be  conducted  by  an  agency  of  a  State  acting 
under  authority  of  State  law;  and  (2)  the  ultimate  winners  must  be 
determined  by  the  results  of  a  horse  race  (sec.  4402 (3) ) . 

Since  the  a]:)pearance  of  the  New  Hampsliire  lottery,  several  other 
States  have  established  and  are  operating  lotteries.  Several  more  States 
have  either  authorized,  or  are  investigating  the  feasibility  of  lottery 
operations.  The  lotteries  which  have  been  established  since  1965.  in- 
cluding a  revised  version  of  the  New  Hampshire  lottery,  differ  sub- 
stantially in  the  manner  in  which  they  operate  from  the  form  of  lottery 
which  was  made  exempt  by  Congress  in  1965.  Although  most  States 
use  a  fonnat  which  gives  the  appearance  that  the  ultimate  winners  are 
determined  on  the  basis  of  a  horse  race,  as  a  matter  of  fact,  ultimate 
winners  are  determined  by  lot.  Consequently,  the  lotteries  did  not 
satisfy  the  second  requirement  for  exemption  from  the  tax  on  wagers, 
that  is,  the  use  of  a  horse  race  to  determine  the  winners. 

The  Congress  believes  that  the  exemption  of  State  lotteries  from 
the  excise  tax  on  wagers  should  be  expanded  to  include  the  types  of 
lotteries  now  generally  used  by  States. 


384 

Explmiation  of  provision 
The  Act  deletes  the  requirement  that  the  ultimate  winners  of  State 
lotteries  must  be  determined  on  the  basis  of  the  results  of  a  horse  race. 
Accordingly,  all  State  lotteries  are  exempt  from  the  wagering  tax 
regardless  of  the  method  used  for  determining  the  winners.  Futher- 
more,  since  lottery  tickets  may  be  dispensed  through  coin-oporated 
vending  machines,  the  provision  also  adds  a  similar  exemption  from 
the  special  occupational  tax  on  the  operation  of  vending  machines  for 
State-run  lotteries. 

Effective  date 
Since  the  Congress  believes  that  none  of  the  Federal  taxes  on  wager- 
ing were  intended  to  be  imposed  on  State-run  lotteries,  the  changes 
referred  to  above  are  to  be  effective  for  wagers  made,  or  for  periods, 
after  March  10, 1964. 

Revenue  effect 
This  provision  will  forestall  the  collection  of  as  yet  uncollected 
Federal  wagering  taxes  on  State  lotteries.  It  is  estimated  that  the  un- 
collected amount,  which  the  Congress  believes  should  not  be  and  was 
not  intended  to  be  a  tax  liability,  amounts  to  about  $200  million. 

9.  Minimum  Exemption  from  Levy  for  Wages,  Salary,  and  Other 
Income  (sec.  1209  of  the  Act  and  sees.  6331,  6332,  and  6334  of 
the  Code) 

Prior  law 

Prior  law  (sec.  6834  of  the  Code)  enumerated  a  relatively  limited 
list  of  items  of  a  taxpayer  which  were  exempt  from  levy  for  taxes.  The 
items  so  exempt  were  generally  as  follows :  ( 1 )  wearing  apparel  and 
school  books  necessary  for  the  taxpayer  or  members  of  his  family ;  (2) 
if  the  taxpayer  is  the  head  of  a  family,  up  to  $500  worth  of  the  follow- 
ing: fuel,  provisions,  furniture,  and  personal  effects  in  his  house- 
hold, arms  for  personal  use,  livestock,  and  poultry;  (3)  up  to  $250 
worth  of  books  and  tools  necessary  for  the  taxpayer's  trade,  business 
or  profession;  (4)  unemployment  benefits  (including  any  portion 
payable  with  respect  to  dependents);  (5)  undelivered  mail;  (6)  an- 
nuity or  pension  payments  under  the  Railroad  Retirement  Act,  bene- 
fits under  the  Railroad  Unemployment  Insurance  Act,  special  pension 
payments  received  by  a  person  whose  name  has  been  entered  on  the 
Army,  Navy,  Air  Force,  and  Coast  Guard  ISIedal  of  Honor  roll,  and 
annuities  based  upon  retired  or  retainer  pay  u' der  the  Retired  Serv- 
iceman's Family  Protection  Plan;  (7)  workmen's  compensation  pay- 
ments (including  any  portion  payable  with  respect  to  dependents)  ; 
and  (8)  so  luuch  of  the  taxpayers'  salary,  wages,  or  other  income  as  is 
necessary  to  comply  with  a  pre-levy  court-ordered  judgment  for  sup- 
port of  his  minor  children. 

Under  prior  law,  a  levy  extended  only  to  obligations  which  existed  at 
the  time  of  levy  (sec.  6331(b)).  Consequently,  the  Internal  Revenue 
Service  could  levy  only  on  salaries  and  wages  v>  hich  had  been  earned 
as  of  the  date  of  the  levy.^  If  the  amount  of  such  wages  or  salary 
levied  upon  was  inadequate  to  satisfy  the  taxpayer's  obligations,  tlie 

^  Under  section  6331  (r!),  except  in  the  case  of  jeopardy  assessments,  and  Initial  levy 
could  be  made  on  the  salary  or  wages  of  an  Individual  only  a'ter  he  was  notified  In  writing 
that  such  a  levy  was  going  to  be  made. 


385 

Internal  Kevenue  Service  was  required  to  utilize  successive  levies 
against  additional  salary  or  wages  of  a  taxpayer  until  those  obligations 
were  satisfied. 

Reasons  for  change 

Since  under  prior  law  no  portion  of  a  taxpayer's  salary  or  wages  was 
exempt  from  levy  (except  for  court-ordered  child  support  payments), 
but  unemployment  compensation  w^as  exempt,  an  employed  taxpayer 
who  was  subject  to  a  levy  was  substantially  worse  off  than  an  unem- 
ployed taxpayer  would  have  been  under  similar  circumstances.  In  the 
case  of  an  employed  taxpayer  subject  to  a  levy,  it  appeared  desirable 
not  to  encourage  him  to  terminate  his  employment  but  rather  to  con- 
tinue his  job.  As  a  consequence.  Congress  concluded  that  a  minimum 
amount  of  a  taxpayer's  salary,  wages  or  other  income  should  be  ex- 
empted from  levy  and  such  amount  should  be  based  in  part  upon  the 
number  of  dependents  of  the  taxpayer. 

Congress  further  believes  that  the  requirement  of  successive  levies 
in  the  case  of  salary  and  wages  has  resulted  in  substantial  administra- 
tive problems  for  the  Intei'nal  Revenue  Service  and  has  not  afforded 
individual  taxpayers  any  significant  benefit. 

Explanation  of  provision 

The  Act  provides  an  exemption  from  levy  for  a  minimum  amount  of 
an  individual's  wages  or  salary  for  personal  services,  or  income  derived 
from  other  sources.  The  amount,  in  the  case  of  an  individual  who  is 
paid  on  a  weekly  basis,  is  $50  per  week  plus  $15  per  week  for  each  of  his 
dependents  (other  than  any  minor  child  of  the  taxpayer  with  respect 
to  whom  an  amount  is  exempted  from  levy  as  a  court-ordered  support 
payment).  Individuals  who  are  paid  on  other  than  a  weekly  basis 
shall  have,  as  nearly  as  possible,  an  equivalent  amount  exempt  from 
levy  under  regulations  to  be  prescribed  by  the  Secretary.  In  order  to 
deter  taxpayers  from  claiming  more  dependents  than  those  to  which 
they  are  entitled,  the  taxpayer  will  have  to  verify  the  number  of  his 
dependents. 

The  Act  provides  that  a  levy  on  salary  or  wages  of  a  taxpayer  is  to 
be  continuous  from  the  date  the  levy  is  first  made  until  the  tax  liability 
with  respect  to  which  it  is  made  is  satisfied  or  becomes  unenforceable 
because  of  the  lapse  of  time.^ 

The  Act  also  provides  that  tlie  Internal  Revenue  Service  must  release 
the  levy  as  soon  as  possible  after  the  liability  out  of  which  such  levy 
arose  is  either  satisfied  or  becomes  unenforceable  by  reason  of  lapse  of 
time  and  is  to  promptly  notify  the  person  upon  whom  the  levy  was 
served  (normally  the  employer)  that  the  levy  has  been  released. 

Effective  date 
These  provisions  were  to  apply  with  respect  to  levies  made  after 
December  31,  1976.  However,  Public  Law  94-528  proAnded  that  these 
provisions  would  apply  only  to  levies  made  after  February  28,  1977. 

Reve7iue  effect 
This  provision  is  not  expected  to  have  any  revenue  effect. 


2  A  conforming  amendment  is  made  to  section  6332. 


386 

10.  Joint  Committee  Refund  Cases  and  Post-Audit  Review  (sec. 
1210  of  the  Act  and  sees.  6405  and  8023  of  the  Code) 

Prior  law 
A  statutory  duty  of  the  Joint  Committee  on  Taxation  in  investi- 
gating: the  operation  and  effect  of  the  Federal  tax  laws  is  the  re^'iew 
of  cases  involving  refunds  or  credits  of  income,  war  profits,  excess 
profits,  and  estate  and  gift  taxes.  Except  for  tentative  ivfunds  under 
section  6411,  under  prior  law  payment  of  such  refunds  in  excess  of 
$100,000  could  not  be  made  until  at  least  30  days  have  passed  after  an 
administrative  report  has  been  submitted  to  the  Joint  Committee. 

Reasons  for  change 

The  $100,000  jurisdictional  amount  for  refimd  cases  reviewed  by 
the  Joint  Connnittee  on  Taxation  had  remained  unchanged  for  over 
30  yeai"s.  Intiation  and  the  growth  of  the  economy  has  caused  the 
number  of  refund  reports  reviewed  by  the  Joint  Committee  to  increase 
substantially  in  recent  years.  For  example,  in  1970  there  were  647 
I'efund  reports  while  in  1975  this  number  increased  by  over  twofold 
to  1,434  reports.  The  Congress  was  also  aware  that,  under  prior  law, 
the  i*eview  of  tax  returns  by  the  Joint  Committee  was  generally 
limited  to  large  refund  cases ;  reviews  were  generally  not  undertaken 
of  specific  issues  or  cases  in  which  large  refunds  woi-e  not  in\ olved. 
As  a  result,  the  Congress  decided  to  increase  the  jurisdictional  amount 
from  $100X>00  to  $200,000  for  refund  cases  which  must  be  reviewed  by 
the  Joint  Connnittee  and  to  allow  the  Joint  Committee  to  conduct  a 
post-audit  review  on  the  handling  of  tax  returns  and  issues  generally 
by  the  Internal  Revenue  Service.  This  would  allow  the  Joint  Com- 
mittee to  examine  more  systematically  the  administrative  enforce- 
ment of  the  tax  laws. 

It  was  also  pointed  out  that  Internal  Revenue  Code  amendments 
made  in  1969  and  1974  to  impose  certain  taxes  on  private  foundations 
and  pension  plans  (under  chapters  42  and  43)  did  not  require  that  re- 
funds of  these  taxes  be  subject  to  Joint  Committee  review.  The  Act 
adds  these  two  areas  to  those  subjects  to  Joint  Committee  review. 

Explanation  of  provisions 
The  Act  makes  three  changes  to  prior  law.  First,  the  jurisdictional 
amount  for  requirement  of  Joint  Connnittee  i-eview  of  refund  cases  is 
increased  from  $100,000  to  $200,000.  A  stn-ond  provision  authorizes  the 
Chief  of  Staff  of  the  Joint  Committee  on  Taxation  to  conduct  a  post- 
audit  rcA  iew  of  tax  returns  generally.  It  is  contemplated  tluit  this 
i-eview  will  be  done  through  random  (or  other)  examination  of  re- 
turns and  other  relevant  information  dealing  with  issues  which  may 
not  arise  in  refund  cases.  In  addition,  this  is  intended  to  assist  the 
Joint  Connnittee  in  its  oversight  responsibilities  of  the  Internal  Rev- 
enue Service  in  reviewing  the  IRS's  auditing  and  other  related  func- 
tions and  procedures  with  respect  to  the  handling  of  tax  i-eturns. 
Finally,  the  Joint  Committee's  refund  case  jurisdiction  is  extended 
to  include  cases  involving  i-efunds  (in  excess  of  $200,000)  of  the  excise 
taxes  on  private  foundations  and  pension  plans  imposed  under  chapters 
42  and  43  of  the  Internal  Revenue  Code. 


387 

Effective  date 

The  provisions  pertaining  to  refund  reports  were  effective  gener- 
ally upon  date  of  enactment  (October  4,  1976).  However,  claims  for 
refund  or  credit  with  respect  to  which  IRS  reports  for  Joint  Commit- 
tee review  have  already  been  submitted  are  not  to  be  affected  by 
the  Act.  The  provision  concerning  post-audit  review  is  effective  on 
January  1,  1977. 

Revenue  effect 
These  provisions  of  the  Act  have  no  revenue  effect. 

11.  Use  of  Social  Security  Numbers  (sec.  1211  of  the  Act,  sec.  6109 
of  the  Code  and  sees.  205  and  208  of  the  Social  Security  Act) 

Prior  law 
A  person  required  to  file  an  income  tax  return  must  include  an 
identifying  number  in  his  return  (sec.  6109).  In  general,  individuals 
use  their  social  security  numbers  for  this  purpose  (regs.  sec.  301.6109- 

The  Social  Security  Act  provided  criminal  penalties  for  the  willful, 
knowing  and  deceitful  use  of  a  social  security  number  for  purposes 
relating  to  obtaining,  or  increasing  the  amount  of,  benefits  under 
Social  Security  and  other  programs  financed  with  Federal  funds  (sec. 
208  (g)  of  the  Social  Security  Act) . 

Under  the  Privacy  Act  of  1974,  it  was  unlawful  for  any  Federal, 
State  or  local  government  agency  to  deny  to  any  individual  any  right, 
benefit,  or  privilege  provided  by  law  because  of  such  individual's 
refusal  to  disclose  his  social  st^cui'ity  account  number,  except  where 
disclosure  is  i-equired  by  Federal  statute  or  is  required  by  a  Federal, 
State  or  local  agency  under  statute  or  regulation  adopted  prior  to 
January  1,  1975.^ 

Reasons  for  change 

Section  6109  of  the  Code  required  taxpayers  to  use  identifying 
numbers  as  prescribed  by  regulations.  Although  the  social  security 
number  has  in  fact  been  used  as  the  identifying  number  since  that 
section  was  enacted  in  1961,  there  was  no  provision  in  the  Code  requir- 
ing or  specifically  authorizing  use  of  the  social  security  number  as 
the  identifying  numl3er  on  tax  returns.  The  Secretary  of  the  Treasury 
has  stated  that  the  ability  of  the  IRS  to  use  social  security  numbei-s 
as  identifying  numbers  for  tax  purposes  is  essential  to  Federal  tax 
administration.  The  Congress  believes  tliat  this  provision  is  necessary 
to  eliminate  any  question  as  to  the  authorit}^  of  the  Secretary  to  use 
tliese  numbers. 

While  the  Social  Security  Act  provided  criminal  penalties  for  the 
wrongful  use  of  a  social  security  numljer  for  tlie  purpose  of  obtaining 
or  increasing  certain  benefit  payments,  including  social  security  bene- 
fits, there  was  no  provision  in  the  Code  or  in  the  Social  Security  Act 
relating  to  the  use  of  a  social  security  number  for  purposes  imrelated 
to  benefit  payments.  The  Congress  believes  that  social  security  num- 
bers sliould  not  be  wrongfully  used  for  any  purpose. 

The  Privacy  Act  of  1974  provided  that  Federal,  State  and  local 
agencies  may  not  deny  any  individual  any  rights,  benefit  or  privilege 

1  Section  7(a)  of  the  Privacy  Act  of  1974,  P.L.  93-579. 


388 

provided  by  law  because  such  individual  refuses  to  disclose  his  social 
security  number.  An  exemption  was  provided  for  disclosures  required 
by  Federal  statute  or  by  a  statute  or  regulation  adopted  before  Jan- 
uary 1,  1975,  in  regard  to  a  Federal,  State  or  local  agency  operating 
a  system  of  records  before  that  date. 

The  Congress  has  been  told  that  State  and  local  governments  con- 
sider the  use  of  social  security  numbers  to  be  needed  as  a  means  of 
positively  identifying  taxpayers  and  as  a  means  of  comparing  infor- 
mation on  State  income  <^ax  returns  with  Federal  tax  returns.  The 
adoption  of  separate  State  systems  of  identifying  numbers  would  be 
costly,  duplicative  and  confusing  to  taxpayers.  The  Congress  believes 
that  State  and  local  governments  should  have  the  authority  to  use 
social  security  numbers  for  identification  purposes  when  they  con- 
sider it  necessary  for  the  administration  of  tax,  general  public  assist- 
ance, drivers  licenses  or  motor  vehicle  registration  laws. 

Explanation  of  provision 

The  Act  amends  section  6109  to  require  that,  except  as  otherwise 
specified  under  regulations,  an  individual  shall  use  his  social  security 
number  as  his  identifying  number  for  tax  purposes. 

The  Act  also  amends  section  208(g)  of  the  Social  Security  Act  to 
make  the  willful,  knowing  and  deceitful  use  of  a  social  security  num- 
ber a  misdemeanor  for  all  purposes,  rather  than  only  for  purposes 
related  to  benefit  payments.  It  also  makes  it  a  misdemeanor  to  dis- 
close, use  or  compel  the  disclosure  of  the  social  security  number  of 
any  person  in  violation  of  the  laws  of  the  United  States. 

The  Act  amends  section  205(c)  (7)  of  the  Social  Security  Act  to 
establish  as  the  policy  of  the  United  States  that  any  State  or  political 
subdivision  thereof  may,  in  the  administration  of  any  tax,  general 
public  assistance,  driver's  license,  or  motor  vehicle  registration  law 
within  its  jurisdiction,  utilize  social  security  account  numbers  for  the 
purpose  of  establishing  the  identification  of  individuals  affected  by 
such  laws.  The  State  or  local  government  may,  in  addition,  require 
such  individuals  to  furnish  their  social  security  number  (or  num- 
bers, if  they  have  more  than  one  such  number)  to  the  State  (or  its 
political  subdivision).  This  section  further  provides  that,  to  the  extent 
that  any  existing  provision  of  Federal  law  is  inconsistent  with  the 
policy  set  forth  above,  such  provision  shall  be  null,  void  and  of  no 
effect. 

Effective  date 

The  provisions  of  this  section  are  effective  on  the  date  of  enactment 
(October  4,  1976). 

Revenue  effect 
The  provision  has  no  effect  on  Federal  revenues. 

12.  Interest  on  Mathematical  Errors  on  Returns  Prepared  by  IRS 
(sec.  1212  of  the  Act  and  sec.  6404  of  the  Code) 

Under  prior  law,  interest  on  any  underpayment  of  tax  ran  from 
the  original  due  date  (regardless  of  extensions)  to  the  date  on  which 
payment  was  received. 


389 

Reasons  for  change 
Congress  felt  that  where  a  deficiency  results  in  whole  or  part  from 
a  mathematical  error  on  a  return  prepared  by  an  officer  or  employee  of 
the  IRS  acting  in  his  official  capacity  to  provide  assistance  to  taxpay- 
ers, the  IRS  should  be  authorized  to  abate  interest  otherwise  owing 
on  the  deficiency  for  the  period  prior  to  notice  and  demand  by  the  IRS 
to  the  taxpayer  for  payment  of  the  deficiency. 

Explanxition  of  ^provision 
The  Act  authorizes  the  IRS  to  abate  any  portion  of  interest  owed 
by  a  taxpayer  as  a  result  of  a  mathematical  error  on  returns  prepared 
by  the  Internal  Revenue  Service  where  the  amount  in  question  is 
below  tolerance  levels  established  by  the  IRS.  The  two  principal  fac- 
tors to  be  taken  into  account  by  the  IRS  in  establishing  the  tolerance 
levels  are  (1)  the  cost  of  determining,  assessing,  and  collecting  the 
interest  and  (2)  sound  and  equitable  tax  administration. 

Effective  date 
This  provision  of  the  Act  applies  to  returns  filed  for  taxable  years 
ending  after  the  date  of  enactment  (after  October  4, 1976). 

Revenue  effect 
This  provision  will  have  only  a  negligible  revenue  loss. 


234-120  O  -  77  -  26 


L.  TAX-EXEMPT  ORGANIZATIONS 

1.  Modification  of  Transitional  Rule  for  Sales  of  Property  by 
Private  Foundations  (sec.  1301  of  the  Act  and  sec.  101(1)  (2) 
of  the  Tax  Reform  Act  of  1%9) 

Prior  law 

The  Tax  Reform  Act  of  1969  amended  tlie  Internal  Revenue  Code 
of  1954  to  impose  taxes  upon  certain  transactions  between  a  private 
foundation  and  its  "disqualified  persons"  (generally,  persons  with  an 
economic  or  managerial  interest  in  the  operation  of  that  foundation) . 
Among  the  transactions  covered  by  these  taxes  on  "self-dealing"  are 
the  sale,  exchange,  or  leasing  of  property  (sec,  4941).  In  order  to 
avoid  unnecessary  disruption  of  then  existing  arrangements,  however, 
the  1969  Act  provided  transitional  rules  permitting  the  continuation, 
without  violation  of  the  self-dealing,  rules  of  any  existing  lease  (in 
effect  on  October  9,  1969)  between  a  foundation  and  a  disqualified 
person  until  1979,  so  long  as  the  lease  remains  at  least  as  favorable  to 
the  private  foundation  as  it  would  have  been  under  an  arm's-length 
transaction  between  unrelated  parties.  However,  for  taxable  years  be- 
ginning after  the  end  of  1 979,  the  leasing  arrangements  must  be  termi- 
nated (sec.  101  (1)  (2)  (C)  of  the  1969  Act) . 

Another  transitional  rule  provided  in  the  1969  Act  permits  a  private 
foundation  to  sell  excess  business  holdings  to  a  disqualified  person,  if 
the  sales  price  equals  or  exceeds  the  fair  market  value  of  the  property 
being  sold.  However,  this  rule  applies  only  to  business  holdings,  and 
not  to  passive  investments,  including  passive  leases  (sec.  101  (1)  (2)  (B) 
of  the  Act). 

Reasons  for  change 

Cases  have  been  brought  to  the  Congress'  attention  in  which  a 
private  foundation  is  leasing  to  a  disqualified  person  property  of  a 
nature  which  is  peculiarly  suited  to  the  use  of  that  person.  In  these 
oases,  the  value  of  the  property  to  the  disqualified  person  is  greater 
than  that  to  any  other  person.  Since  under  the  1969  Act  such  a  leasing 
arrangement  must  be  terminated  not  later  than  the  end  of  the  last 
taxable  year  beginning  in  1979,  and  the  property  could  not  be  sold  to  the 
disqualified  person  by  the  private  foundation,  the  foundation  probably 
would  have  been  put  in  the  position  of  being  forced  to  dispose  of  its 
property  to  unrelated  persons  for  less  than  the  value  of  that  property 
to  disqualified  persons. 

This  particular  combination  of  circumstances  regarding  the  sale  of 
leased  property  was  not  brought  to  the  attention  of  the  Congress  when 
it  was  considerincr  the  Tax  Reform  Act  of  1969.  In  eifect,  the  sale-of- 
leased-propei-ty  situation  fell  between  the  above-noted  transitional 
rules.  It  appears  likely  that  if  this  particular  point  had  been  presented 
in  1969,  the  Act  would  have  been  modified  to  deal  with  the  situation. 
Accordingly,  the  Congress  minimized  this  hardship  by  the  addition 
of  a  new  transitional  rule. 

(390) 


391 

Explanation  of  provision 

The  Act  revises  the  transitional  rules  applicable  to  the  private 
foundation  provisions  of  the  Tax  Reform  Act  of  1969  by  adding  a  new 
transitional  rule  to  deal  with  the  sale  of  property  by  a  private  founda- 
tion to  a  disqualified  person.  Under  this  rule,  a  private  foundation  may 
sell,  exchange,  or  otherwise  dispose  of  property  (other  than  by  lease) 
to  a  disqualified  person  if,  at  the  time  of  the  disposition,  the  founda- 
tion is  leasing  substantially  all  of  that  property  under  a  lease  subject 
to  the  1979  lease  transitional  rule  described  above,  and  the  foundation 
receives  in  return  an  amount  which  equals  or  exceeds  the  fair  market 
value  of  the  property.  In  computing  the  fair  market  value  of  the 
property,  no  diminution  of  that  value  is  to  result  from  the  fact  that  the 
property  is  subject  to  any  lease  to  disqualified  persons. 

The  fair  market  value  of  the  property  is  to  be  determined  either  at 
the  time  of  its  disposition,  or  at  the  time  (after  June  30,  1976)  that  a 
contract  is  executed  for  disposition  of  the  property.  The  contractual 
valuation  date  permits  the  foundation  and  the  purchaser  to  have  a 
fixed  price  in  their  agreement  even  though  some  time  may  elapse  and 
the  value  of  the  property  changes  between  the  contract  and  the  actual 
settlement  date. 

Effective  date 
This  provision  applies  to  dispositions  occurring  before  January  1, 
1978,  and  after  the  date  of  enactment  (October  4, 1976) . 

Revenue  effect 
This  provision  is  expected  to  have  a  revenue  loss  of  less  than  $5  mil- 
lion in  fiscal  years  1977  and  1978  and  no  revenue  effect  thereafter. 

2.  New  Private  Foundation  Set-Asides  (sec.  1302  of  the  Act  and 
sec.  4942  of  the  Code) 

Prior  law 

Every  private  foundation  (other  than  an  operating  foundation,  sec. 
4942(a)  (1))  must  make  "qualifying  distributions"  (sec.  4942(g))  of 
its  "distributable  amount"  ^  for  each  year.  If  a  foundation  fails  to  dis- 
tribute for  charitable,  etc.,  purposes  at  least  the  minimum  required 
amount  for  a  given  year,  the  foundation  is  subject  to  a  tax  of  15 
percent  of  the  shortfall.  This  tax  applies  for  each  year  that  the 
shortfall  remains  to  be  distributed.  Aii  additional  tax  of  100  per- 
cent applies  if  the  shortfall  has  not  been  distributed  by  the  90th 
day  after  the  Internal  Revenue  Service  has  mailed  to  the  foundation 
a  notice  of  deficiency  with  respect  to  the  15-percent  tax. 

An  amount  set  aside  to  be  paid  out  for  a  specific  project  may  be 
treated  as  a  "qualifying  distribution"  for  the  year  of  the  set-aside. 
But  under  prior  law  such  an  amount  set  aside  could  be  treated  as  a 
"qualifying  distribution"  only  if  the  set-aside  was  approved  in  ad- 
vance by  the  Internal  Revenue  Service.  To  obtain  such  approval,  the 
foundation  had  to  establish  both  that  the  amounts  set  aside  would  be 
paid  for  the  specific  project  within  5  years,^  and  that  the  project  was 

1  The  definition  of  "distributable  amount"  is  modified  by  section  1303  of  the  Act. 
(This  is  described  l>elow  In  3.  Reduction  in  Minimum  Distribution  Amount  for  Private 
Foundations.) 

2  The  statute  permits  the  Service  to  extend  the  payout  period  "For  good  cause 
shown  •  •   ♦." 


m2 

one  which  can  better  be  accomplished  by  that  set-aside  than  by  the 
immediate  payment  of  funds.  If  the  Internal  Revenue  Service  did  not 
give  timely  approval  of  a  set-aside,  then  the  set-aside  did  not  constitute 
a  qualifying  distribution. 

Reasons  for  change 

In  some  cases,  the  Internal  Revenue  Service  had  been  reluctant  to 
approve  set-asides  that  were  repeatedly  used  by  a  private  foundation  in 
making  grants,  even  thongh  the  purpose  for  not  paying  the  grant  all 
at  once  was  to  allow  the  foundation  to  ensure  that  the  funds  were  being 
properly  spent.  However,  foundations  which  had  similar  grant  pro- 
grams in  effect  before  the  1969  Act  generally  did  not  have  to  obtain 
prior  approval  for  programs  to  replace  them  because  the  amounts  actu- 
ally distributed  under  such  foundations'  other  pre-1969  Act  programs 
still  in  effect  and  the  replacement  programs  had  been  sufficient  by 
themselves  to  meet  the  minimum  payout  requirements. 

The  Congress  decided  that,  if  a  new  foundation  is  established,  or 
when  an  existing  foundation's  assets  were  significantly  increased  be- 
fore 1972  because  of  a  contribution,^  then  the  payout  rules  should 
permit  such  a  foundation  to  establish  set-aside  programs  for  projects 
which  are  designed  to  run  several  years  and  which  require  founda- 
tion monitoring.  As  a  result  of  the  1969  Act  set-aside  rules,  new 
foundations  and  some  existing  ones  whose  assets  were  suddenly  and 
significantly  increased  could  be  subject  to  penalties  for  failure  to 
fulfill  payout  requirements,  if  their  new  set-aside  programs  did  not 
receive  timely,  advance  Service  approval.  The  rules  thus  deterred 
such  foundations  from  instituting  the  type  of  long-term  supervised 
projects  conducted  by  many  major  foundations  and  otherwise  gen- 
erally favored  by  the  Internal  Revenue  Code  provisions  on  private 
foundations. 

Explanation  of  pr'ovision 

The  ACT  modifies  the  set-aside  rules  for  private  foundations  to  per- 
mit a  foimdation  to  treat  as  a  current  charitable  expenditure  under 
temporary,  relaxed  set-aside  rules,  an  amount  set  aside  to  be  paid  out 
over  the  following  five  years.  However,  the  foundation  nuist  continue 
to  comply  with  the  ordinary  charitable  expenditure  requirements. 

Under  the  Act,  foundations  Avould  be  permitted  to  set  aside  for  sub- 
sequent payment  amounts  which  might  otherwise  be  required  to  be  paid 
out  immediately  in  order  to  avoid  the  penalty  tax.  By  permitting  a 
foundation  to  make  set-asides  in  certain  limited  circumstances  without 
obtaining  prior  Service  approval,  the  Act  alleviates  a  situation  which 
was  unforeseen  at  the  time  of  the  1969  legislation,  that  is,  the  case  of  a 
new  foundation  or  an  existing  foundation  whose  assets  were  sud- 
dently  multiplied  many  times  over,  which  finds  it  is  impossible,  as  a 
result  of  the  Service's  inaction,  to  meet  the  payout  requirements  in  its 
early  years  if  it  uses  the  set-aside,  because  each  set-aside  grant  must  be 
specifically  approved  in  advance  by  the  Internal  Revenue  Service. 

The  private  foundations  which  are  expected  to  receive  significant 
help  from  the  special  set-aside  rules  in  this  amendment  are  new  foun- 

3  In  one  case  that  has  been  brought  to  the  Congress'  attention,  receipt  of  a  beqnest 
caused  a  foundation's  assets  to  grow  from  about  ?100  million  to  about  $1  billion. 


393 

dations  created  after  1971  and  existing  foundations  which  complete 
a  qualifying  five-year  set-aside  project  in  1976. 

The  Act  continues  prior  law  in  requiring,  for  a  set-aside,  that  the 
private  foundation  establish  to  the.  satisfaction  of  the  Internal  Revenue 
Service  (1)  that  the  amount  will  be  paid  for  the  specific  project  within 
5  years  and  (2)  that  the  project  is  one  which  can  be  better  accomplished 
by  that  set-aside  than  by  immediate  payment  of  funds.  However,  the 
Act  provides  an  alternative  to  the  second  of  the  above  requii-ements. 
Under  this  alt-ernative,  the  set-aside  is  to  be  allowed  if  the  foundation 
meets  the  first  of  the  above  requirements  and  also  satisfies  the  following 
standards: 

First,  the  set-aside  must  be  for  a  project  which  will  not  be  com- 
pleted before  the  end  of  the  year  in  which  the  set-aside  is  made. 

Second,  the  private  foundation  must  disburse  for  charitable  pur- 
poses in  each  taxable  year  beginning  after  December  31,  1975  (or,  if 
later,  after  the  end  of  the  fourth  taxable  year  following  the  yea,r  in 
which  the  foundation  was  created*),  not  less  than  the  foundation's 
distributable  amount.  (See  footnote  1,  above).  For  this  purpose,  only 
actual  distributions  (cash  or  its  equivalent)  tliat  are  made  in  the  tax- 
able year  are  taken  into  account.  However,  for  this  purpose  all  actual 
distributions  are  taken  into  account,  even  though  they  may  be  distribu- 
tions of  amounts  that  previously  were  given  set-aside  treatment. 

The  third  standard  is  that  during  the  four  taxable  years  imme- 
diately preceding  the  foundation's  first  taxable  year  beginning  after 
December  31,  1975  (or,  if  later,  the  first  four  taxable  years  after  the 
year  of  the  foundation's  creation),  the  foundation  must  actually  dis- 
tribute for  charitable,  etc.,  purposes  an  aggregate  araount  not  less  than 
the  sum  of  the  following : 

80  percent  of  the  first  preceding  taxable  year's  distributable 

amount,  plus 
60  percent  of  the  second  preceding  taxable  year's  distributable 

amount,  plus 
40  percent  of  the  third  preceding  taxable  year's  distributable 

amount,  plus 
20  percent  of  the  fourth  preceding  taxable  year's  distributable 
amount. 

As  under  the  second  standard,  all  actual  distributions  made  dur- 
ing the  four-year  period,  and  no  others,  are  taken  into  accoimt. 
However,  in  this  case  only  the  aggregate  amount  is  relevant ;  it  is  not 
necessary,  for  example,  that  the  distributions  be  matched  to  the  dis- 
tributable amounts  for  each  separate  year  of  the  four-year  period. 

Fourth,  if  a  private  foundation  fails  in  any  taxable  year  to  disburse 
the  required  amounts  of  cash  or  its  equivalent  and  if  (1)  the  failure 
was  not  willful  and  was  due  to  reasonable  cause,  and  (2)  the  founda- 
tion distributes  an  amount  equal  to  that  which  it  failed  to  distribute 
during  the  taxable  y*»ar  within  the  initial  correction  period  provided 

*  A  private  foundation  Is  not  to  be  permitted  to  come  under  the  rules  of  this  provision 
unless  it  qualifies  to  do  so  at  its  first  opportunity.  For  example,  if  a  private  foundation 
that  is  now  in  existence  were  in  1985  to  conclude  that  it  wishes  to  come  under  the  rules 
of  this  provision  for  automatic  set-asldes,  it  is  not  to  then  be  permitted  to  transfer  some 
or  all  of  its  assets  to  a  new  private  foundation  and  then  have  the  new  private  foundation 
seek  to  comply  with  the  rules.  The  "new"  private  foundation  would  be  regarded,  for  these 
purposes,  as  having  been  created  not  later  than  the  time  the  transferor  foundation  was 
created.  See,  for  example,  the  provisions  of  Treasury  Regulations  §  1.507-3(a). 


394 

by  statute  (generally,  90  days  after  the  Service  has  sent  a  notice  of 
deficiency  to  the  foundation,  sec.  4942(j)  (2)),  then  that  distribution 
is  treated  (for  purposes  of  this  special  set-aside  rule)  as  though  it 
had  been  made  in  the  year  in  which  it  originally  should  have  been 
made.  This  delayed  distribution  enables  the  foundation  to  continue  to 
use  this  special  set-aside  rule.  However,  if  this  shortfall  in  cash  dis- 
tributions also  results  in  a  failure  to  meet  the  regular  distribution  re- 
quirements of  the  law,  then  the  delayed  distribution  does  not  enable 
the  foundation  to  avoid  the  15-percent  excise  tax  described  above  (un- 
less the  foundation  also  meets  the  technical  requirement  of  sec.  4942 
(a)(2)). 

The  fifth  standard  in  the  provision  in  effect  gives  the  foundation 
a  5-year  carryover  of  any  excess  disbursements  it  may  make  in  any 
taxable  year  beginning  after  December  31,  1975.  As  is  the  case  under 
the  second,  third,  and  fourth  standards,  only  actual  distributions  made 
during  the  taxable  year  are  taken  into  account  for  purposes  of  this 
carryover.  A  technical  provision  holds  the  statute  of  limitations  on 
assessments  and  collections  open  during  the  extended  payout  period. 

Effective  date 
This  provision  applies  to  taxable  j^ears  beginning  on   or   after 
January  1,  1975. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

3.  Reduction  in  Minimum  Distribution  Amount  for  Private  Foun- 
dations (sec.  1303  of  the  Act  and  sec.  4942  of  the  Code) 

Prior  law 

Under  prior  law  (sec.  4942),  each  private  foundation  ^  had  to  dis- 
tribute currently  for  charitable,  etc.,  purposes,  the  greater  of  all  its 
income  or  an  annually  determined  variable  percentage  of  its  average 
investment  assets  (sometimes  referred  to  as  "noncharitable  assets"). 
Graduated  sanctions  were  imposed  in  the  event  of  failure  to  distribute 
the  required  amount.  For  taxable  years  beginning  in  1976,  the  applica- 
ble percentage  under  prior  law  was  6,75  percent.  This  percentage 
was  determined  annually  by  the  Treasury  Department,  pursuant  to 
statutory  authorization,  on  the  basis  of  changes  in  money  rates  and 
investment  yields,  taking  into  account  a  standard  of  a  6-percent 
foundation  payout  rate  for  1969  and  with  respect  to  any  calendar 
year,  comparing  money  rates  and  inv^estment  yields  for  1969  with 
those  for  the  immediately  preceding  calendar  year. 

The  minimum  distribution  requirement  generally  had  to  be  met  for  a 
year  by  making  the  required  amount  of  charitable  distributions  in  that 
year  or  in  the  following  year. 

Failure  to  comply  with  the  minimum  pa^yout  requirement  resulted 
in  sanctions  against  the  foundation.  The  firet  level  of  sanction  was  a 
tax  of  15  percent  of  the  amount  that  should  have  been,  but  w^as  not, 
paid  out.  This  tax  was  imposed  for  each  year  until  the  private  foun- 


1  Different  rules  are  provided  for  private  foundations  wliicli  are  operating  foundations. 
Tlie  changes  made  by  this  provision  of  the  Act  affect  private  operating  foundations  only 
In  one  respect.  This  Is  discussed  below,  under  explanation  of  provision. 


395 

dation  was  notified  of  its  obligation  or  until  the  foundation  itself  cor- 
rected its  earlier  failure  by  making  the  necessary  payouts.  However, 
to  the  extent  the  failure  to  meet  the  minimum  payout  requirement 
resulted  from  an  incorrect  valuation  of  the  foundation's  relevant  assets 
and  this  incorrect  valuation  was  not  willful  but  was  due  to  reasonable 
cause,  then  the  foundation  could  avoid  the  first-level  tax  by  promptly 
making  additional  distributions. 

Within  90  days  after  notification  by  the  Internal  Kevenue  Service 
the  foundation  had  to  correct  its  failure  to  make  the  appropriate 
charitable  distributions.  This  90-day  period  could  be  extended.  If  the 
necessary  distributions  were  not  made  within  the  appropriate  period 
the  second  level  of  sanctions  was  imposed — a  tax  of  100  percent  of  the 
amount  required  to  be  paid  out.  (A  penalty  doubling  the  amount 
of  the  first  or  second  level  of  tax  is  imposed  in  the  case  of  repeated 
violations,  or  a  willful  and  flagrant  violation  (sec.  6684).  If  an  or- 
ganization persistently  violated  the  payout  rules,  a  third-level  sanc- 
tion might  be  imposed,  under  which  the  foimdation  must  return  to 
the  Treasury  all  the  income,  estate,  and  gift  tax  benefits  received  by 
the  foundation  or  any  of  its  substantial  contributors  (sec.  507)). 

Reasons  for  change 

The  Tax  Reform  Act  of  1969,  as  reported  by  the  House  Committee 
on  Ways  and  Means,  as  passed  by  the  House,  and  as  reported  by  the 
Senate  Committee  on  Finance,  provided  for  an  initial  applicable  per- 
centage of  5  percent.  This  figure  was  raised  to  6  percent  by  a  Senate 
floor  amendment  and  this  was  agreed  to  in  the  legislation  which  was 
finally  enacted. 

The  Congress  has  become  convinced  that  the  original  judgment  of 
the  Ways  and  Means  and  Finance  Committees  and  of  the  House  as 
to  the  appropriate  applicable  percentage,  based  upon  the  economic 
conditions  of  1969,  was  correct  and  that  the  higher  rate  provided  by 
the  Senate  floor  amendment  could  have  damaging  effects  on  the  con- 
tinuing viability  of  many  foundations.  The  use  of  1969  money  rates 
and  investment  yields  for  adjusting  the  annual  rate  now  appears  too 
limited  a  base  for  an  economically  valid  income  rate  projection.  In 
addition,  changing  the  rate  annually  could  create  significant  uncer- 
tainty for  foundation  managers  in  planning  their  grant-making 
programs. 

Explanation  of  provision 

The  Act  reduces  the  mandatory  annual  payout  percentage  applicable 
to  private  foundations  to  5  percent  and  eliminates  the  authority  of 
the  Treasury  Department  to  change  that  rate  from  year  to  year.  The 
other  provisions  of  prior  law  relating  to  the  minimum  distribution 
amount,  including  the  provisions  requiring  distribution  of  adjusted 
net  income  (if  that  is  greater  than  the  minimum  distributable  amount) 
and  the  rules  for  corrections  and  sanctions,  are  not  changed  by  this 
provision. 

Private  operating  foundation  (sec.  4942 (j)  (3) )  are  affected  by  the 
Act  only  in  that  the  amendment  reduces  the  minimum  payout  require- 
ment of  a  private  operating  foundation  which  qualifies  as  such  under 
the  so-called  ^'endowment  alternative"  (sec.  4942(j)  (3)  (B)  (ii) ).  To 
qualify  under  this  alternative  an  operating  foundation  must  have  an 


396 

endowment  ^  which,  assuming  a  rate  of  return  which  is  two-thirds  of 
the  minimum  payout  rate,  is  no  more  than  adequate  to  meet  its  cur- 
rent operating  expenses.  The  effect  of  the  Act  is  to  reduce  the  endow- 
ment alternative  minimiun  payout  rate  to  Sy^  percent  (two- thirds  of 
5  percent) . 

The  Act  also  establishes  certain  explicit  rules  for  valuing  a  private 
foundation's  noncharitable  assets  in  determining  the  required  chari- 
table expenditures  (minimum  investment  return).  In  determining 
the  value  of  securities  foi-  minimum  charitable  expenditures  purposes, 
their  fair  market  value  (determined  without  regard  to  any  reduction 
in  value)  shall  not  be  reduced  unless,  and  only  to  the  extent  that,  the 
private  foundation  establishes  that  as  a  result  of  (1)  the  size  of  the 
block  of  such  securities,  (2)  the  fact  that  the  securities  are  securities  in 
a  closely  held  corporation,  or  (3)  the  fact  that  the  sale  of  such  secu- 
rities would  result  in  a  forced  or  distress  sale,  the  securities  could  not 
be  liquidated  within  a  reasonable  period  of  time  except  at  a  price  less 
than  fair  market  value.  Any  reduction  in  value  shall  be  made  only  for 
one  or  more  of  these  three  reasons  and  shall  not  in  the  aggregate  exceed 
10  percent  of  the  fair  market  value  of  the  securities. 

Effective  date 
This  provision  applies  to  taxable  years  beginning  after  December 
31, 1975. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

4.  Extension  of  Time  To  Conform  Charitable  Remainder  Trusts 
for  Estate  Tax  Purposes  (sec.  1304  of  the  Act  and  sec.  2055 
(e)(3)  of  the  Code) 

Prior  lam 

The  Tax  Reform  Act  of  1969  imposed  new  requirements  which  must 
be  satisfied  by  a  charitable  remainder  trust  in  order  for  an  estate  tax 
deduction  to  be  allowed  for  the  transfer  of  a  remainder  interest  to 
charity.  Under  these  new  requirements,  no  estate  tax  deduction  is  allow- 
able for  a  remainder  interest  in  property  (other  than  a  remainder  in- 
terest in  a  farm  or  personal  residence)  passing  at  the  time  of  a  deca- 
dent's death  in  trust  unless  the  trust  is  in  the  form  of  a  charitable 
remainder  annuity  trust  or  unitrust  or  pooled  income  fund.  These 
rules  generally  apply  in  the  case  of  decedents  dying  after  December  31, 
1969.  However,  certain  exceptions  were  provided  in  the  case  of  wills  ex- 
ecutexl  or  property  transferred  in  trust  on  or  before  October  9,  1969. 
In  general,  these  exceptions  did  not  apply  the  new  rules  to  these  wills 
and  revocable  trusts  until  October  9, 1972  (unless  the  will  was  modified 
in  the  meantime) ,  to  allow  a  reasonable  period  of  time  to  take  the  new 
rules  into  account. 

In  1970,  the  Internal  Revenue  Service  issued  proposed  regulations 
with  respect  to  the  new  requirements  for  a  charitable  remainder 
annuity  trust  or  vmitrust  (under  sec.  664  of  the  Ode).  These  regula- 
tions provided  additional  transitional  rules  allowing  trusts  created 
after  July  31,  1969,  (which  did  not  come  within  the  statutory  excep- 
tions) to  qualify  for  an  income,  estate,  or  gift  tax  deduction  if  the 

2  Plus  any  other  assets  not  devoted  directly  to  the  active  conduct  of  the  activities  for 
which  the  organization  is  organized. 


397 

governing  instrument  was  amended  prior  to  January  1,  1971.  Subse- 
quently, the  date  by  which  the  government  instrument  had  to  be 
amended  was  further  extended  by  the  Internal  Eevenue  Service.^  On 
August  22,  1972,  the  Internal  Revenue  Service  issued  final  regulations 
which  further  extended  the  date  to  December  31, 1972.  On  September  5, 
1972,  the  Internal  Revenue  Service  published  Rev.  Rul.  72-395  (1972- 
Z  C.B.  340),  which  provided  sample  provisions  for  inclusion  in  the 
governing  instrument  of  a  charitable  remainder  trust  that  could  be 
used  to  satisfy  the  requirements  under  section  664. 

In  1974,  Congress  extended  the  date  by  which  the  governing  instru- 
ment of  a  trust  created  after  July  31,  1969,  and  before  September  21, 
1974,  or  i^ursuant  to  a  will  executed  before  September  21,  1974,  could 
be  amended  (P.L.  93-483).  Under  that  Act,  if  the  governing  instru- 
ment is  amended  to  conform  by  December  31,  1975,  to  meet  the  re-« 
quirements  of  a  charitable  remainder  annuity  trust  or  unitrust  or 
pooled  income  fund,  an  estate  tax  deduction  would  be  allowed  for  the 
charitable  interest  which  passed  in  trust  from  the  decedent  even  though 
the  interest  failed  to  qualify  at  the  time  of  the  decedent's  death. 

Where  a  judicial  proceeding  was  required  to  amend  the  governing 
instrument,  the  judicial  proceeding  must  have  begun  before  December 
31,  1975,  and  the  governing  instrument  must  have  been  amended  to 
conform  to  these  requirements  by  the  30th  day  after  the  judgment 
becomes  final. 

In  any  case  where  the  governing  instrument  was  amended  after  the 
due  date  for  filing  the  estate  tax  return,  the  deduction  would  be  allowed 
upon  the  filing  of  a  timely  claim  for  credit  or  refund  (sec.  6511)  of  an 
overpayment.  However,  no  interest  would  be  allowed  for  the  period 
prior  to  the  end  of  180  days  after  the  claim  for  credit  or  refund  is  filed. 

Reasons  foi^  change 

Despite  the  additional  period  provided  by  the  1974  amendment,  it 
came  to  the  attention  of  the  Congress  that  there  are  many  wills  becom- 
ing effective  which  provide  a  charitable  remainder  which  still  do  not 
meet  the  requirements  for  qualifications  under  section  664  for  a  chari- 
table remainder  annuity  trust  or  unitrust.  Moreover,  the  Congress 
was  informed  that  there  are  also  a  number  of  trusts  and  wills  which 
were  drafted  after  September  21,  1974,  which  do  not  comply  with  the 
new  rules  for  the  allowance  of  a  charitable  deduction  for  estate  tax 
purposes. 

The  Congress  believes  it  is  appropriate  to  provide  an  additional 
2-year  extension  to  permit  wills  establishing  charitable  remainder 
trusts  to  be  amended  to  comply  with  the  1969  Act  rules  for  a  charitable 
remainder  for  estate  tax  purposes  because  the  policy  of  these  rules  is 
furthered  when  such  trusts  are  amended  to  meet  these  rules.  In  addi- 
tion, failure  to  meet  these  rules  results  in  additional  estate  taxes  that 
often  are  borne  substantially  by  charity. 

While  the  Congress  believes  that  an  additional  extension  of  two 
years  is  appropriate  at  this  time  under  the  circumstances,  the  Congress 
believes  that  this  should  be  the  last  extension  permitted.  By  the  end 
of  this  extension,  there  will  have  been  eight  years  since  the  general 
effective  date  of  the  new  requirements  for  deduction  under  section  2055 


iT.I.R.  1060  (December  13,  1970)  extended  the  date  to  June  30,  1971;  T.I.R.  1085 
(June  11,  1971),  extended  the  date  to  December  31,  1971  ;  T.I.R.  1120  (December  17,  1971)  ; 
extended  the  date  to  June  30,  1972;  and  T.I.R.  1182  (June  29,  1972),  extended  the  date 
to  the  90th  day  after  final  regulations  were  issued. 


398 

(e)  of  the  Code.  The  Congress  believes  that  such  an  eight-year  period 
should  be  more  than  enough  time  for  taxpayers  and  their  lawyers  to 
learn  the  new  rules  and  to  implement  them  into  their  estate  plans. 

Also,  the  Congress  intends  that  the  Internal  Revenue  Service  make 
every  effort  to  publicize  to  taxpayers'  attorneys,  trust  companies,  etc., 
the  requirements  of  the  1969  Act  with  respect  to  charitable  remainder 
trusts.  The  Congress  solicits  the  assistance  of  commercial  tax  services 
in  similarly  publicizing  these  requirements. 

Explanation  of  'provision 
The  Act  extends  to  Decern;  -er  31, 1977,  the  date  by  which  the  govern- 
ing instrument  of  a  charitable  remainder  trust  created  after  July  81, 
1969,  must  be  amended  in  order  to  qualify  as  a  charitable  remainder 
annuity  or  unitrust  or  pooled  income  fund  for  purposes  of  the  estate 
tax  deduction.  The  Act  also  extends  the  date  in  the  case  of  a  trust 
created  after  July  31, 1969,  pursuant  to  a  will  executed  before  Decem- 
ber 31,  1977.  Under  the  Act,  if  the  governing  instrmuent  is  amended 
by  December  31,  1977,  to  conform  to  the  requirements  of  a  charitable 
remainder  annuity  or  unitrust  or  pooled  income  fund,  an  estate  tax  de- 
duction will  be  allowed  for  the  charitable  interest  which  passed  in 
trust  from  the  decedent  even  though  a  deduction  originally  was  not 
allowed  for  this  interest  because  the  trust  failed  to  qualify  as  a  char- 
itable remainder  trust  at  the  time  of  the  decedent's  death.  This  applies 
to  trusts  created  after  July  31,  1969.  For  these  purposes,  a  trust  which 
first  became  irrevocable,  in  whole  or  in  part,  after  that  date  is  treated 
as  having  been  created  after  that  date. 

Effective  date 
This  amendment  applies  with  respect  to  decedents  dying  after 
December  31, 1969. 

Revenue  effect 
It  is  estimated  that  this  provision  will  decrease  budget  receipts  by 
$5  million  during  fiscal  year  1977  and  1978. 

5.  Income  From  Fairs,  Expositions,  and  Trade  Shows  (sec.  1305 
of  the  Act  and  sec.  513  of  the  Code) 

Prior  law 

The  unrelated  business  income  tax  applies  to  income  from  the  con- 
duct by  an  exempt  organization  of  an  unrelated  trade  or  business.  The 
term  "unrelated  trade  or  business"  means  any  trade  or  business  the 
conduct  of  which  is  not  substantially  related  (aside  from  the  need  of 
such  organization  for  income  derived  from  such  trade  or  business)  to 
the  exercise  of  its  exempt  purpose.  The  term  "trade  or  business"  in- 
cludes any  activit}'  carried  on  for  the  production  of  income  from  the 
sale  of  goods  or  services.  The  law  further  provides  that,  for  the  pur- 
pose of  defining  the  trade  or  business  activity,  the  activity  was  not  to 
lose  its  identity  as  a  trade  or  business  merely  because  it  is  carried  on 
within  a  larger  aggregate  or  similar  activities  or  witliin  a  large  com- 
plex of  other  endeavors  which  may  (or  may  not)  be  related  to  the  ex- 
empt purposes  of  the  organization. 

One  major  purpose  of  this  provision  is  to  make  certain  that  an 
exempt  organization  does  not  commercially  exph^it  its  exempt  status 
for  the  purpose  of  unfairly  competing  with  taxpaying  organizations. 
An  example  of  such  activity  specifically  cited  in  the  law  is  the  carrying 
of  advertising  in  a  journal  published  by  an  exempt  organization. 


399 

Reasons  for  change 
In  two  instances,  the  Internal  Revenue  Service  has  ruled  that  activi- 
ties which  are  not  conducted  in  competition  with  commercial  activities 
of  taxpaying  org^anizations  are  nevertheless  considered  to  be  unrelated 
trade  or  business  activities  which  are  subject  to  the  unrelated  business 
income  tax.  In  one  case  (Rev.  Rul.  68-505, 1968-2  CB  248) ,  the  Service 
ruled  that  an  exempt  county  fair  association  which  conducts  a  horse 
racing  meet  with  parimutuel  betting  is  carrying  on  an  unrelated  trade 
or  business  subject  to  the  unrelated  business  income  tax.  In  another 
case  the  Service  determined,  in  a  series  of  revenue  rulings  (TIR-1409^, 
1975-2  CB  220-227),  that  income  that  an  exempt  business  league  re- 
ceives at  its  convention  trade  show  from  renting  display  space  may 
constitute  unrelated  business  taxable  income  if  selling  by  the  exhibitor 
is  permitted  or  tolerated  at  the  show. 

Reasons  for  change 

The  Congress  does  not  believe  that  the  activities  dealt  with  in  those 
ruling  are  generally  unrelated  to  the  exempt  purposes  of  the  organiza- 
tions that  conduct  them.  It  is  customary  for  tax-exempt  organizations 
to  provide  entertainment,  including  horee  racing,  at  fairs  and  exposi- 
tions in  order  to  attract  the  public  to  the  educational  exhibits  on  dis- 
play. In  addition,  trade  associations  use  trade  shows  as  a  means  of 
promoting  and  stimulating  an  interest  in,  and  demand  for,  their  indus- 
tries' products  in  general.  They  are  also  able  to  educate  their  members 
regarding  new  developments  and  techniques  which  are  available  to  the 
trade. 

In  neither  case  are  the  exempt  organizations  exploiting  their  exempt 
status  in  order  to  compete  unfairly  with  taxpaying  organizations. 
Generally,  horse  racing  dates  are  controlled  by  State  authorities  and 
are  made  available  on  a  State-wide  basis  to  only  one  organization  for 
any  one  period.  Trade  shows  are  generally  conducted  only  by  trade 
associations  and  not  by  taxpaying  entiti  '^s. 

Explanation  of  provision 
In  the  case  of  fairs  and  expositions,  the  Act  exempts  from  the  un- 
related business  income  tax  the  income  derived  from  a  qualified  pub- 
lic entertainment  activity  by  an  organization  which  is  exempt  under 
section  501(c)  (3),  (4),  or  (5)  of  the  Code  (charitable,  social  wel- 
fare, or  agricultural)  if  the  organization's  activity  meets  one  of  the 
following  conditions : 

(1)  the  public  entertainment  activity  is  conducted  in  conjunction 
with  a  public  international,  national.  State,  regional,  or  local  fair  or 
exposition ; 

(2)  the  activity  is  conducted  in  accordance  with  State  law  which 
permits  that  activity  to  be  conducted  only  by  that  type  of  exempt  orga- 
nization or  by  a  governmental  entity ;  or 

(3)  the  activity  is  conducted  in  accordance  with  State  law  which 
allows  that  activity  to  be  conducted  for  not  more  than  20  days  in  any 
year  and  which  permits  the  organization  to  pay  a  lower  percentage  of 
the  revenue  from  this  activity  than  the  State  requires  from  other 
organizations. 

In  order  to  qualify  for  this  treatment,  the  organization  must  regu- 
larly conduct,  as  one  of  its  substantial  exempt  purposes,  a  fair  or  expo- 
sition which  is  both  agricultural  and  educational.  Thus,  a  book  fair 


400 

held  by  a  miivei'sity  does  not  como  ^vitllin  tliis  provision  since  such  a 
fair  is  not  an  a<>:ricuitmal  fair  or  exposition. 

Tlie  condncting  of  qualitiod  public  entertainment  activities  is  not 
to  ati'ect  the  tax-exempt  status  of  the  or«ranization. 

In  tlie  case  of  conventions  and  trade  sliows  the  Act  exempts  from 
the  unrelated  business  income  tax  the  income  derived  from  a  qualified 
convention  and  trade  show  activity  by  an  orpmization  which  is  ex- 
empt under  section  501(c)  (5)  or  ((>)  of  the  Code  (generally,  miions 
or  trade  ass(viations)  and  which  regularly  conducts  as  one  of  its  ex- 
empt ])urposes  a  convention  or  trade  show  activity  which  stimulates 
interest  in,  and  demand  for  an  industry's  products  in  jjeneral.  In 
order  to  constitute  a  qualifying  convention  and  trade  show  activity  all 
the  following  conditions  nuist  be  met : 

Fii*st,  it  must,  be  conducted  in  conjunction  with  an  international, 
national.  State,  regional,  or  local  conventiim,  annual  meeting,  or  show ; 

Second,  one  of  the  purposes  of  the  orpinization  in  sponsoring  that 
activity  must  be  the  promotion  and  stnnulation  of  interest  in,  and 
demand  for,  the  industry's  products  and  service's  in  general;  and 

Third,  the  show  nnist  promote  tliat  purpose  througli  the  character 
of  the  exhibits  and  the  extent  of  the  industry  products  displayed. 

Effective  dates 
This  provision  applies  to  taxable  yeare  beginning  after  Decem- 
ber 31,  19(V2,  with  respect  to  qualified  }niblic  entertainment  activities, 
and  to  taxable  yeai-s  begimiing  after  the  date  of  enactment  (October  4, 
1976),  with  respect  to  qualified  convention  and  trade  show  activities. 

Revenue  effect 
It  is  estimated  that  the  revenue  impact  of  these  provisions  will  be 
relatively  small. 

6.  Declaratory  Judgments  as  to  Tax-Exempt  Status  as  Char- 
itable, etc.,  Organization  (sec.  1306  of  the  Act  and  new  sec. 
7428  of  the  Code) 

Prior  laic 
An  organization  that  meets  the  requirements  of  section  501(c)  (3) 
of  the  Code  ^  is  exempt  from  tax  on  its  income.- 


1  "SEC.  501  EXEMPTION  FROM  TAX  ON  CORPORATIONS,  CERTAIN  TRUSTS, 
ETC. 

"(a)  Exemptiou  From  Taxation.^ — An  organization  described  In  subsection  (c)  or  (d) 
or  section  401(a)  shall  be  exempt  from  taxation  under  this  subtitle  unless  such  exemption 
is  denied  under  section  502  or  503. 

•  •••••* 
"(c)    List  of  Exempt  Organizations. — The  following  organizations  are   referred   to   in 

subsection  (a)  : 

•  •••••• 

"(3)  Corporations,  and  any  community  chest,  fund,  or  foundation,  organized  and  oper- 
ated exclusively  for  religious,  charitable,  scientific,  testing  for  public  safety,  literary,  or 
educational  purposes,  or  to  foster  national  or  international  amateur  sports  competition 
(but  only  if  no  part  of  its  activities  invoice  the  provision  of  athletic  facilities  or  equip- 
ment), or  for  the  prevention  of  cruelty  to  children  or  animals,  no  part  of  the  net 
earnings  of  which  inures  to  the  benefit  of  any  private  shareholder  or  individual,  no 
substantial  part  of  the  activities  of  which  is  carrying  on  propag;\nda.  or  otherwise 
attempting,  to  intluence  legislation  (CJ-cept  as  othericise  provided  in  subsection  (h)),  and 
which  does  not  particiv>ate  in,  or  intervene  in  (including  the  publishing  or  distributing  of 
stateujcntsi.  any  political  campaign  on  behalf  of  any  candidate  for  public  office."  (The 
first  italicized  item  was  added  by  section  1313  of  the  Act,  described  below,  under  13. 
Exemption  of  Cortaio  Amateur  Athletic  Orgajiizations  From  Tax ;  the  second  Itali- 
cized item  was  added  by  section  1307  of  the  Act,  described  below,  under  7.  Lobbying 
Activities  of  Public  Charities.) 

*  Such  an  organization  is,  nevertheless,  subject  to  tax  on  its  "unrelated  business  taxable 
income"  (sec.  511  et  seq.)  and.  if  it  is  a  private  foundation,  is  also  subject  to  tax  on  its 
"net  investment  Income"  (sec.  4940  or  494S)  ;  however.  It  is  not  subject  to  Federal  income 
tax  on  its  related  business  income.  The  tax  on  private  foundations'  investment  income  is  at 
the  rate  of  4  percent ;  by  comparison,  the  rates  applicable  to  taxable  corporations  are 
up  to  4S  percent,  and  to  taxable  trusts  are  up  to  70  percent. 


401 

In  general,  a  domestic  organization  which  is  exempt  under  section 
501(c)  (3)  is  also  eligible  to  receive  deductible  charitable  contributions 
(sec.  170(c)(2)). 

If  sucli  an  organization  is  a  private  foundation  (defined  in  sec.  509), 
then  it  is  subject  to  a  series  of  restrictions  on  its  activities  (sec.  4941 
et  seq.)^  as  well  as  a  tax  on  its  investment  income  (see  footnote  2 
above).  Also,  if  it  is  classified  as  a  private  foundation  (other  than  an 
operating  foundation  (sec.  4942(j)  (H) ) ,  its  status  as  a  charitable  con- 
tribution donee  is  in  some  respects  significantly  less  favorable  than  if 
it  is  not  so  classified  (compare  sec.  509(a)  with  sec.  170(b)  (1) ). 

Although  the  tax  status  of  an  organization  generally  has  not  de- 
pended on  the  Internal  Revenue  Service's  position  as  to  the  organiza- 
tion, as  a  practical  matter,  most  organizations  hoping  to  qualify  for 
exempt  status  found  it  imperative  to  obtain  a  favorable  ruling  letter 
from  the  Service  and  to  be  listed  in  the  Service's  "blue  book"  (Cumula- 
tive List  of  Organizations  Described  in  Section  170(c)  of  the  Internal 
Revenue  Code  of  1954,  Publication  78).  An  exemption  letter  and  list- 
ing in  the  blue  book  assured  potential  donors  in  advance  that  contribu- 
tions to  the  organization  would  qualify  as  charitable  deductions  under 
section  170(c)  (2).  In  general,  potential  donors  could  rely  upon  these 
indicia  even  tliough  the  organization  mi^ht  not  in  fact  be  qualified 
imder  i\\Q  statute  for  this  treatment  at  tlie  time  of  the  gift.P 

In  two  cases  dec'ded  in  1974  {Boh  Jones  University  v.  Simon^  416 
U.S.  725,  and  Alexandei'  v.  ^^ Americans  United''^  Inc.,  416  U.S.  752), 
the  Supreme  Court  held  that  an  organization  could  not  obtain  the 
assistance  of  the  courts  to  restrain  the  Internal  Revenue  Service  from 
withdrawing  a  favorable  ruling  letter  or  withdrawing  its  listing  in 
the  blue  book.  In  effect,  this  meant  that  a  judicial  determination  as 
to  the  organization's  status  could  not  be  obtained  by  the  organization 
or  its  contributors,  except  in  the  context  of  a  suit  to  redetermine  a  tax 
deficiency  or  to  determine  eligibility  for  a  refund  of  taxes. 

By  the  time  the  Supreme  Court  issued  its  opinions  in  Boh  Jones 
and  Amsiicans  United,  both  Houses  of  Congi-ess  had  already  passed 
versions  of  what  became  the  Employee  Retirement  Income  Security 
Act  of  1974  (Public  Law  93^06).  Each  House's  vereion  of  that  bill 
included  provisions  for  declaratory  judgments  as  to  the  tax-qualified 
status  of  employee  retirement  plans.  This  ultimately  became  section 
1041  cf  that  Act,  which  added  section  7476  to  the  Internal  Revenue 
C^de. 

Under  that  provision,  the  Tax  Court  has  been  given  jurisdiciion  to 
hear  declaratory  judgment  suits  as  to  the  tax  qualifications  of  an  em- 
ployee retirement  plan  '^ pension,  profit  sharing,  stock  bonus,  etc.), 
so  that  the  plan's  status  can  be  tested  without  the  necessity  of  the 
Service  issuing  a  notice  of  deficiency  or  a  taxpayer  suing  for  a  refund 
of  taxes. 

Reasons  for  change 

In  Boh  Jones  University  v.  Simon,  the  Supreme  Court  summarized 
the  problems  faced  by  an  organization  seeking  to  establish  its  chari- 
table tax-exempt  status.  The  Court  noted  that,  as  it  interpreted  present 
law. 

"Congress  has  imposed  an  especially  harsh  regime  on  §  501(c) 
(3)    organizations  threatened  with  loss  of  tax-exempt  status  and 

»  See  Rev.  Proc.  1972-39,  1972-2  CB  818,  for  the  Service's  position  on  the  extent  to 
which  contributors  may  rely  on  the  listing  of  an  organization  in  the  blue  book. 


402 

with  withdrawal  of  advanc<i  assurance  of  deductibility  of  contribu- 
tion. *  *  *  The  degree  of  bureaucratic  control  that,  practically 
speaking,  has  been  placed  in  the  Service  over  thvyse  in  petitioner's 
position  [i.e.,  the  position  of  Bob  Jones  University]  is  susceptible  to 
abuse,  regardless  of  how  conscientiously  the  Service  may  atteni})t  to 
carry  out  its  responsibilities.  Specific  treatment  of  not-for-profit  orga- 
nizations to  allow  them  to  seek  preenforcement  review  may  well  merit 
consideration."  * 

The  opinion  tlien  suggested  that  this  was  an  appropriate  matter  for 
the  Congress  to  consider.' 

In  order  to  provide  an  effective  appeal  from  an  Internal  Revenue 
Service  determination  that  an  organization  was  not  exempt  from  tax, 
or  was  not  an  eligible  donee  for  charitable  contributions,  or  was  a 
private  foundation  (an  operating  foundation  or  a  nonoperating  foim- 
dation),  it  was  urged  that  there  be  access  to  the  courts  through  some 
declaratory  judgment  procedure. 

The  same  line  of  reasoning  outlined  by  the  Supreme  Court  in  those 
two  cases,  and  which  motivated  the  Congress  to  act  with  regard  to 
employee  retirement  plans,  applies  in  this  case.  Accordingly,  the 
Congress  agreed  to  provide  in  this  Act  for  a  declaratory  judgment 
procedure  under  which  an  organization  can  obtain  a  judicial  deter- 
mination of  its  own  status "  as  a  charitable,  etc.,  organization,  its 
status  as  an  eligible  charitable  contributions  donee,  its  status  as  a 
private  foundation,  or  its  status  as  a  private  operating  foundation. 
Also,  the  Act  provides  assurances  regarding  contributions  made  dur- 
ing the  litigation  period. 

In  connection  with  this,  and  as  an  aid  to  proper  oversight  and  to 
future  decision-making  in  this  area,  the  Congress  intends  that  the 
Internal  Revenue  Service  report  annually  to  the  tax-writing  commit- 
tees of  the  Congress  on  the  Service's  activities  with  regard  to  organi- 
zations exempt  under  section  501(a),  including  the  following:   (1) 


*  The  Court's  opinion  noted  that  former  Internal  Revenue  Commissioner  Thrower  had 
criticized  the  then-existing  system  for  resolving  such  disputes  between  the  Service  and 
the  organization. 

"This  is  an  extremely  unfortunate  situation  for  several  reasons.  First,  it  offends  my 
sense  of  justice  for  undue  delay  to  be  Imposed  on  one  who  needs  a  prompt  decision. 
Second,  in  practical  effect  it  gives  a  greater  finality  to  IRS  decisions  than  we  would 
want  or  Congress  Intended.  Third,  it  inhibits  the  growth  of  a  body  of  case  law  interpre- 
tative of  tlie  exempt  organization  provisions  that  could  guide  the  IRS  in  its  further 
deliberations."  (Thrower,  IRS  Is  Considering  Far  Reaching  Changes  in  Ruling  on  Exempt 
Organizations,  34  Journal  of  Taxation  16,8  (1971).) 

^  In  a  dissenting  opinion  to  Alexander  v.  "Americans  United",  Inc.,  the  companion  case 
to  Bob  Jones  Universiti/  v.  Simon,  Mr.  Justice  Blaclimun  stated  that,  "where  the  philan- 
thropic organization  Is  concerned,  there  appears  to  be  little  to  circumscribe  the  almost 
unfettered  power  of  the  Commissioner.''  This  may  be  very  well  so  long  as  one  subscribes 
to  the  particular  brand  of  social  policy  the  Commissioner  happens  to  be  advocating  at 
the  time  (a  social  policy  the  merits  of  which  I  make  no  attempt  to  evaluate),  but  applica- 
tions of  our  tax  laws  should  not  operate  In  so  fickle  a  fashion.  Surely,  social  policy  in 
the  first  instance  Is  a  matter  for  legislative  concern.  To  the  extent  these  determinations 
are  reposed  in  the  authority  of  the  Internal  Revenue  Service,  they  should  have  the  system 
of  checlvs  and  balances  provided  by  judicial  review  before  an  organization  that  for  years 
has  been  favored  with  an  exemption  ruling  is  imperiled  by  an  allegedly  unconstitutional 
change  of  direction  on  the  part  of  the  Service."  (Footnote  omitted.) 

*  The  Supreme  Court  has  Implicitly  held  that  under  certain  circumstances  suits  can  be 
brought  by  third  parties  to  restrain  the  Internal  Revenue  Service  from  treating  an 
organization  as  being  exempt,  Coit  v.  Oreen,  404  U.S.  997  (1971),  affirming  Green  \. 
ConnaUy,  330  F.  Supp.  (D.C.,  B.C.,  1971),  a  decision  by  a  special  3-judge  district  court. 
The  Act  does  not  deal  with  this  matter.  This  Act  constitutes  neither  an  Implied  endorse- 
ment nor  an  Implied  criticism  of  such  "third-party"  suits.  However,  the  Congress  does  Intend 
that,  with  respect  to  accepting  amicus  curiae  briefs  and  permitting  appearances  by  third 
parties  in  declaratory  judgment  suits  under  this  Act,  the  courts  should  be  as  generous  as 
they  can  be.  In  the  light  of  the  need  for  expeditious  decisions  In  those  cases  and  the 
general  state  of  the  courts'  calendars. 


403 

the  number  of  organizations  that  applied  for  recognition  of  exempt 
status,  (2)  the  number  of  organizations  whose  applications  were  ac- 
cepted and  the  number  of  organizations  whose  applications  were 
denied,  (3)  the  number  of  organizations  whose  prior  favorable  ruling 
letters  were  revoked,  (4)  the  number  of  organizations  that  were  audited 
during  the  year,  and  (5)  the  numl)er  of  organizations  that  the  Service 
regards  as  being  exempt.  I'o  the  extent  possible,  these  statistics  should 
be  broken  out  by  type  of  organization  (e.g.,  public  charity,  private 
foimdation,  social  welfare  organization,  fraternal  beneficial  associ- 
ation, and  veterans  organization).  In  addition,  the  Service  should 
report  the  amovmt  of  its  expenditures  for  the  year,  the  amount  of  its 
requested  appropriations  for  the  following  2  years,  the  amount  appro- 
priated for  each  of  the  years,  and  the  amounts  authorized  to  be  appro- 
priated imder  the  terms  of  section  1052  of  the  Employee  Retirement 
Income  Security  Act  of  1974. 

Explanation  of  'provision 

In  general. — The  Act  provides  that  the  Federal  district  court 
for  the  District  of  Columbia,  the  United  States  Court  of  Claims, 
and  the  United  States  Tax  Court  are  to  have  jurisdiction  in  the  case 
of  an  actual  controversy  involving  a  determination  (or  failure  to  make 
a  determination)  by  the  Internal  Revenue  Sendee  with  respect  to  the 
initial  or  continuing  qualification  or  classification  of  an  organization 
as  an  exempt  charitable,  etc.,  organization  (sec.  501(c)(3)),  as  a 
qualified  charitable  contribution  donee  (sec.  170(c)  (2)),  as  a  private 
foundation  (sec.  509,  or  as  a  private  operating  foundation  (sec.  4942 
(j)  (3)).  A  suit  under  this  provision  can  be  brought  only  by  the  or- 
ganization whose  qualification  .>r  status  is  at  issue. 

The  courts  have  jurisdiction  to  make  a  declaration  with  respect  to 
the  status  of  the  organization  and  an}^  such  declaration  is  to  have  the 
force  and  effect  of  a  decision  or  final  judgment  and  is  to  be  reviewable 
as  auch. 

The  court  is  to  base  its  determination  upon  the  reasons  provided  by 
the  Internal  Revenue  Service  in  its  notice  to  the  party  making  the  re- 
quest for  a  determination,  or  based  upon  any  new  argument  which 
the  Service  may  wish  to  introduce  at  the  time  of  the  trial.  The  burden- 
of-proof  rules  are  to  be  developed  by  the  courts  under  their  rule- 
making powers.  Insofar  as  is  practical,  those  rules  should  conform  to 
the  rules  that  the  Tax  Court  develops  with  regard  to  declaratoi-y  judg- 
ment suits  as  to  retirement  plans,  under  section  7476  of  the  Code.  (See 
e.g.,  title  XXI  of  the  Tax  Court's  Rules  of  Practice  and  Procedure.) 

The  judgment  of  the  court  in  a  declaratory  judgment  proceeding 
shall  be  binding  upon  the  parties  to  the  case  based  upon  the  facts  as 
presented  to  the  court"  in  the  case  for  the  year  or  years  involved. 
This,  of  course,  does  not  foreclose  Service  action  for  later  years 
(within  the  linilts  of  the  legal  doctrines  of  estoppel  and  stare  decisis) 
if  the  governing  law  or  the  organization's  operations  have  changed 
since  the  years  to  which  the  declaratory  judgment  applies,  or  (espe- 
cially in  the  case  of  a  new  oigani/ation)  if  the  organization  does  not 
in  operation  meet  the  requirements  for  qualification. 


^  In  many  cases,  this  would  be  essentially  the  administrative  record  before  the  Internal 
Revenue  Service;  see,  e.g.,  paragraphs  (5)  and  (6)  of  the  prefatory  note  to  title  XXI 
of  the  Tax  Court's  Rules  of  Practice  and  Procedure. 


404 

This  provision  is  intended  to  facilitate  relatively  prompt  judicial 
review  of  the  si^ecified  types  of  exempt  or^-anization  issues;  it  is  not 
intended  to  supplant  the  normal  avenues  of  judicial  review  (redeter- 
mination of  a  deficiency  or  suit  for  refund  of  taxes)  where  those  nor- 
mal procedures  could  be  expected  to  provide  oppoi-tunities  for  prompt 
determinations.  Consequently,  it  is  expected  that  the  courts  will  not 
entei'tain  a  declaratory  judgment  suit  with  reg'ard  to  a  period  for 
which  a  notice  of  deficiency  has  already  been  issued,  except  upon  a 
showing  by  the  organization  that  the  declaratory  judgment  route  is 
likely  to  substantially  reduce  the  time  necessary  to  attain  a  final 
judicial  review  of  the  Service's  determination.  Also,  it  is  expected  that 
in  general  a  court  wdiicli  has  accepted  pleadings  in  a  declaratory  judg- 
ment proceeding  will  yield  to  a  court  which  has  accepted  pleadings  in 
a  redetermination  of  deficiency  or  a  tax  refund  suit,  unless  the  proceed- 
ings in  the  declaratory  judgment  suit  are  so  far  along  that  it  would 
facilitate  the  interest  of  prompt  justice  for  the  latter  court  to  yield  to 
the  former.  The  Congress'  action  is  not  to  be  permitted  to  create  con- 
flicting determinations  on  the  parts  of  different  ti'ial  courts  with 
regard  to  any  of  the  questions  that  may  be  determined  in  a  declaratory 
judgment  suit;  nor  is  the  Congress'  action  to  operate  so  as  to  require 
duplication  of  effort  on  the  part  of  parties,  witnesses,  or  courts. 

Contributions  mude  during  the  litigation  period. — As  is  the  case 
regarding  retiremient  plans  (under  sec.  7476)  the  courts  have  juris- 
diction to  determine  whether  the  Service  has  correctly  concluded  that 
a  previously  exempt  organization  has  lost  its  charitable  donee  status 
because  of  changes  in  operation,  changes  in  the  governing  law, 
changes  in  the  governing  instrument,  etc.*  In  order  to  reduce  the 
likelihood  of  the  litigation  "drying  up"  the  resources  of  an  organiza- 
tion's support  (especially  if  that  organization  depends  primarily  on 
current  contributions  from  the  general  public),  the  Act  provides  that, 
under  specified  circumstances,  contributions  made  during  the  litiga- 
tion period  may  be  deductible  even  though  the  court  ultimately  deter- 
mines that  the  organization  had  lost  its  status  as  an  eligible  charita- 
ble donee  under  section  170(c)  (2)  of  the  Code. 

This  protection  applies  only  where  the  organization  had  previ- 
ously been  declared  to  be  an  eligible  donee,  the  Service  has  published  a 
notice  of  the  revocation  of  its  advance  assurance  of  deductibility  of 
contributions,  and  the  organization  has  initiated  its  proceeding  before 
the  91st  day  after  the  Service  mailed  its  adverse  determination  to  the 
organization.  The  "publication"  requirement  is  satisfied  if  the  Internal 
Revenue  Service  has  made  a  public  announcement,  such  as  by  issuing  a 
press  release  or  by  printing  the  notice  in  the  Internal  Revenue  Bulletin. 

8  A  recent  United  States  Tax  Court  decision  (Sheppard  &  Myers,  Inc.,  67  T.C.  No.  3 
(October  6,  1976))  held  that  the  retirement  plans  declaratory  judgment  provisions  do 
not  apply  to  revocations  of  favorable  determination  letters.  The  statutory  language 
("In  a  case  of  actual  controversy  involving — (1)  a  determination  by  the  Secretary  ♦  *  * 
with  respect  to  the  initial  qualification  or  continuing  qualification  *  *  *"  (emphasis 
supplied))  of  the  employee  plans  declaratory  judgment  provision  (sec.  7476(a))  is  in 
this  respect  the  same  as  the  statutory  language  of  the  exempt  organizations  declarator.v 
judgment  provisions  (sec.  7428(a))  added  by  this  Act.  That  court's  opinion,  although 
issued  after  enactment  of  the  1976  Act,  omits  mention  of  this  Act ;  it  also  makes  no 
mention  of  the  statements  in  both  the  House  and  Senate  reports  on  this  Act  that  this  statu- 
tory language,  in  both  Acts,  is  Intended  to  grant  jurisdiction  in  cases  where  the  Internal 
Revenue  Service  has  concluded  that  a  previously  qualified  organization  has  lost  Its 
preferred  tax  status. 


405 

Sometimes,  the  first  notice  to  the  public  consists  of  a  notice  of  sus- 
pension of  advance  assurance  of  deductibility  of  contributions  to  the 
organization.  (See  sec.  4  of  Rev.  Proc.  72-39,  1972-2  CB  818.)  In 
terms  of  its  effect  on  potential  contributors,  such  a  notice  is  the  func- 
tional equivalent  of  a  notice  of  revocation.  That  is,  potential  contrib- 
utors will  be  reluctant  to  make  contributions  to  the  organization  once 
notice  of  such  a  suspension  is  published.  Consequently,  for  purposes 
of  the  provision  prptecting  contributions  made  during  the  litigation 
period,  a  notice  of  suspension  of  advance  assurance  is  to  be  treated  the 
same  as  a  notice  of  revocation  of  advance  assurance  of  deductibility. 

If  these  criteria  are  met,  then  contributions  made  by  an  individual 
or  by  an  organization  described  in  section  170(c)  (2)  which  is  exempt 
from  tax  under  section  501(a)  to  or  on  behalf  of  the  organization  in 
the  period  beginning  on  the  date  of  publication  of  the  notice  of  revoca- 
tion and  ending  on  the  date  on  which  the  court  has  first  determined 
that  the  organization  is  not  an  eligible  donee  under  section  170(c)  (2) 
are  to  be  treated  as  having  been  made  to  or  on  behalf  of  an  organiza- 
tion described  in  sexition  170(c)  (2),  for  purposes  of  determining  the 
income  tax  charitable  contribution  deduction  of  the  contributor.  How- 
ever, the  aggregate  of  deductions  by  any  individual  contributor  to  be 
given  this  protection  with  regard  to  contributions  to  or  on  behalf  of 
any  one  organization  may  not  exceed  $1,000  for  the  entire  period.® 
(For  these  purposes,  a  husband  and  wife  are  treated  as  one  contribu- 
tor.) This  benefit  does  not  apply  to  any  individual  who  was  respon- 
sible, in  Avhole  or  in  part,  for  the  actions  (or  failures  to  act)  on  the 
part  of  the  organization  which  were  the  basis  for  the  revocation. 

From  time  to  time,  the  Internal  Revenue  Service,  in  announcing  its 
revocation  of  assurance  as  to  exempt  status,  has  applied  this  revoca- 
tion retroactively,  to  the  date  of  the  asserted  improper  actions  or  fail- 
ures to  act  (sec.  7805(b)).  The  Congress  understands  that  in  such 
cases  the  retroactive  revocation  was  not  applied  to  those  contributors 
who  were  innocent  of  the  improper  actions  or  failures  to  act.  The  Con- 
gress intends  that  the  Service  continue  to  follow  this  course,  which  is 
consistent  with  the  rule  provided  in  this  Act. 

Exhaustion  of  adminiMrative  remedies  required. — For  an  organi- 
zation to  receive  a  declaratory  judgment  under  this  provision,  it 
must  demonstrate  to  the  court  that  it  has  exhausted  all  administrative 
remedies  which  are  available  to  it  within  the  Internal  Revenue  Service. 
Thus,  it  must  demonstrate  that  it  has  made  a  request  to  the  Internal 
Revenue  Service  for  a  determination  and  that  the  Internal  Revenue 
Service  has  either  failed  to  act,  or  has  acted  adversely  to  it,  and  that 
it  has  appealed  any  adverse  determination  by  a  district  office  to  the 
national  office  of  the  Internal  Revenue  Service  or  has  requested  or 
obtained  through  the  district  director  technical  advice  of  the  national 
office.  To  exhaust  its  administrative  remedies,  the  organization  must 
satisfy  all  appropriate  procedural  requirements  of  the  Service.  For 
example,  the  Service  may  decline  to  make  a  determination  if  the  or- 
ganization fails  to  comply  with  a  reasonable  request  by  the  Service  to 
supply  the  necessary  information  on  which  to  make  a  determination. 


»0f  course,   this  ?1,000  "cap"  Is  not  to  restrict  deductibility  if  the  final  decision   or 
judgment  is  in  favor  of  the  charitable,  etc.,  organization. 


234-120  O  -  77  -  27 


406 

An  organization  is  not  to  be  deemed  to  have  exhausted  its  admin- 
istrative remedies  in  a  case  where  there  is  a  failure  by  the  Internal 
Revenue  Service  to  make  a  determination,  before  the  expiration  of 
270  days  after  the  request  for  such  a  determination  has  been  made. 
Once  this  270-day  period  has  elapsed,  an  organization  which  has  taken 
all  reasonable  steps  to  secure  a  determination  may  bring  an  action  even 
though  there  has  been  no  notice  of  determination  from  the  Internal 
Revenue  Service. 

Of  course,  if  the  Service  makes  a  determination  during  this  270-day 
period,  then  the  organization  need  not  wait  until  the  end  of  the  270- 
day  period  to  initiate  the  declaratory  judgment  proceeding.  However, 
no  petition  under  this  provision  may  be  filed  more  than  90  days  after 
the  date  on  which  the  Service  sends  notice  to  the  organization  of  its 
determination  (including  refusals  to  make  determinations)  as  to  the 
status  of  the  organization. 

Tax  Court  coTrnnissioners. — In  order  to  provide  the  Tax  Court  with 
flexibility  in  carrying  out  this  provision,  the  Act  authorizes  the  Chief 
Judge  of  the  Tax  Court  to  assign  the  commissioners  ("special  trial 
judges")  of  the  Tax  Court  to  hear  and  make  determinations  with 
respect  to  petitions  for  a  declaratory  judgment,  subject  to  such  condi- 
tions and  review  as  the  Court  may  provide.  It  is  anticipated,  for  ex- 
ample, that  the  court  may  initially  provide  that  all  the  declaratory 
judgment  cases  are  to  be  heard  by  judges,  rather  than  commissioners. 
However,  if  the  volume  of  these  cases  is  large,  then  the  Tax  Court  may 
expedite  the  resolution  of  these  cases  by  authorizing  its  commissioners 
to  hear  and  enter  decisions  in  cases  where  similar  issues  have  already 
been  heard  and  decided  by  the  judges  of  the  Court.  However,  as  is  the 
case  with  regard  to  Tax  Court  declaratory  judgments  in  employee 
retirement  plan  cases,  this  example  is  not  intended  to  be  a  restriction 
on  the  Tax  Court's  authority  with  regard  to  the  use  of  these  commis- 
sioners in  declaratory  judgment  cases.  The  flexibility  is  granted  to  the 
Court  to  assign  its  commissioners  to  hear  and  decide  these  cases  in 
such  a  manner  as  the  Court  may  deem  appropriate. 

Effective  date 

These  provisions  are  to  apply  to  pleadings  filed  with  the  Federal  dis- 
trict court  for  the  District  of  Columbia,  the  United  States  Court  of 
Claims,  or  the  United  States  Tax  Court  more  than  6  months  after  the 
date  of  enactment,  but  only  with  respect  to  Service  determination  (or 
requests  by  the  organizations  for  Service  determinations)  made  after 
January  1,  1976. 

These  effective  date  provisions  have  been  chosen  basically  for  two 
purposes:  (1)  to  provide  the  courts  an  opportunity  to  establish  any 
necessary  rules  and  otherwise  make  administrative  preparations  for 
initiation  of  these  new  declaratory  judgment  proceedings,  and  (2)  to 
assure  that  "stale"  cases  are  not  made  the  subject  of  court  suits  without 
the  organization  first  giving  the  Internal  Revenue  Service  an  oppor- 
tunity to  reexamine  the  case.  It  is  not  the  intention  of  the  Congress 
that  the  Service  be  permitted  to  cut  off  an  organization's  declaratory 
judgment  suit  rights  by  sending  the  organization  its  unfavorable  de- 
termination more  than  90  days  before  this  provision  would  otlior- 
wise  become  effective.  It  is  intended,  in  such  a  case,  that  the  Service 
send  another  determination  to  the  organization  at  such  a  time  that 


4^ 

the  organization  would  have  an  opportunity  to  initiate  a  court  pro- 
ceeding for  a  declaratory  judgment.  For  example,  if  the  Service  sent 
an  organization  an  unfavorable  determination  in  July  1976,  the  Service 
should  send  that  organiz.ation  anotlier  determination  in,  for  example, 
April  1977.  The  April  notification  is  to  start  the  running  of  the  90-day 
period  for  initiating  court  proceedings.  The  July  notification  is  to  start 
the  litigation  period,  during  which  deductibility  of  contributions  is 
to  be  protected. 

Revenue  effect 
These  provisions  are  not  expected  to  have  any  revenue  effect. 

7.  Lobbying  Activities  of  Public  Charities  (sec.  1307  of  the  Act 
and  sees.  501  and  4911  of  the  Code) 

Prior  law 
Prior  law  (sec.  501(c)  (3)  of  the  Internal  Revenue  Code  of  1954) 
imposed  upon  every  organization  qualifying  for  tax-exempt  status 
as  an  educational,  charitable,  religious,  et<;.,  organization  the  req[uire 
ment  that  "no  substantial  part  of  the  activities  of  [the  organization] 
is  carrying  on  propaganda,  or  otherwise  attempting,  to  influence  leg- 
islation". This  requirement  was  also  a  precondition  of  such  an  orga- 
nization's qualification  to  receive  charitable  contributions  that  are  de- 
ductible for  income,  estate,  or  gift  tax  purposes  (sees.  170(c) ,  2055  (a) , 
2106(a) ,  2522(a) , and  2522(b) ) . 

Reasons  for  change 

The  language  of  the  lobbying  provision  was  first  enacted  in  1934. 
Since  that  time  neither  Treasury  regulations  nor  court  decisions  gave 
enough  detailed  meaning  to  the  statutory  language  to  permit  most 
charitable  organizations  to  know  approximately  where  the  limits 
were  between  what  was  permitted  by  the  statute  and  what  was  for- 
bidden by  it.  This  vagueness  was,  in  large  part,  a  function  of  the  un- 
certainty in  the  meaning  of  the  terms  "substantial  part"  and 
"activities". 

Many  believed  that  the  standards  as  to  the  permissible  level  of  activi- 
ties under  prior  law  were  too  vague  and  thereby  tended  to  encourage 
subjective  and  selective  enforcement. 

Except  in  the  case  of  private  foundations,  the  only  sanctions  avail- 
able under  prior  law  with  respect  to  an  organization  which  exceeded 
the  limits  on  permitted  lobbying  were  loss  of  exempt  status  under 
section  501(c)  (3)  and  loss  of  qualification  to  receive  deductible  chari- 
table contributions.  Some  organizations  (particularly  organizations 
which  had  already  built  up  substantial  endowments)  could  split  up 
their  activities  between  a  lobbying  organization  and  a  charitable  or- 
ganization. For  such  organizations,  these  sanctions  may  have  had  little 
effect,  and  this  lack  of  effect  may  have  tended  to  discourage  enforce- 
ment effort.' 


1  The  Treasury  Department's  regulations  (Regs.  §  1.501(c)  (3) -1  (c)  (3)  (v) )  specifically 
|)rovicled  that  an  organization  that  lost  its  exempt  status  under  section  501(c)(3)  because 
of  excessive  lobbying  could  become  exempt  on  its  own  income  under  section  501(c)(4)  as 
a  "social  welfare"  organization.  Also,  a  number  of  organizations  that  in  this  manner 
shifted  to  section  501(c)(4)  had  created  related  organizations  to  carry  on  their  chari- 
table activities,  to  qualify  for  exemption  under  501(c)(3),  and  to  qualify  to  receive 
deductible  charitable  contributions.  If  the  original  organization  had  built  up  a  substan- 
tial endowment  during  its  years  of  section  501(c)(3)  status,  it  could  then  carry  on  its 
"excessive"  lobbying  activities  financed  by  the  income  it  received  from  its  tax-deductible 
endowment.  As  a  result,  although  there  may  have  been  some  inconvenience  and  ad- 
ministrative confusion  during  the  changeover  period,  it  was  possible  in  such  a  case  for 
the  lobbying  rules  to  be  violated  without  any  significant  tax  consequences. 


408 

For  other  organizations  which  could  not  split  up  their  activities  be- 
tween a  lobbying  organization  and  a  charitable  organization  and 
which  had  to  continue  to  rely  upon  the  receipt  of  deductible  con- 
tributions to  carry  on  their  exempt  purposes,  loss  of  section  501  (c)  (3) 
status  could  not  be  so  easily  compensated  for  and  constituted  a  severe 
blow  to  the  organization. 

The  Act  is  designed  to  set  relatively  specific  expenditure  limits 
to  replace  the  uncertain  standards  of  prior  law,  to  provide  a  more 
rational  relationship  between  the  sanctions  and  the  violations  of 
standards,  and  to  make  it  more  practical  to  properly  enforce  the  law. 
However,  these  new  rules  replace  prior  law  only  as  to  charitable 
organizations  which  elect  to  come  under  the  standards  of  the  Act. 
The  new  rules  also  do  not  apply  to  churches  and  organizations  affili- 
ated with  churches,  nor  do  they  apply  to  private  foundations;  prior 
law  continues  to  apply  to  these  organizations.  The  Act  provides 
for  a  tax  of  25  percent  of  the  amount  by  which  the  expenditures  ex- 
ceed the  permissible  level.  Revocation  of  exemption  is  reserved  for 
those  cases  where  the  excess  is  unreasonably  great  over  a  period  of 
time. 

Explanation  of  provision 

The  Act  permits  public  charitable  tax-exempt  organizations  to 
elect  to  replace  the  "substantial  part  of  activities"  test  with  a  limit 
defined  in  terms  of  expenditures  for  influencing  legislation.  The  basic 
permitted  level  of  such  expenditures  ("lobbying  nontaxable  amount") 
for  a  year  is  20  percent  of  the  first  $5()0,Oo6  of  the  organization's  ex- 
empt purpose  expenditures  for  the  vear,  plus  15  percent  of  the  second 
$500,000,  plus  10  percent  of  the  third  $500,000,  plus  5  percent  of  any 
additional  expenditures.  Hojvever,  in  no  event  is  this  permitted  level 
to  exceed  a  "cap"  of  $1,000,000  for  any  one  year. 

Within  those  limits,  a  separate  limitation  is  placed  on  so-called 
"grass  roots  lobbying" — that  is,  attempts  to  influence  the  general 
public  on  legislative  matters.  This  grass  roots  nontaxable  amount  is 
one-fourth  of  the  lobbying  nontaxable  amount. 

Sanctions. — An  electing  organization  that  exceeds  either  the  gen- 
eral limitation  or  the  grass  roots  limitation  in  a  taxable  year  is  to 
be  subject  to  an  excise  tax  of  25  percent  of  its  excess  lobbying  expendi- 
tures. Furthermore,  if  an  electing  organization's  lobbying  expendi- 
tures normally  (that  is,  on  the  average  over  a  four-year  period) 
exceed  150  percent  of  the  limitations  describe  above,^  the  organiza- 
tion is  to  lose  its  exempt  status  under  section  501  (c)  (3).^ 

If,  for  a  taxable  year,  the  organization's  expenditures  exceed  both 
the  nontaxable  lobbying  amount  and  the  nontaxable  grass  roots 
amount,  then  the  25-percent  tax  is  to  be  impos^ed  on  whichever  one  of 
these  excesses  is  the  greater. 

These  sanctions  are  to  operate  automatically.  That  is,  if  an  organiza- 
tion exceeds  the  permitted  lobbying  amounts,  then  it  is  subject  to  the 
excise  tax  and  may  also  be  subject  to  the  loss  of  exempt   status. 


2  An  organization's  lobbying  expenditures  "normally"  exceed  150  percent  of  the  per- 
mitted amount  if  (1)  the  sum  of  its  lobbying  expenditures  (or  grass  roots  expenditures) 
for  the  4  years  Immediately  preceding  the  current  year  is  greater  than  (2)  150  percent 
of  the  sum  of  the  "lobbying  nontaxable  amounts"  (or  grass  roots  nontaxable  amounts) 
for  those  same  4  years. 

'  As  is  further  described  below,  in  such  a  case  the  organization  is  not  to  be  permitied 
to  "shift"  to  section  501(c)  (4)  status. 


409 

Imposition  of  these  sanctions  (or,  in  the  case  of  loss  of  exemption,  the 
effective  date  of  the  sanction)  is  not  to  depend  on  the  exercise  of  dis- 
cretion by  the  Internal  Revenue  Service.  However,  imposition  of  these 
sanctions  on  the  organization  is  not  intended  to  preclude  the  Service 
from  continuing  its  present  practice  of  generally  disallowing  deduc- 
tions of  contributions  to  an  organization  only  where  the  contributions 
are  made  on  or  aft-er  the  date  that  the  Service  announces  the  organiza- 
tion is  no  longer  exempt  (see  discussion  of  this  point  above,  under  6. 
Declaratory  Judgments  as  to  Tax-Exempt  Status  as  Charitable,  etc., 
Organization). 

As  in  the  case  of  the  chapter  42  (private  foundation)  and  chapter 
43  (qualified  pension,  etc.,  plans)  taxes,  in  order  to  assess  a  deficiency 
of  the  excise  tax  imposed  under  these  new  provisions  on  excess  lobbying 
expenditures,  the  Internal  Revenue  Service  must  send  a  notice  of 
deficiency  to  the  exempt  organization.  The  exempt  organization  can 
obtain  judicial  review,  without  first  paying  the  tax,  by  petitioning 
the  Tax  Court  for  a  redetermination  of  the  deficiency.  Alternatively, 
the  organization  can  pay  the  tax,  file  a  claim  for  refund,  and  then  sue 
for  a  refund  in  the  Court  of  Claims  or  a  Federal  district  court. 

The  Act  also  makes  it  clear  that  this  excise  tax,  like  the  excise  taxes 
imposed  with  respect  to  private  foundations  and  qualified  pensions, 
etc.,  plans,  is  in  no  event  to  be  deductible. 

InpLvencing  legislation. — For  purposes  of  these  new  rules,  the  Act 
defines  the  term  "influencing  legislation"  as  any  attempt  to  influence 
any  legislation  through  an  attempt  to  affect  the  opinion  of  the  general 
public  or  any  segment  thereof  ("grass  roots  lobbying")  and  any 
attempt  to  influence  any  legislation  through  communication  with  any 
member  or  employee  of  a  legislative  body,  or  with  any  other  govern- 
ment official  or  employee  who  may  participate  in  the  formulation  of 
the  legislation  ("direct  lobbying") . 

Generally,  the  term  "legislation"  includes  action  with  respect  to 
Acts,  bills,  resolutions,  or  similar  items  by  the  Congress,  any  State 
legislature,  any  local  council,  or  similar  governing  Dody,  or  by  the 
public  in  a  referendum,  initiative,  constitutional  amendment,  or  simi- 
lar procedure.^  The  term  "action"  is  limited  to  the  introduction,  amend- 
ment, enactment,  defeat,  or  repeal  of  Acts,  bills,  resolutions,  or  similar 
items. 

The  Act  excludes  from  "influencing  legislation"  three  categories  of 
activities  which  the  Congress  also  excluded  from  that  concept  under 
the  private  foundation  provisions  (sec.  4945(e)).  These  are  (1)  mak- 
ing available  the  result  of  nonpartisan  analysis,  study,  or  research; 
(2)  providing  technical  advice  or  assistance  in  response  to  a  request 
by  a  governmental  body;  and  (3)  so-called  self-defense  direct  lobby- 
ing— ^that  is,  appearances  before  or  communications  to  a  legislative 
body  with  respect  to  a  possible  decision  of  that  body  which  might 
affect  the  existence  of  the  organization,  its  powers  and  duties,  its  tax- 
exempt  status,  or  the  deduction  of  contributions  to  the  organization."* 


«As  the  Internal  Revenue  Service  has  noted  (Rev.  Rul.  73-440,  1973-2  CB  177),  the 
prohibition  on  substantial  lobbying  activities  Includes  attempts  to  influence  legislation 
of  a  foreign  country. 

5  The  Internal  Revenue  Service  had  ruled  that  the  first  of  these  categories  of  activities 
did  not  affect  the  exempt  charitable  status  of  an  organization  (Rev.  Rul.  64-195,  1964-2 
CB  138)  under  prior  law.  The  second  of  these  categories  had  also  been  specifically  ruled 
by  the  Internal  Revenue  Service  as  not  constituting  "Influencing  legislation"  In  the  case 
of  public  charities  (Rev.  Rul.  70-449,  1970-2  CB  111). 


410 

In  addition,  the  Act  excludes  communications  between  the  organiza- 
tion and  its  bona  fide  members  unless  the  communications  directly 
encourage  the  members  to  influence  legislation  or  directly  encourage 
the  members  to  urge  nonmembei-s  to  influence  legislation.  For  example, 
where  a  publication  is  designed  primarily  for  members  but  an  insub- 
stantial portion  of  the  distribution  is  to  nonmembers  and  an  insub- 
stantial portion  of  the  material  in  the  publication  is  devoted  to  legis- 
lative issues,  the  discussion  of  such  legislative  issues  is  to  be  considered 
as  a  communication  with  bona  fide  members,  not  a  communication 
with  other  persons.® 

In  general,  to  be  a  "bona  fide  member,"  a  person  must  have  more 
than  a  nominal  connection  with  the  organization.  The  person  should 
have  affirmatively  expressed  a  desire  to  be  a  member.  In  addition,  the 
person  must,  in  the  usual  case,  also  fall  in  one  of  the  following  classes : 

(1)  pay  dues  of  more  than  a  nominal  amount ; 

(2)  make  a  contribution  of  more  than  a  nominal  amount  of  time 
to  the  organization ;  or 

(3)  be  one  of  a  limited  number  of  "Honorary"  or  "Life"  mem- 
bers chosen  for  a  valid  reason. 

It  is  not  intended  that  these  rules  be  exclusive,  and  an  organization 
with  membership  rules  that  do  not  fall  within  any  of  these  categories 
may  still  be  able  to  treat  its  members  as  "bona  fide  members"  if  it  can 
demonstrate  to  the  Internal  Revenue  Service  that  there  was  a  good 
reason  for  its  membership  requirements  not  meeting  these  standards 
and  that  these  membership  requirements  do  not  serve  as  a  subterfuge 
for  grass  roots  lobbying  activities. 

Under  the  Act,  a  communication  between  an  electing  organization 
and  any  bona  fide  member  of  the  organization  to  directly  encourage 
that  member  to  engage  in  direct  lobbying  is  to  be  treated  as  direct 
lobbying.  If  the  communication  is  to  directly  encourage  the  member 
to  urge  nonmembers  to  engage  in  direct  lobbying  or  grass  roots  lobby- 
ing, then  it  is  to  be  treated  as  the  organization  engaging  in  grass  roots 
lobbying. 

Under  the  Act,  if  an  organization  communicates  with  a  member  or 
employee  of  a  legislative  body  and  one  of  the  purposes  is  influencing 
legislation,  then  the  appropriate  portion  of  the  costs  of  that  effort  are 
to  be  treated  as  lobbying  expenditures.  If  the  communication  is  with 
a  government  official  or  employee  who  is  not  a  member  of  or  employed 
by  a  legislative  body,  then  the  costs  of  the  communication  are  to  be 
taken  into  account  only  if  the  principal  purpose  of  the  communication 
is  to  influence  legislation. 

Exempt  purpose  expenditures, — As  indicated  above,  the  determina- 
tion of  whether  an  electing  organization  is  subject  to  the  excise  tax 
established  by  the  Act  is  to  be  made  by  comparing  the  amount  of  the 
lobbying  expenditures  with  the  organization's  "exempt  purpose  ex- 

"  An  allocable  portion  of  the  cost  of  a  publication  which  is  designed  primarily  for 
members  and  which  includes  some  material  directly  encouraging  the  members  to  engage  in 
direct  lobbying  is  to  be  treated  as  an  expenditure  for  direct  lobbying.  However,  the  fact 
that  some  copies  of  the  publication  are  distributed  to  libraries  and  other  bona  fide 
subscribers  will  not  cause  any  portion  of  those  expenditures  to  be  treated  as  expendi- 
tures for  grass  roots  lobbying.  On  the  other  hand,  if  more  than  15  percent  of  the  copies 
of  the  publication  are  distributed  to  nonmembers  (including  libraries),  the  portion  of  the 
cost  of  the  publication  allocable  to  the  lobbying  material  is  to  be  allocated  between  the 
activities  relating  to  members  and  the  activities  relating  to  nonmembers  (grass  roots 
lobbying)  in  proportion  to  the  distribution  of  the  publication. 


411 

penditures"  for  the  taxable  year.  The  term  "exempt  purpose  expend- 
itures" includes  the  total  of  the  amounts  paid  or  incurred  by  the  or- 
ganization for  exempt  religious,  charitable,  educational,  etc.,  purposes. 

In  computing  exempt  purpose  expenditures,  amounts  properly 
chargeable  to  capital  account  are  to  be  capitalized.  However,  when  the 
capital  item  is  depreciable,  then  a  reasonable  allowance  for  deprecia- 
tion, computed  on  a  straight-line  basis,  is  to  be  treated  as  an  exempt 
purpose  expenditure. 

For  purposes  of  these  provisions,  the  term  "exempt  purpose  expen- 
diture" also  includes  administrative  expenses  paid  or  incurred  with 
respect  to  any  charitable,  etc.,  purpose:  it  also  includes  all  amounts 
paid  or  incurred  the  purpose  of  influencing  legislation,  whether  or 
not  for  exempt  purposes.' 

Exempt  purpose  expenditures  do  not  include  amounts  paid  or  incur- 
red to  or  for  a  separate  fund-raising  unit  of  an  organization  (or  an 
affiliated  organization's  fund-raising  unit)  ;  they  also  do  not  include 
amounts  paid  or  incurred  to  or  for  any  other  organization,  if  those 
amounts  are  pair  or  incurred  primarily  for  fund  raising. 

AfJiImtio7i  I'ulss. — In  order  to  forestall  the  creation  of  numerous 
organizations  to  avoid  the  effects  of  the  decreasing  percentage  test 
used  to  compute  the  lobbying  and  grass  roots  nontaxable  amounts,  or 
efforts  to  avoid  tlie  $1,000,000  "cap"  on  lobbying  expenditures,  the 
act  provides  a  method  of  aggregating  the  expenditures  of  related 
organizations. 

If  two  or  more  organizations  are  members  of  an  affiliated  group,  and 
at  least  one  organization  in  that  group  has  elected  to  come  under  the 
new  rules  of  the  Act  then  the  calculations  of  lobbying  expenditures  and 
exempt  purpose  expenditures  are  to  be  made  by  taking  into  account  the 
expenditures  of  the  entire  group.  If  the  expenditures  of  the  group  as 
a  whole  do  not  exceed  the  permitted  limiits,  then  the  members  of  the 
group  that  elected  the  new  standards  are  treated  as  not  exceeding  the 
permitted  limits.  On  the  other  hand,  if  the  expenditures  of  the  group 
as  a  whole  do  exceed  the  permitted  limits,  then  each  of  the  organiza- 
tions that  elected  to  have  the  new  iniles  apply  is  treated  as  having  ex- 
ceeded the  permitted  limits.  Each  of  those  electing  organizations  is  to 
pay  the  tax  on  its  proportionate  share  of  the  group's  excess  lobbying 
expenditures. 

Only  those  members  of  the  affiliated  group  that  have  elected  are  to 
be  subject  to  this  tax.  The  nonelecting  members  of  the  group  are  to  re- 
main under  prior  law  with  regard  to  their  expenditures  and  other 
activities. 

Generally,  two  organizations  are  affiliated  if  (1)  one  organization 
is  bound  by  decisions  of  the  otlier  organization  on  legislative  issues,  or 
(2)  the  governing  board  of  one  organization  includes  enough  repre- 
sentatives of  the  other  organization  to  cause  or  prevent  action  on  legis- 
lative  issues   by   the    first   organization.    Where   organizations    are 

'  Ths  Act  deals  only  with  whether  an  organization  Is  to  be  treated  as  violating  the 
lobbying  limits  of  the  law.  The  Act  does  not  affect  the  question  of  whether  an  expendi- 
ture might  cause  the  organization  to  lose  its  charitable  status  because  the  expenditure 
violates  the  requirement  that  the  organization  be  organized  and  operated  "exclusively" 
for  charitable,  etc.,  purposes.  (The  Supreme  Court  has  defined  "exclusively"  in  this  con- 
text to  mean  that  there  is  no  uonexempt  purpose  that  is  "substantial  In  nature."  Better 
Business  Bureau  v.  U.S.,  326  U.S.  279,  283  (1945).)  Also,  the  Act  does  not  deal  with  the 
circumstances  under  which  an  expenditure  might  be  treated  as  electioneering,  which  con- 
stitutes another  cause  for  loss  of  exempt  status. 


412 

affiliated,  as  described  above,  in  a  chain  or  similar  fashion,  all  orga- 
nizations in  the  chain  are  to  be  treated  as  one  group  of  affiliated 
organizations.  Thus,  for  instance,  if  organization  Y  is  bound  by  the 
decisions  of  organization  X  on  legislative  issues  and  organization  Z 
is  bound  by  the  decisions  of  organization  Y  on  such  issues,  then  X,  Y, 
and  Z  are  all  members  of  one  affiliated  group  of  organizations.  How- 
ever, if  a  group  of  autonomous  organizations  control  another  orga- 
nization but  no  one  organization  in  the  controlling  group  can,  by  itself, 
control  the  actions  of  the  potentially  controlled  organization,  the 
organizations  are  not  treated  as  an  affiliated  group  by  reason  of  the 
"interlocking  directorates"  ride. 

There  is  affiliation  if  either  of  the  two  conditions  is  satisfied ;  that  is, 
if  there  is  either  control  through  the  operation  of  the  governing  in- 
strument or  voting  control  through  "interlocking  directorates."  In 
general,  any  degree  of  control  by  operation  of  governing  instruments 
is  enough  to  satisfy  this  affiliation  test.  The  existence  of  the  power  is 
sufficient,  whether  or  not  the  "controlling"  organization  is  exercising 
the  power.  However,  where  the  affiliation  in  the  group  exists  solely 
because  of  the  control  provisions  of  governing  instruments  (i.e.,  there 
are  no  interlocking  directorates)  and  where  those  control  provisions 
operate  only  with  respect  to  national  legislation,  then  the  expenditure 
standards  are  to  be  applied  in  the  following  manner : 

( 1 )  The  controlling  organization  is  to  be  charged  with  all  of  its 
lobbying  expenditures  and  also  with  the  national  legislation 
lobbying  expenditures  of  all  of  the  other  affiliated  organizations. 
The  controlling  organization  is  not  to  be  charged  with  any  other 
lobbying  expenditures  (or  other  exempt  purpose  expenditures) 
made  by  the  other  organizations  with  respect  to  issues  other  than 
national  legislation  issues. 

(2)  Each  local  organization  is  to  be  treated  as  though  it  were 
not  a  member  of  an  affiliated  group ;  that  is,  the  local  organization 
is  to  take  account  of  its  own  expenditures  only. 

For  these  purposes,  an  issue  that  has  both  national  and  local  ramifi- 
cations is  to  be  categorized  on  the  basis  of  whether  or  not  the  contem- 
plated legislation  is  Congressional  legislation.  For  example,  lobbying 
with  respect  to  a  U.S.  constitutional  amendment  is  to  be  treated  as 
Congressional  lobbying  up  to  the  time  the  proposed  amendment  is  ap- 
proved by  the  Congress.  Lobbying  campaigns  with  respect  to  State 
ratification  are  to  be  treated  as  lobbying  with  respect  to  State 
legislatures. 

The  "interlocking  directorates"  rule  is  to  be  applied  by  taking  into 
account  whether  the  governing  board  of  the  potentially  controlled  or- 
ganization includes  enough  representatives  of  the  controlling  orga- 
nization so  as  to  cause  or  prevent  action  on  legislative  issues  by  the 
controlled  organization.  The  representatives  are  to  include  persons  who 
are  specifically  designated  representatives  of  the  controlled  organiza- 
tion, members  of  the  governing  board  of  the  controlling  organization, 
officers  of  the  controlling  organization,  and  paid  executive  staff  mem- 
bers of  the  controlling  organization.  Although  titles  are  significant  in 
determining  whether  a  person  is  a  member  of  the  "executive  staff"  of 
an  organization,  in  general  the  test  will  be  the  extent  to  which  the 
employee  exercises  executive-type  powers  in  that  organization. 

Where  there  is  an  affiliated  group,  a  number  of  the  provisions 


413 

discussed  above  are  to  be  applied  as  though  the  affiliated  group  con- 
stitutes one  organization.  In  the  case  of  the  "self-defense"  exclusion 
from  the  definition  of  influencing  legislation,  for  example,  the  effort 
by  a  national  organization  to  deal  with  matters  which  might  affect 
the  existence  of  the  local  members  of  its  affiliated  group  are  to  be 
treated  as  self-defense  expenditures  by  the  national  organization. 
Similarly,  communications  by  the  national  organization  to  members 
of  the  local  organizations  in  its  affiliated  group  are  to  be  treated  the 
same  as  communications  by  the  national  organization  to  its  own 
members.  Also,  where  the  national  organization  pays  or  incurs  ex- 
penditures for  fund-raising  by  its  local  affiliates,  those  expenditures 
are  to  be  treated  as  though  they  had  been  paid  or  incurred  for  the 
national  organization's  fund-raising  purposes. 

Because  the  question  of  wliether  an  affiliated  group  exists  may  be 
critical  in  determining  whether  an  organization  has  violated  the 
standards  under  the  Act,  the  Congress  intends  that  the  Internal 
Revenue  Service  make  provision  for  issuing  opinion  letters  at  the 
request  of  electing  organizations  to  determine  whether  those  organiza* 
tions  are  members  of  affiliated  grouj^s  and  to  determine  which  other 
organizations  are  members  of  such  groups.  Of  course,  if  conditions 
change  materially,  then  the  conclusion  stated  in  any  such  opinion  letter 
would  not  bind  the  Service.  However,  a  willingness  by  the  Service  to 
rule  on  such  questions  would  go  far  to  further  reduce  the  uncer- 
tainty that  has  prevailed  in  this  part  of  the  law\ 

Disallowance  of  deduction  for  out-of-pocket  expenses  to  influence 
legislation. — Under  present  law,  a  deduction  is  available  for  certain 
out-of-pocket  expenditures  incurred  by  a  person  on  behalf  of  a  chari- 
table organization.  Since,  for  purposes  of  the  new  expenditures  test, 
it  is  necessary  to  have  relevant  expenditures  appear  in  the  books  and 
records  of  the  organization,  an  expenditure  test  could  readily  be 
evaded  if  the  lobbying  could  be  conducted  on  behalf  of  the  organiza- 
tion by  individuals  with  deductible  out-of-pocket  contributions.  Ac- 
cordingly, the  Act  provides  that  a  person  may  not  deduct  an  out-of- 
pocket  expenditure  on  behalf  of  a  charitable  organization  if  the 
expenditure  is  made  for  the  purpose  of  influencing  legislation  and  if 
the  organization  is  eligible  to  elect  the  expenditures  test  provided 
by  the  Act.« 

Status  of  organization  after  loss  of  charitahle  status. — Under  prior 
law,  an  organization  which  lost  its  exempt  staJtus  under  section  501 
(c)  (8)  generally  could  nevertheless  remain  exempt  on  it^s  own  income 
(although  generally  ineligible  to  receive  deductible  charitable  con- 
tributions) as  a  "social  welfare"  organization  under  section  501(c) 
(4) .  The  availability  of  this  continued  exemption  permitted  an  orga- 
nization to  build  up  an  endowment  out  of  deductible  contributions  as 
a  charitable  organization  and  then  use  that  tax-favored  fund  to  sup- 
port substantial  amounts  of  lobbying  as  a  section  501(c)(4)  social 
welfare  organization.^ 

"Treasury  Regulations  §  1.170A-1  (h)  (6)  provide  that  "No  deduction  shall  be  allowed 
under  section  170  for  expenditures  for  lobbying  purposes,  promotion  or  defeat  of  legis- 
lation, etc."  However,  It  is  not  clear  that  this  provision  of  the  Regulations  has  been 
applied  to  disallow  deductions  for  such  expenditures. 

»  State  law  would  in  the  usual  case  require  the  funds  originally  dedicated  to  charitable 
purposes  to  remain  so  dedicated,  even  though  the  organization  may  have  lost  Its  Internal 
Revenue  Code  charitable  status.  However,  it  is  not  clear  whether  State  law  would  pre- 
vent such  an   organization  from  carrying  on   substantial   lobbying  activities. 


414 

In  order  to  stop  such  a  transfer  of  clmritable  endowment,  the  Act 
provides  that  an  organization  which  is  eligible  to  elect  under  the  ex- 
penditur-es  test  provided  by  the  Act  cannot  become  a  social  welfare 
organization  exempt  under  section  501  (c)  (4)  if  it  has  lost  its  status  as 
a  charity  because  of  excessive  lobbying.  The  Act  also  gives  the  Treas- 
ury Department  the  authority  to  prescribe  regulations  to  prevent 
avoidance  of  this  rule  (for  example,  by  dii^eot  or  indirect  transfers  of 
all  or  part  of  the  assets  of  an  organization  to  an  organization  con- 
trolled by  the  same  pei-son  or  persons  who  contix)l  the  transferor  or- 
ganization). 

This  new  provision  does  not  apply  to  churches  (or  organizations 
related  to  churches),  which  are  ineligible  to  make  an  election  of  the 
new  rule^  relating  to  lobbying  (see  discussion  below,  under  Eligible 
organizations) . 

This  rule  forbidding  an  organization  that  loses  its  charitable,  etc., 
status  to  become  a  tax-exempt  social  welfare  organization  applies  only 
if  the  loss  of  charitable,  etc.,  status  is  because  of  excessive  lobbying.  As 
under  pi'esent  law,  such  an  organization  could  ultimately  reestablish 
its  status  as  a  charitable  organization.  (See,  for  example,  John  Dam 
Charitable  Trust,  32  T.C.  469  (1969),  afd..  284  F.2d  726  (C.A.  9, 
I960).)  However,  the  organization  could  never  establish  exempt 
status  under  section  501  (c)  (4) . 

This  rule  applies  only  in  the  case  of  organizations  that  have  lost 
their  charitable,  etc.,  status  as  a  result  of  activities  occurring  after 
the  date  of  enactment  (October  4, 1976) . 

Disclosure  of  lobbying  ex'penditures. — Prior  law  (sec.  6033(b)) 
has  required  most  charitable,  etc.,  organizations  (with  specific  exemp- 
tions made  for  churches  and  certain  other  organizations)  to  include  on 
their  information  returns  certain  specified  categories  of  infoiTnation 
related  generally  to  types  of  expenditures  made  by  the  organization. 
Another  provision  of  prior  law  (sec.  6104(b))  has  provided  that  the 
information  required  to  be  furnished  on  those  information  returns  was 
to  be  made  available  to  the  public. 

In  order  to  permit  the  public  to  obtain  information  as  to  lobbying 
expenditures  by  organizations  that  have  elected  to  come  under  the 
standards  of  the  Act,  section  6033  is  amended  to  specifically  require 
that  any  organization  that  has  elected  under  these  rules  must  disclose 
on  its  information  return  the  amount  of  its  lobbying  expenditures 
(total  and  grass  roots),  together  with  the  amount  that  it  could  have 
spent  for  these  purposes  without  being  subject  to  new  excise  tax  pro- 
vided by  the  Act.  If  an  electing  organization  is  a  member  of  an  affili- 
ated group,  then  it  must  provide  this  information  with  respect  to  the 
entire  group,  as  well  as  with  respect  to  itself. 

This  Act  is  not  intended  to  restrict  any  authority  that  the  Treasury 
Department  may  have  had  under  prior  law  to  require  exempt  orga- 
nizations to  provide  information  for  the  purpose  of  carrying  out  the 
internal  revenue  laws. 

In  addition,  the  Act  requires  the  Internal  Revenue  Service  to  notify 
the  appropriate  State  officer  of  the  mailing  of  a  notice  of  deficiency  of 
the  tax  imposed  on  excess  lobbying  expenditures.  The  appropriate 
State  officer  is  the  State  offical  charged  with  overseeing  charitable, 
etc.,  organizations.  Prior  law  (sec.  6104(c) )  already  required  the  Serv- 
ice to  notify  the  appi-opriate  State  official  if  the  Service  believed  that 


415 

the  organization  had  been  operated  in  such  a  way  as  to  no  longer  meet 
the  requirements  of  its  exemption. 

Electiatis. — Notwithstanding  the  concerns  which  caused  many  or- 
ganiza/tions  to  urge  tlie  Congress  to  change  prior  law,  some  organiza- 
tions appeared  to  prefer  to  continue  under  the  rules  of  prior  law.  In 
recognition  of  the  fact  tliat  the  Act  requires  some  change  in  prior  prac- 
tices, especially  as  to  the  ket^ping  of  records  of  expenditures  and  the 
disclosure  of  such  information  on  the  annual  return,  the  Act  permits 
organizations  to  elect  the  new  rules  or  to  remain  under  prior  law. 

An  election  by  an  organization  to  have  its  legislative  activities 
measured  by  the  new  expenditures  test  is  to  be  ell'eotive  for  all  taxable 
years  of  the  oi-ganization  which  end  aft«r  the  date  the  election  is  made, 
and  begin  before  tlie  date  the  election  is  revoked  by  the  organization. 
Thus,  an  organization  c^n,  at  any  time  before  the  end  of  the  taxable 
year,  elect  the  new  rules  for  that  taxable  year.  Once  such  an  election 
is  made,  it  can  be  revoked  only  prospectively — ^that  is,  it  caimot  be  re- 
voked for  a  taxable  year  after  that  year  has  begun. 

Eligible  organizations. — Concerns  have  been  expressed  by  a  num- 
ber of  church  groups  that  both  prior  law  and  the  rules  in  the  Act 
might  violate  their  constitutional  rights  under  the  First  Amendment. 
Such  groups  have  indicated  a  concern  that  if  a  church  were  permitted 
to  elect  the  new  rules,  then  the  Internal  Revenue  Service  might  be 
influenced  by  this  legislation  even  though  the  church  in  fact  did  not 
elect. 

As  a  result  of  the  concerns  expressed  by  a  number  of  churches  and 
in  response  to  their  specific  request,  the  Act  does  not  permit  a  church 
or  a  convention  or  association  of  churches  (or  an  integrated  auxiliary 
or  a  member  of  an  affiliated  group  which  includes  a  church,  etc.),  to 
elect  to  come  under  these  provisions.^" 

The  Act  excludes  from  the  new  rules  not  only  churches  and  con- 
ventions or  associations  of  churches,  but  also  integrated  auxiliaries 
of  churches  or  of  conventions  or  associations  of  churches. 

The  Act  also  specifically  provides  that  the  new  rules  under  the  Act 
are  not  to  have  any  effect  "on  the  way  the  lobbying  language  of  section 
501(c)  (3)  ("no  substantial  part  of  the  activities  of  which  is  carrying 
on  propaganda,  or  otherwise  attempting,  to  influence  legislation") 
is  to  be  applied  to  organizations  which  do  not  elect  (or  are  ineligible 
to  elect)  to  come  under  these  rules. 

Eifect  of  court  decision. — The  Congress  is  aware  of  the  recent  ta_x 
litigation  involving  (liristian  Echoes  National  Ministry,  Inc.  In  this 
case,  the  Internal  Revenue  Service  revoked  a  prior  favorable  section 
501(c)  (3)  exemption  ruling  and  assessed  Social  Security  (FICA)  tax 
deficiencies.  The  organization  paid  the  FICA  taxes  and  sued  for  re- 
fimd  in  Federal  district  court.  The  district  court  held  for  the  organi- 
zation (28  AFTR  2d  71-5934  (N.I).  Okla.  1971)).  The  Govern- 
ment appealed  directly  to  the  United  States  Supreme  Court,  which 
held  that  it  had  no  jurisdiction  to  entertain  the  direct  appeal  (404 
U.S.  561    (1972)).  The  (xovernment  then  appealed  to  the  Court  of 

»»  Since  private  foundations  are  already  subject  to  excise  taxes  on  activities  involving 
influencing  legislation  under  section  4945,  they  are  ineligible  for  these  new  rules.  Also, 
organizations  which  are  public  charities  because  they  are  support  organizations  (under 
sec.  .'509(a)(3))  of  certain  types  of  social  welfare  organizations  (sec.  501(c)(4)),  labor 
unions,  etc.  (sec.  501  (c)5)),  or  trade  associations  (sec.  .501(c)(6))  are  ineligible  to  make 
this  election. 


416 

Appeals  for  the  Tenth  Circuit,  which  reversed  tlie  district  court 
decision  and  upheld  the  Government's  position  tliat  the  organization 
was  not  exempt  because  of  excessive  lobbying  activities  (470  F.'id 
849  (1972)).  The  organization  then  petitioned  the  Supreme  Court 
for  a  writ  of  certiorari,  which  was  denied  (414  U.S.  864  (1973) ). 

In  the  course  of  their  opinions,  the  various  courts  stated  conclusions 
regarding  a  number  of  legal  issues  or  issues  of  mixed  law  and  fact. 
If  the  Act  and  the  committee  reports  were  silent  with  regard  to  this 
case,  then  some  might  have  argued  that  Congressional  enactment 
implied  Congressional  ratification  of  the  decision  and  of  one  or  all  of 
the  statements  in  the  opinions  in  this  case.  Others  might  have  said 
that  Congressional  action  constituted  the  sort  of  revision  that 
amounted  to  a  rejection  of  the  decision  or  opinions  in  tliis  case. 

The  Congress  proceeded  on  this  Act  without  evaluating  that  liti- 
gation. So  that  unwarranted  inferences  may  not  be  drawn  from  the 
enactment  of  this  Act,  the  Congress  states  tliat  its  actions  are  not  to 
be  regarded  in  any  way  as  an  approval  or  disapproval  of  the  decision 
of  the  Court  of  Appeals  for  the  Tenth  Circuit  in  Christian  Echoes 
Natio7ial.  Ministry,  Inc.  v.  U.S..  470  F.'id  849  ( 1972 ) ,  or  of  the  reason- 
ing in  any  of  the  opinions  leading  to  that  decision. 

Effective  dates 
In  order  to  provide  time  for  the  Treasury  Department  to  promul- 
gate the  necessary  regulations  interpreting  the  Act  and  providing  for 
making  elections  under  the  new  rules,  the  Act's  provisions,  with  cer- 
tain limited  exceptions,  become  effective  only  for  taxable  years  be- 
ginning after  December  31,  1976.  However,  the  rule  which  provides 
that  a  section  501(c)  (3)  organization  which  loses  its  charitable,  etc., 
status  because  of  excess  lobbying  status  cannot  thereafter  be  exempt 
under  section  501(c)  (4)  applies  to  activities  occurring  after  the  date 
of  enactment  (October  4,  1976).  The  amendments  conforming  the 
estate  tax  charitable  deduction  provisions  applies  to  the  estates  of 
decedents  dying  after  December  31,  1976,  and  the  amendments  con- 
forming the  gift  tax  charitable  deduction  requirements  apply  to  gifts 
in  calendar  years  beginning  after  December  31, 1976. 

Revenue  ejfect 

It  is  estimated  that  this  provision  will  affect  budget  receipts  by  less 
than  $5  million  annually. 

8.  Tax  Liens,  etc.,  Not  to  Constitute  "Acquisition  Indebtedness'' 
(sec.  1308  of  the  Act  and  sec.  514(c)(2)  of  the  Code) 

Prior  law 

Generally,  any  organization  which  is  exempt  from  Federal  income 
tax  (under  section  501  (a) )  is  taxed  only  on  income  from  trades  or  busi- 
nesses which  are  unrelated  to  the  organization's  exempt  purposes;  it  is 
not  taxed  on  passive  investment  income  and  income  from  any  trade 
or  business  which  is  related  to  the  oi-ganization's  exempt  purposes.^ 

Before  1969,  some  exemj^t  organizations  had  used  their  tax-exempt 
status  to  acquire  businesses  through  debt  financing,  with  purchase 

^  There  are  some  exceptions  to  the  general  rule  that  passive  investment  income  is  tax- 
exempt.  For  example,  social  clubs  (sec.  501(c)(7))  and  voluntary  employees'  beneficiary 
associations  (sec.  501(c)(9))  are  generally  taxed  on  such  income.  Also,  private  founda- 
tions are  subject  to  an  excise  tax  of  4  percent  on  their  net  investment  income. 


417 

money  obligations  to  be  repaid  out  of  tax-exempt  profits ;  for  example, 
as  from  leasing  the  assets  of  acquired  businesses  to  the  businesses'  for- 
mer owners. 

The  Tax  Reform  Act  of  1969  provided  (in  the  so-called  "Clay 
Brown  j^rovision")  that  an  exempt  organization's  income  from  "debt- 
iinanced  property",  which  is  not  used  for  its  exempt  function,  is  to  be 
subject  to  tax  in  the  proportion  in  which  the  property  is  financed  by 
debt.  In  general,  debt-financed  property  is  defined  as  '"any  property 
which  is  field  to  produce  income  and  with  respect  to  which  there  is 
acquisition  indebtedness"'  (sec.  514(b)  (1) ).  A  debt  constitutes  acquisi- 
tion indebtedness  with  respect  to  property  if  the  debt  was  incurred  in 
acquiring  or  improving  the  property,  or  if  the  debt  would  not  have 
been  incurred  ''but  for"  tlie  acquisition  or  improvement  of  the 
property.^ 

Where  property  "is  acquired  subject  to  a  mortgage  or  other  similar 
lien,"  the  debt  secured  by  that  lien  is  generally  considered  acquisition 
indebtedness.  The  Treasury  Regulations  (Reg.  §  1.514:(c)-l(b)  (2)) 
provide,  in  effect,  a  special  rule  for  debts  for  the  payment  of  taxes,  as 
follows:  "[I]n  the  case  where  State  law  provides  that  a  tax  lien  at- 
taches to  property  prior  to  the  time  when  such  lien  becomes  due  and 
payable,  such  lien  shall  not  be  treated  as  similar  to  a  mortgage  until 
after  it  has  become  due  and  payable  and  the  organization  has  had  an 
opportunity  to  pay  such  lien  in  accordance  with  State  law." 

There  has  been  no  similar  exception  for  State  or  local  governments' 
special  assessments  to  finance  improvements. 

Reasons  for  change 

It  is  common  practice  for  State  and  local  governmental  units  in 
some  States  to  undertake  certain  improvements  to  land,  such  as  roads, 
curbs,  gutters,  sewer  systems,  etc.,  and  to  finance  these  improvements 
either  through  general  tax  revenues  or  special  assessments  imposed  on 
the  land  which  the  improvements  are  intended  to  benefit.  The  imme- 
diate funds  for  the  improvements  are  provided  by  the  sale  of  bonds 
secured  by  liens  on  the  land.  The  bonds  are  then  paid  off  either 
through  the  general  tax  revenues  or  the  special  assessments  over  a 
period  of  years. 

The  Internal  Revenue  Service  has  taken  the  position  that  if  a  lien 
arises  from  a  special  assessment  of  the  type  described  above,  as  op- 
posed to  a  property  tax  lien,  the  lien  securing  the  installment  pay- 
ments of  the  assessment  will  constitute  acquisition  indebtedness,  even 
though  the  installment  payments  are  due  in  future  periods. 

The  indebtedness  arising  from  a  special  assessment  of  this  sort  does 
not  appear  to  be  the  type  of  indebtedness  that  the  debt-financed  prop- 
erty provisions  were  intended  to  deal  with  in  the  1969  Act. 


2  There  are  several  exceptions  from  the  term  "acquisition  indebtedness."  For  instance,  one 
exception  is  Indebtedness  on  property  which  an  exempt  organization  receives  by  devise,  be- 
quest, or,  under  certain  conditions,  by  gift.  This  exception  allows  the  organization  re- 
ceiving the  property  10  years  to  dispose  of  it  free  of  tax  under  this  provision,  or  to  retain 
the  property  and  reduce  or  discharpe  the  indebtedness  on  it  with  tax-free  income.  Also, 
the  term,  "acquisition  indebtedness"  does  not  include  indebtedness  which  was  necessarily 
incurred  in  the  performance  or  exercise  of  the  purpose  or  function  constituting  the  basis 
of  the  organization's  exemption.  Special  exceptions  are  also  provided  for  the  sale  of  an- 
nuities and  for  debts  insured  by  the  Federal  Housing  Administration  to  finance  low-  and 
moderate-Income  housing. 


418 

Explanation  of  provision 

The  Act  provides  that  the  indebtedness  with  respect  to  which 
a  lien  arising  from  taxes  or  a  lien  for  special  assessments  made  by 
a  State  or  an  instrumentality  or  a  subdivision  of  a  State  will  not 
be  acquisition  indebtedness  until  and  to  the  extent  that,  an  amount 
secured  by  the  lien  becomes  due  and  payable  and  the  exempt  orga- 
nization has  had  an  opportunity  to  pay  the  taxes  or  special  assess- 
ments in  accordance  with  State  law.^  Howevei-,  it  is  not  intended  that 
this  provision  apply  to  special  assessments  for  improvements  which 
are  not  of  a  type  normally  made  by  a  State  or  local  governmental 
unit  or  instrumentality  in  circumstances  in  which  the  use  of  the  special 
assessment  is  essentially  a  device  for  financing  improvements  of  the 
sort  that  normally  would  be  financed  privately  rather  than  through  a 
government. 

In  determining  when  a  lien  becomes  due  and  payable  and  the  exempt 
organization  has  had  an  opportunity  to  pay  the  necessary  amount  in 
accordance  with  State  law,  consideration  must  be  given  to  the  reali- 
ties of  the  situation,  and  not  merely  the  formal  recitations  of  State  law. 
For  example,  Hawaii  law  (sec.  67-28)  provides  that  special  assess- 
ments become  "due  and  payable"  at  the  end  of  a  designated  30-day 
period.  Hov^ever,  a  failure  to  pay  the  assessment  at  the  end  of  that 
period  constitutes,  under  State  law-,  an  election  to  pay  the  assessment  in 
installments  (sec.  67-23;  see  sec.  67-25).  Sanctions  are  then  provided 
(sees.  67-27  and  67-29)  in  the  event  of  failure  to  pay  the  installments 
when  due.  In  such  a  situation,  the  Congress  intends  that,  for  purposes 
of  this  provision,  the  assessment  lien  becomes  due  and  payable  only  at 
the  time  when  the  relevant  installment  is  required  to  be  paid. 

Effective  date 
Since  this  provision  is  intended  to  reflect  the  intent  of  Congress  when 
it  amended  section  514  in  1969,  the  provision  is  to  apply  to  all  taxable 
years  ending  after  December  81,  1969. 

Revenue  effect 

It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

9.  Extension  of  Private  Foundation  Transition  Rule  for  Sale  of 
Business  holdings  (sec.  1309  of  the  Act  and  sec.  101(1)  (2)  (B) 
of  the  Tax  Reform  Act  of  1969) 

Prior  law 

The  Tax  Reform  Act  of  1969  imposed  taxes  upon  certain  trans- 
actions between  a  private  foundation  and  its  "disqualified  persons" 
(generally,  persons  with  an  economic  or  managerial  interest  in  the  op- 
eration of  that  foundation).  Among  the  transactions  to  which  these 
taxes  on  "self-dealing"  apply  are  the  sale,  exchange,  or  leasing  of 
property  (sec.  4941).  The  1969  Act  also  added  a  provision  to  the  Code 
which  limits  the  combined  ownership  of  a  business  enterprise  by  a 
private  foundation  and  all  disqualified  persons  and  taxes  any  excess 
holdings  which  are  not  divested  within  a  required  period  of  time  (sec. 
4948). 


*  This  amendment  is  Intended  to  apply  also  to  the  definition  of  business-lease  indebted- 
ness in  section  514(g).  However,  since  that  provision  is  repealed  by  section  1901  (a)  (72) 
(B)  of  the  Act,  no  modifyinp  amendment  is  made  to  it. 


419 

The  1969  Act  permits  a  private  foundation  to  sell  excess  business 
holdings  (held,  or  treated  as  held,  by  the  foundation  on  May  26,  1969) 
to  a  disqualified  person  if  the  sales  price  equals  or  exceeds  the  fair 
market  value  of  the  property  being  sold.  This  rule  was  generally  in- 
tended to  allow  private  foundations  and  disqualified  persons  to  dis- 
entangle their  affairs  and  was  based  on  the  fact  that  in  the  case  of 
many  closely-held  companies  the  only  ready  market  for  a  private 
foundation's  holdings  would  be  disqualified  persons.  This  rule  has  no 
terminal  date.  This  rule  (sec.  101(1)  (2)  (B)  of  the  1969  Act)  also  pro- 
vides that  prior  to  January  1,  1975,  a  private  foundation  could  have 
sold  business  holdings  which  would  have  been  excess  business  hold- 
ings but  for  the  special  "grandfather"  rules  in  the  statute  (sec.  4943 
(c)  (4)  and  (5) )  to  disqualified  persons. 

Reasons  for  change 
It  has  come  to  the  attention  of  Congress  that,  despite  the  5-year 
transitional  period  in  which  the  "grandfathered"  excess  business  hold- 
ings could  have  been  sold  to  disqualified  persons  by  private  founda- 
tions, some  private  foundations  that  have  wished  to  make  such  a 
sale  or  other  disposition  have  not  done  so.  The  Congress  believes 
generally  that  it  is  still  desirable  to  encourage  private  foundations 
to  divest  themselves  of  holdings  in  enterprises  in  which  disqualified 
persons  have  a  significant  interest  provided  that  the  foundation  re- 
ceives fair  market  value  for  the  business  holdings.  However,  the 
Congress  continues  to  believe  that,  in  general,  it  is  still  desirable  to 
prevent  most  sales,  exchanges,  or  other  dispositions  between  a  private 
foundation  and  disqualified  persons  and  therefore  it  makes  these  sales 
to  disqualified  persons  possible  without  imposition  of  the  self -dealing 
tax  only  through  the  remainder  of  1976, 

Explanation  of  provision 
The  Act  extends  the  effective  date  of  a  private  foundation  transi- 
tional rule  in  the  Tax  Reform  Act  of  1969  (sec.  101(1)  (2)  (B) )  to 
make  that  transitional  rule  apply  to  a  sale,  exchange,  or  other  disposi- 
tion of  the  "nonexcess"  business  holdings  referred  to  above  which  takes 
place  before  January  1,  1977.  This  extension  does  not  effect  any  of  the 
other  requirements  of  section  101  (1)  (2)  (B).  Therefore,  for  example, 
the  requirement  that  such  a  disposition  is  allowed  only  as  to  property 
which  is  owned  by  a  private  foundation  on  May  26,  1969  (or  which  is 
considered  as  having  been  owned  by  a  private  foundation  on  that  date) , 
and  the  requirement  that  the  foundation  receive  at  least  fair  market 
value  for  the  property,  are  not  affected  by  this  amendment.^ 

Effective  date 
This  provision  applies  to  dispositions  occurring  after  the  date  of 
enactment  (October  4,  1976)  and  before  January  1,  1977. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

1  In  addition,  if  a  transaction  under  this  transitional  rule  involves  the  receipt  of  in- 
debtedness bv  the  private  foundation,  the  receipt  and  holding  of  such  indebtedness  is  to 
he  governed  bv  the  rules  under  section  101(1)  (2)  (C)  of  the  1969  Act  and  Regs.  §  53.4941 
(d)-4(c)(4). 


420 

10.  Private  Foundations  Imputed  Interest  (sec.  1310  of  the  Act 
and  4942  of  the  Code) 

Prim'  law 
In  general,  a  penalty  tax  is  imposed  (sec.  4942)  on  any  private 
foundation  pother  than  an  operating  foundation)  which  fails  to  make 
charitable  distributions  amounting  to  the  greater  of  its  adjusted  net 
income  or  its  minimum  investment  return.  In  order  to  qualify  as  an 
operating  foundation,  an  organization  must  make  charitable  distribu- 
tions of  substantially  all  of  its  adjusted  net  income  directly  for  the  ac- 
tive conduct  of  its  exempt  purposes.  The  minimum  investment  return  is 
5  percent  of  the  average  value  of  the  foundation's  noncharitable  assets 
for  the  taxable  year.  (See  above,  3,  Reduction  in  Minimum  Distribu- 
tion Amount  for  Private  Foundations.)  The  adjusted  net  income  of  a 
foundation  (for  purposes  of  these  charitable  distribution  rules)  is  its 
gross  income  (including  tax-exempt  interest,  certain  capital  gains,  and 
certain  amounts  treated  as  qualifying  distributions  from  other  private 
foundations)  less  trade  or  business  expenses,  expenses  for  the  produc- 
tion or  collection  of  income,  depreciation,  and  cost  depletion.  Adjusted 
net  income  includes  imputed  interest. 

Reasons  for  change 
It  has  come  to  the  attention  of  the  Congress  that  there  are  some 
foundations  which  sold  property  prior  to  the  enactment  of  the  rules 
applicable  to  foundations  in  1969  on  an  installment  sales  basis  that  did 
not  call  for  a  stated  rate  of  interest.  Prior  to  the  enactment  of  the  pri- 
vate foundation  rules,  whether  the  foundation  had  interest  income  was 
not  relevant  because  the  foundation  paid  no  Federal  taxes  on  interest 
income.  However,  with  the  enactment  of  the  private  foundation  rules, 
the  requirement  that  an  operating  foundation  distribute  income  im- 
puted to  the  foundation  (under  sec.  483)  could  be  onerous.  The  founda- 
tion might  either  be  forced  to  expand  drastically  its  ongoing  active  pro- 
gram, or  be  forced  to  make  one-time  grants,  which  cause  it  to  fail  one 
of  the  requirements  for  operating  foundation  status  (spending  sub- 
stantially all  of  its  income  for  the  active  conduct  of  its  exempt  activ- 
ities, as  distinguished  from  making  grants).  The  consequences  to  a 
nonoperating  foundation,  although  not  apt  to  be  as  severe,  nevertheless 
might  include  disruption  of  otherwise  appropriate  charitable  ex- 
penditure planning.  Consequently,  the  Congress  does  not  believe  that 
it  is  appropriate  to  require  a  foundation  to  distribute  income  which  is 
imputed  to  it  because  of  a  sale  made  before  the  Tax  Reform  Act  of 
1969. 

Explanation  of  provision 
The  Act  changes  the  definition  of  adjusted  net  income  for  purposes 
of  determining  how  much  must  be  distributed  or  spent  (to  avoid  tax 
under  sec.  4942)  to  exclude  interest  income  imputed  to  the  foundation 
(sec.  483)  in  the  case  of  sales  made  before  the  1969  Act.  Although  the 
private  foundation  will  not  be  required  to  distribute  any  income  im- 
puted to  the  foundation.  Because  of  such  a  sale,  the  imputed  income  is 
still  included  in  the  net  investment  income  of  the  private  foundation 
for  purposes  of  the  4-percent  tax  (provided  by  sees.  4940  and  4948). 


421 

Effective  date 
This  provision  applies  to  taxable  years  ending  after  the  date  of  en- 
actment (i.e.,  after  October  4. 1976) . 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

11.  Unrelated  Business  Income  From  Services  Provided  by  a  Tax- 
exempt  Hospital  to  Other  Tax-exempt  Hospitals  (sec.  1311  of 
the  Act  and  sec.  513  of  the  Code) 

Prior  law 
A  tax  is  imposed  (sees.  511  through  514)  on  income  from  the  un- 
related trades  or  businesses  of  most  exempt  organizations,  including 
hospitals  which  are  exempt  under  section  501(c)  (3)  (relating  to  orga- 
nizations organized  and  operated  for  religious,  charitable,  scientific, 
educational,  etc.  purposes).  The  term  "unrelated  trade  or  business"  is 
defined  (sec.  513)  as  any  trade  or  business  the  conduct  of  which  is  not 
substantially  related  (aside  from  the  need  of  such  organization  for 
income  or  funds  or  the  use  it  makes  of  the  profits  derived)  to  the 
exercise  or  performance  by  such  organization  of  any  religious,  chari- 
table, scientific,  educational,  etc.,  purpose.  In  Rev.  Rul.  69-633,  1969-2 
CB  121,  the  Internal  Revenue  Service  ruled  that  income  which  a  tax- 
exempt  hospital  derives  from  providing  laundry  services  to  other 
tax-exempt  hospitals  constitutes  unrelated  business  taxable  income  to 
the  hospital  providing  the  services,  since  the  providing  of  services 
to  other  hospitals  is  not  substantially  related  to  the  exempt  purposes 
of  the  hospital  providing  the  services. 

Reasons  for  change 

Under  present  law,  a  tax-exempt  hospital  which  directly  provides 
certain  services  needed  in  its  function  as  an  exempt  hospital  is  not 
taxed  on  the  imputed  income  from  those  services.  In  addition,  under 
present  law  ( as  expanded  by  other  amendments  made  by  the  Act ;  see 
below,  12.  Clinical  Services  Provided  to  Tax-exempt  Hospitals),  sev- 
eral tax-exempt  hospitals  can  create  and  operate,  on  a  cooperative 
basis,  a  new  tax-exempt  organization  to  provide  those  services  to  its 
members. 

However,  it  is  often  impractical  for  a  number  of  small  hospitals  to 
perform  these  services  directly  or  to  create  a  separate  cooperatively- 
operated  organization  to  provide  these  services.  Instead,  it  may  be 
more  practical  for  one  hospital  to  provide  these  services  to  several 
small  tax-exempt  hospitals  for  a  fee.  The  Congress  believes  that  such 
arrangements  should  be  encouraged  since  they  often  result  in  a  cost 
savings  to  the  hospital  and  its  patients.  Moreover,  the  Congress  does 
not  believe  that  a  hospital  providing  such  services  substantially  com- 
petes with  other  organizations  which  are  not  tax-exempt. 

Explanation  of  provision 
The  Act  provides  that  a  hospital  is  not  engaged  in  an  unrelated 
trade  or  business  simply  because  it  provides  services  to  other  hospitals 


234-120  O  -  77  -  28 


422 

if  those  services  could  have  been  provided,  on  a  tax-free  basis,  by  a 
cooperative  organization  consisting  of  several  tax-exempt  hospitals. 
The  exclusion  from  the  unrelated  business  tax  applies  only  where  (1) 
the  services  are  provided  only  to  other  tax-exempt  hospitals,  each  one 
of  which  has  facilities  to  serve  not  more  than  100  inpatients,  and  (2) 
the  services  would  be  consistent  with  the  recipient  hospital's  exempt 
purposes.  In  addition,  the  exemption  from  the  unrelated  business  in- 
come tax  is  provided  only  to  the  extent  that  the  services  are  provided 
at  a  fee  or  other  charge  that  does  not  exceed  the  actual  cost  of  provid- 
ing those  services  plus  a  reasonable  amount  for  a  return  on  the  capital 
goods  used  in  providing  those  services.  For  this  purpose,  the  actual  cost 
of  providing  the  services  includes  straight-line  depreciation.  The  Con- 
gress intends  that  the  IRS  not  require  that  hospitals  providing  the 
services  keep  detailed  records  to  substantiate  compliance  with  this 
new  requirement,  so  long  as  the  fees  charged  for  the  services  provided 
by  the  hospital  reasonably  approximate  the  cost  of  providing  those 
services. 

Effective  date 
This  amendment  applies  to  all  "open"  taxable  years  to  which  the 
Internal  Revenue  Code  of  1954  applies. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

12.  Clinical  Services  Provided  to  Tax-exempt  Hospitals  (sec.  1312 
of  the  Act  an  sec,  501(e)  of  the  Code) 

Prior  law 
Under  prior  law  (sec.  501(e)),  certain  cooperatively-operated 
service  organizations  which  have  been  created  by  tax-exempt  hospitals 
are  also  considered  to  be  tax-exempt  charitable  organizations.  In 
order  to  qualify  for  that  tax-exempt  status,  a  hospital  service  organi- 
zation (1)  must  be  organized  and  operated  solely  to  perform  certain 
specified  services  which,  if  performed  directly  by  a  tax-exempt  hos- 
pital, would  constitute  activities  in  the  exercise  or  perfonnance  of  the 
purpose  or  function  constituting  the  basis  for  its  exemption,  and  (2) 
must  perform  these  services  solely  for  two  oi  inore  tax-exempt  hos- 
pitals. That  provision  does  not  apply  to  organizations  which  perform 
services  other  than  those  listed  in  the  statute,  such  as  clinical  services. 

Reasons  for  change 
The  Congress  believes  that  it  is  appropriate  to  encourage  the  crea- 
tion and  operation  of  cooperative  service  organizations  by  exempt  hos- 
pitals because  of  the  cost  savings  to  the  hospitals  and  their  patients 
that  result  from  providing  certain  services,  such  as  clinical  services, 
on  a  cooperative  basis.  Moreover,  exemption  from  State  taxation 
which  this  would  facilitate  in  many  cases  would  be  particularly  help- 
ful in  the  case  of  clinical  services,  since  they  require  relatively  sub- 
stantial investments  in  plant  and  equipment.  In  addition,  under 
present  law,  it  is  possible  for  a  cooperatively-operated  clinical  facility 
to  avoid  paying  any  Federal  income  tax  if  it  returns  any  excess  income 
to  its  exempt  hospital  members  as  patronage  dividends. 


423 

Explanation  of  provisio9i 
The  Act  adds  the  performance  of  clinical  services  to  the  types  of 
services  that  can  be  performed  on  a  cooperative  basis  by  tax-exempt 
hospitals.  Thus,  it  is  permissible,  under  the  Act,  for  tax-exempt  hos- 
pitals to  create  a  cooperative  service  organization  to  provide  clinical 
facilities  to  these  hospitals. 

Effective  date 
The  amendment  is  effective  for  taxable  yeai-s  ending  after  Decem- 
ber 31, 1976. 

Beveniie  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 
13.  Exemption  of  Certain  Amateur  Athletic  Organizations  From 

Tax  (sec.  1313  of  the  Act  and  sees.  170,  501,  2055,  and  2522  of 

the  Code) 

Prior  loAJt) 
Under  prior  law,  organizations  which  teach  youth  or  which  are 
affiliated  with  charitable  organizations  have  been  able  to  qualify  for 
exemption  under  section  501(c)  (3)  and  have  been  eligible  to  receive 
tax-deductible  contributions.  Other  organizations  which  foster  na- 
tional or  international  amateur  sports  competition  may  be  exempt 
from  taxation  under  other  provisions  (such  as  section  501(c)  (4)  (re- 
lating to  social  welfare  organizations)  or  501(c)(6)  (relating  to 
business  leagues) )  but  often  do  not  qualify  to  receive  tax-deductible 
contributions. 

Reasons  for  change 
Prior  policy  on  the  qualification  for  section  501(c)(3)  status  has 
been  a  source  of  confusion  and  inequity  for  amateur  sports  organiza- 
tions whereby  some  gained  favored  tax-exempt  status  while  others, 
apparently  equally  deserving,  did  not.  The  failure  of  some  of  these  or- 
ganizations to  obtain  section  501  (c)  (3)  status  and  to  qualify  to  receive 
tax-deductible  contributions  has  discouraged  contributions  to  these 
organizations,  and  has  deterred  other  organizations  from  going 
through  the  legal  expense  of  applying  to  the  Internal  Revenue  Service 
for  recognition  of  section  501  (c)(3)  status.  Congress  believes  that  it  is, 
in  general,  appropriate  to  treat  the  fostering  of  national  or  interna- 
tional amateur  sports  competition  as  a  charitable  purpose. 
Congress  believes  that  it  is,  in  general,  appropriate  to  treat  the  foster- 
ing of  national  or  international  amateur  sports  competition  as  a.  chari- 
table purpose. 

ExplaTiation  of  provision 
The  Act  permits  an  organization  the  primary  purpose  of  which  is 
to  foster  national  or  international  amateur  sports  competition  to  qual- 
ify as  an  organization  described  in  section  501(c)  (3)  and  to  receive 
tax-deductible  contributions,  but  only  if  no  part  of  the  organization's 
activities  involves  the  provision  of  athletic  facilities  or  equipment. 
This  restriction  on  the  provision  of  athletic  facilities  and  equipment  is 


424 

intended  to  prevent  the  allowance  of  these  benefits  for  organizations 
which,  like  social  clubs,  provide  facilities  and  equipment  for  their 
members.  This  provision  is  not  intended  to  adversely  affect  the  quali- 
fication for  charitable  tax-exempt  status  or  tax  deductible  contribu- 
tions of  any  organization  which  would  qualify  under  the  standards  of 
prior  law. 

Ejfective  date 
This  provision  applies  on  October  5,  1976  (the  day  following  the 
date  of  enactment) . 

Revenue  ejfect 
It  is  estimated  that  this  provision  will  result  in  a  revenue  loss  of  less 
than  $5  million  annually. 


M.  CAPITAL  GAINS  AND  LOSSES 

1.  Deduction  of  Capital  Losses  Against  Ordinary  Income  (sec. 
1401  of  the  Act  and  sec.  1211  of  the  Code) 

Prior  law 
Capital  losses  of  individuals  are  deductible  in  full  against  capital 
gains,  but  under  prior  law  the  excess  of  capital  losses  over  capital 
gains  could  be  deducted  only  against  up  to  $1,000  of  ordinary  income 
each  year  ($500  for  a  married  person  who  files  a  separate  return). 
Only  50  percent  of  net  long-term  capital  losses  in  excess  of  net  short- 
term  capital  gains  may  be  deducted  from  ordinary  income.  Thus, 
$2,000  of  net  long-term  capital  losses  is  required  to  offset  $1,000  of  ordi- 
nary income.  Capital  losses  in  excess  of  the  limitation  may  be  carried 
over  to  future  years  indefinitely. 

Reasons  for  change 

The  Congress  believed  that  the  $1,000  limit  on  the  deduction  of 
capital  losses  against  ordinary  income,  which  has  been  in  the  law 
since  1942,  was  too  strict.  Consumer  prices  have  risen  significantly 
since  this  limit  was  originally  enacted,  and  taxpayers  who  have  capital 
losses  which  are  not  offset  by  capital  gains  should  be  able  to  deduct  a 
greater  amount  against  ordinary  income. 

Congress  believed,  however,  that  it  is  appropriate  to  retain  some 
limitations  on  the  deduction  of  net  capital  losses  against  ordinary  in- 
come. Because  taxpayers  have  discretion  over  when  they  realize  their 
capital  gains  and  losses,  unlimited  deductibility  of  net  capital  losses 
against  ordinary  income  would  encourage  investors  to  realize  their 
capital  losses  immediately  to  gain  the  benefit  of  the  deduction  against 
ordinary  income  but  to  defer  realization  of  their  capital  gains. 

Explanation  of  provision 
The  Act  increases  the  amount  of  ordinary  income  against  which 
capital  losses  may  be  deducted  from  $1,000  to  $2,000  in  1977  and  to 
$3,000  in  1978  and  future  years.  These  amounts  are  halved  for  married 
persons  who  file  separate  returns.  As  under  prior  law,  only  50  percent 
of  net  long-term  capital  losses  in  excess  of  net  short-term  capital  gains 
may  be  deducted  from  ordinary  income. 

Eifective  date 
This  provision  is  to  apply  to  taxable  years  beginning  after  Decem- 
ber 31, 1976. 

Revenue  effect 
This  provision  will  reduce  receipts  by  $22  million  in  fiscal  year  1977, 
$162  million  in  fiscal  year  1978  and  $273  million  in  fiscal  year  1981. 

(425) 


426 

2.  Increase  in  Holding  Period  for  Long-Term  Capital  Gains  (sec. 
1402  of  the  Act  and  sec.  1222  of  the  Code) 

Prior  law 

Under  prior  law,  gains  or  losses  on  capital  assets  held  for  more  than 
six  montiis  were  considered  long-term  capital  gains  or  losses.  For  in- 
dividuals, 50  percent  of  the  excess  of  net  long-term  capital  gains  over 
net  short-term  capital  losses  is  excluded  from  income,  and  the  excess 
of  net  long-term  capital  losses  over  net  siiort-term  capital  gains  must  be 
reduced  by  50  percent  before  being  deducted  against  ordinary  income 
(up  to  the  $1,000  limitation  whicli  was  raised  to  $3,000  in  this  Act). 
Also,  individuals  may  elect  to  have  the  initial  $50,000  of  net  long-term 
capital  gains  taxed  at  an  alternative  rate  of  25  percent. 

In  the  case  of  corporations,  the  excess  of  net  long-term  capital  gains 
over  net  short-term  capital  losses  is  taxed  at  an  alternative  rate  of  30 
percent,  rather  than  at  the  regular  48-percent  corporate  rate.  How- 
ever, corporations  whose  taxable  incomes  (including  capital  gains) 
are  less  than  $50,000  would  be  taxed  at  the  lower  normal  tax  rates. 

Gains  realized  on  the  sale  or  exchange  of  captial  assets  held  for  not 
more  than  six  months  were  considered  as  short-term  capital  gains  that 
are  not  eligible  for  the  exclusion  or  alternative  rate. 

Reasons  for  change 

A  distinction  is  made  between  short-term  and  long-term  capital 
gains  with  respect  to  two  major  considerations.  In  both  respects, 
careful  examination  of  the  function  of  the  distinction  has  led  Con- 
gress to  the  conclusion  that  the  six-month  holding  period  w  as  inappro- 
priately short. 

First,  the  special  capital  gains  treatment  is  provided  for  long-term 
gains  in  recognition  of  the  fact  the  gain  on  the  sale  of  an  asset  which 
is  attributable  to  the  appreciation  in  value  of  the  asset  over  a  long 
period  of  time  otherwise  would  be  taxed  in  one  year  and,  in  the  case 
of  an  individual,  at  progressive  rates. 

Second,  it  is  argued  that  there  should  be  special  tax  treatment  for 
gains  on  assets  held  for  investment  but  not  on  those  held  for  speculative 
profit.  The  underlying  concept  is  that  a  person  who  holds  an  asset 
for  only  a  short  time  is  primarily  interested  in  obtaining  quick 
gains  from  short-term  market  fluctuations,  which  is  a  distinctively 
speculative  activity.  In  contrast,  the  person  who  holds  an  asset 
for  a  long  time  probably  is  interested  fundamentally  in  the  income 
from  his  investment  and  in  the  long-term  appreciation  value. 

Congress  believed  that  both  of  these  I'easons  for  distinguishing 
between  long-term  and  short-term  capital  gains  suggest  that  the  hold- 
ing period  should  be  one  full  year.  The  six-month  holding  period  cannot 
be  justified  by  the  imfairness  that  results  from  taxing  income  accrued 
over  a  long  period  of  time  in  a  single  yeai-  at  progressive  rates  (the 
so-called  "bunching"  problem).  This  argument  clearly  suggests  a 
holding  period  of  one  year,  since  tax  liability  for  all  other  types  of 
income  is  determined  on  an  annual  basis. 

Also,  while  there  is  no  clearcut  analytical  distinction  between  invest- 
ment and  speculative  gains.  Congress  believed  that  gains  on  assets 


427 

held  between  six  months  and  one  year  are  essentially  similar  in  charac- 
ter to  those  held  less  than  six  months. 

Explanation  of  provision 
The  Act  increases  the  holding  period  defining  long-term  capital 
gains  from  six  months  to  nine  months  in  1977  and  to  one  year  in  1978 
and  future  years.  There  is  a  transitional  rule  for  installment  sales, 
whereby  if  a  gain  would  have  been  long-term  in  the  year  of  the  sale, 
it  is  considered  long-term  even  if  it  is  included  in  income  on  the  install- 
ment basis  in  a  year  in  which  it  would  have  been  considered  short-term. 
Gains  on  agricultural  commodity  futures  contracts  (but  not  options 
on  future  contracts)  are  exempted  from  the  increase  in  the  holding 
period.  The  Act  amends  the  provision  which  required  that  in  certain 
circumstances  timber  cut  durmg  a  taxable  year  received  capital  gain 
treatment  only  if  held  for  6  months  prior  to  that  taxable  year.  Since 
the  Act  increases  this  6-month  period  to  9  months  in  1977  and  for  12 
months  in  subsequent  yeare,  the  requirement  that  the  holding  period 
be  determined  by  the  beginning  of  the  year  of  cutting  is  eliminated. 
Thus,  timber  is  to  have  the  same  holding  period  for  long-term  capital 
gain  treatment  as  all  other  assets  generally. 

Effective  date 

This  provision  is  to  apply  to  taxable  years  beginning  after  Decem- 
ber 31, 1976. 

In  the  case  of  a  short  sale  made  in  a  taxable  year  beginning  in  1976 
and  closed  in  a  taxable  year  beginning  in  1977,  when  the  taxpayer  owns 
substantially  identical  property,  the  property  used  to  close  the  short 
sale  will  have  to  have  been  held  by  the  taxpayer  for  more  than  9  months 
in  order  for  the  gain  or  loss  on  the  short  sale  to  be  long-term.  Similarly, 
for  such  short  sales  "against  the  box"  closed  in  taxable  years  begin- 
ning in  1978,  the  holding  period  must  be  more  than  one  year. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in  tax 
receipts  of  $33  million  for  fiscal  year  1977,  $218  million  for  1978,  and 
$407  million  for  1981. 

3.  Capital  Loss  Carryover  for  Regulated  Investment  Companies 
(sec.  1403  of  the  Act  and  sec.  1212  of  the  Code) 

Prior  law 

Generally,  corporations  may  deduct  their  capital  losses  against  their 
capital  gains  and  may  carry  back  any  excess  capital  losses  3  years  and 
carryover  any  additional  capital  losses  for  up  to  5  years.  In  this  3-year 
carryback  and  5-year  carryforward  period,  corporations  generally 
may  offset  their  net  capital  losses  only  against  their  capital  gains  in 
these  years. 

However,  under  prior  law  regulated  investment  companies  (mutual 
funds)  could  only  carry  over  their  net  capital  losses  for  5  years  and 
were  allowed  no  carryback. 

Reasons  for  change 
Regulated  investment  comj^anies  are  a  way  for  relatively  small  in- 
vestors to  invest  in  common  stocks  and  other  securities.  Generally, 


428 

when  a  regulated  investment  company  distributes  a  substantial  frac- 
tion of  its  income  to  shareholders,  it  is  exempt  from  the  corporate  in- 
come tax.  The  general  intent  of  Congress  has  l)een  that  the  income 
from  these  investments  should  be  treated  as  if  the  individual  share- 
holders were  investing  directly  in  the  securities  that  they  own  through 
the  mutual  fund. 

In  some  respects,  however,  the  law  treats  an  individual  who  invests 
through  a  mutual  fund  more  harshly  than  one  who  invests  directly. 
Regulated  investment  companies  could  carry  their  capital  losses  for- 
ward for  only  five  years,  so  unless  they  had  capital  gains  in  this  period, 
the  individual  shareholders  could  lose  the  benefit  of  deducting  these 
capital  losses  against  capital  gains  received  by  the  mutual  fund.  (When 
they  sell  their  shares  in  the  mutual  fund,  however,  they  may  deduct 
any  capital  loss  on  their  shaies  against  their  other  capital  gains  and  a 
limited  amount  of  ordinary  income.)  Individuals  who  invest  in  securi- 
ties directly,  however,  are  permitted  an  unlimited  capital  loss  carry- 
over and  also  could  deduct  capital  losses  agaijist  up  to  $1,000  of  ordi- 
nary income  each  year  (an  amount  that  is  raised  to  $3,000  in  this  Act). 

Mutual  funds  were  also  treated  more  harshly  than  other  corpora- 
tions which,  in  addition  to  the  5-year  carryover  for  net  capital  losses, 
also  have  a  3-year  carryback  for  such  losses.  Since  mutual  funds  dis- 
tribute most  of  their  capital  gains  currently,  they  could  derive  little 
benefit  from  the  3-year  capital  loss  carryback  even  if  it  were  extended 
to  them.  Thus,  while  corporations  generally  can  net  their  capital  gains 
and  losses  over  a  9-year  period,  regulated  investment  companies  are 
limited  to  a  6-year  period.  In  view  of  this  and  since  regulated  invest- 
ment companies  are  essentially  conduits  for  their  individual  share- 
holders. Congress  believed  it  was  appropriate  to  extend  the  5-year 
carryforward  period  for  capital  losses  by  3  additional  years. 

Explanation  of  frovision 
The  Act  extends  the  capital  loss  carryover  period  for  regulated  in- 
vestment companies  from  five  years  to  eight  years.  To  receive  the  eight- 
year  carryforward,  a  corporation  must  be  a  regulated  investment  com- 
pany in  both  the  year  the  capital  loss  is  incurred  and  the  year  it  is 
deducted. 

Effective  date 

The  eight-year  carryover  is  to  apply  to  loss  years  ending  on  or  after 
January  1, 1970. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  tax 
receipts  of  $13  million  for  fiscal  year  1977,  $21  million  for  1978,  and 
$51  million  for  1981. 

4.  Gain  on  Sale  of  Residence  by  Elderly  (sec.  1404  of  the  Act  and 
sec.  121(b)  of  the  Code) 

Prior  law 
Under  prior  law,  if  a  taxpayer  who  had  attained  age  65  sold  his 
principal  residence,  he  could  exclude  from  income  the  entire  gain  on 


429 

the  sale  if  the  adjusted  sales  price  were  $20,000  or  less.  If  the  adjusted 
sales  price  exceeded  $20,000,  he  could  exclude  that  portion  of  the  gain 
in  the  ratio  of  which  $20,000  bore  to  the  adjusted  sales  price. 

Reasons  for  change 

This  provision  of  prior  law  was  first  enacted  in  the  Revenue  Act  of 
1964. 

The  sale  price  of  homes  has  gone  upward  along  with  the  general  price 
level  since  the  senior  citizen  exclusion  was  instituted  in  1964.  Accord- 
ing to  the  Bureau  of  the  Census,  the  median  sales  price  of  single  family 
homes  in  1964  was  $22,400.  This  figure  reached  more  than  $40,000  in 
1976.  In  other  words,  the  sale  price  of  homes  has  about  doubled 
since  the  exclusion  was  established. 

The  Congress  believed  that  the  exclusion  should  be  increased  to  re- 
store the  senior  citizen's  exclusion  closer  to  its  comparable  level  in 
1964. 

Explmiation  of  provision 
The  Act  increases  from  $20,000  to  $35,000  the  adjusted  sales  price 
limitation  which  determines  the  maximum  amount  which  taxpayers 
age  65  or  over  can  exclude  from  capital  gains  tax  upon  sale  of  principal 
residences. 

Effective  date 
The  provision  applies  to  sales  or  exchanges  occurring  in  taxable 
years  beginning  after  December  31,  1976. 

Revenue  effect 
This  provision  is  expected  to  decrease  revenues  by  $4  million  in  fiscal 
1977  and  $25  million  annually  thereafter. 


N.  PENSION  AND  INSURANCE  TAXATION 

1.  Individual  Retirement  Account  (IRA)  for  Spouse  (sec.  1501  of 
the  Act  and  sec.  220  of  the  Code) 

Prior  law 
Under  prior  law,  the  IRA  deduction  could  not  exceed  $1,500  or  15 
percent  of  compensation  (whichever  is  less),  so  that  a  person  without 
compensation  from  employment  or  self -tni])loyment  was  not  allowed 
an  IRA  deduction.  The  IRA  deduction  wan  not  allowed  to  a  person 
for  a  contribution  to  the  IRA  of  another  person.  Also,  the  IRA  deduc- 
tion for  a  year  was  allowed  only  for  IRA  contributions  made  during 
the  year. 

Reasons  for  change 

Prior  law  did  not  permit  an  employee  to  make  deductible  contribu- 
tions to  an  IRA  for  the  benefit  of  a  spouse  not  working  outside  the 
home.  Consequently  a  spouse  who  did  not  have  income  from  employ- 
ment or  self -employment  did  not  have  equal  access  to  a  tax-deferred 
retirement  program  under  prior  law.  The  Congress  believes  that  this 
was  unfair  to  a  spouse  who  receives  no  compensation  but  performs 
valuable  household  work. 

In  order  to  extend  the  benefits  of  an  IRA  to  homemakers,  the  Con- 
gress added  a  provision  which  permits  employees  to  set  aside  retire- 
ment savings  for  their  uncompensated  spouses. 

Explanation  of  provision 

Under  the  Act,  an  individual  with  compensation  (and  who  is  eli- 
gible to  deduct  IRA  contributions)  can  contribute  up  to  $875  to  his 
own  IRA  and  $875  to  an  IRA  separately  owned  by  his  spouse  or  can 
contribute  up  to  $1,750  to  an  IRA  which  credits  $875  to  a  subaccount 
for  the  husband  and  $875  to  a  subaccount  for  his  wife.  (The  single 
account  with  two  subaccounts  could  be  considered  a  common  inve^- 
ment  fund.) 

Under  the  Act,  an  individual's  earnings  and  the  ownership  of  ac- 
counts (or  subaccounts)  are  determined  without  regard  to  community 
property  laws. 

Although  the  spouses  own  separate  subaccounts,  each  could  have  a 
right  of  survivorship  with  respect  to  the  subaccount  of  the  other.  As 
under  prior  law,  the  deduction  cannot  exceed  15  percent  of  compensa- 
tion. Under  the  Act,  an  IRA  deduction  is  allowed  under  the  new  rules 
or  the  prior  rules  ( but  not  both ) . 

The  expanded  IRA  rules  are  avaihible  for  a  taxable  year  during 
which  only  one  spouse  is  employed  and  the  other  spouse  has  no  earn- 
ings and  is  not  an  active  participant  in  a  tax-favored  retirement  plan 
or  a  government  plan.  For  example,  if  a  husband  works  all  year,  and 
his  wife  receives  no  compensation  and  is  not  an  active  participant  in  a 
plan  at  any  time  during  the  year,  the  expanded  IRA  rules  will  apply. 

(430) 


431 

If  the  spouses  have  different  taxable  years,  the  usual  $1,500  IRA  limit 
will  apply  (rather  than  the  $1,750  limit),  for  example,  to  a  contribu- 
tion by  the  husband  if  his  wife  receives  compensation  during  her  taxa- 
ble year  ending  with  or  within  the  taxable  year  of  her  husband.  If  both 
husband  and  wife  receive  compensation  at  any  time  during  the  taxable 
year,  each  could  deduct  contributions  to  an  IRA  under  the  rules  for  sep- 
arate  IRAs,  if  each  is  otherwise  entitled  to  deduct  such  contributions. 

Under  the  Act,  if  a  contribution  is  made  during  the  first  45  days  of 
a  year  on  account  of  the  previous  year,  the  deduction  for  the  contribu- 
tion is  allowed  for  the  previous  year,  on  the  basis  of  the  facts  and  law 
applicable  for  the  previous  year,  as  if  the  contribution  were  made  on 
the  last  day  of  the  previous  year. 

The  Act  modifies  the  prior  law  under  which  penalties  were  imposed 
on  an  IRA  contribution  in  excess  of  the  deductible  limitations.  Under 
the  Act,  penalties  will  not  be  imposed  if  the  contribution  does  not 
exceed  $1,500  (or  $1,750,  whichever  applies)  and  the  excess  over  15 
percent  of  earnings  is  withdrawn  from  the  IRA  before  the  time  the 
tax  return  for  the  year  of  the  excess  contribution  is  due  (including 
extensions). 

Effective  date 
The  provision  applies  to  taxable  years  beginning  after  December  31, 
1976. 

Revenue  effect 
This  provision  is  expected  to  produce  a  revenue  loss  of  $2  million  in 
fiscal  1977,  $14  million  in  fiscal  1978,  $15  million  in  fiscal  1979,  and  $17 
million  annually  thereafter. 

2.  Limitation  on  Contributions  to  Certain  H.R.  10  Plans  (sec.  1502 
of  the  Act  and  sees.  415(c)  and  404(e)(4)  of  the  Code) 

Prior  law 
Under  prior  law,  a  self-employed  individual  could  set  aside  a  mini- 
mum contribution  of  up  to  $750  of  self-employment  income  in  an 
H.R.  10  plan  without  regard  to  the  rule  generally  limiting  H.R.  10 
plan  contributions  to  15  percent  of  self -employment  income.  HoW' 
ever,  due  to  a  technicality  in  the  law,  a  plan  could  have  been  dis- 
qualified if  the  contribution  exceeded  25  percent  of  the  individual's 
self-employment  income. 

Reasons  for  change 
The  minimum  contribution  rule  was  enacted  in  order  to  enable 
certain  organizations  of  the  self-employed  (such  as  the  Jockeys' 
Guild)  to  set  up  retirement  plans  for  their  members  without  having 
to  confront  complex  recordkeeping  and  administrative  problems,  and 
in  order  to  allow  any  moderate  or  lower  income  self-employed  indi- 
vidual who  wishes  to  do  so  to  save  for  retirement.  The  25-percent  ceil- 
ing on  allocations  under  defined  contribution  plans,  however,  generally 
made  the  $750  limitation  miavailable  to  its  intended  beneficiaries. 

Explanation  of  provision 
The  Act  allows  a  self-employed  individual  to  set  aside  up  to  $750  of 
self -employment  income  in  an  H.R.  10  plan  without  regard  to  the  usual 
15-perc«nt  limitation  or  the  25-percent  limitation.  The  exception  only 


432 

applies  if  the  individual's  adjusted  gross  income  (determined  sepa- 
rately in  the  case  of  a  married  individual,  without  regard  to  the  deduc- 
tion for  the  minimum  contribution,  and  without  regard  to  com- 
mmiity  property  laws)  does  not  exceed  $15,000.  The  $15,000  limit  in- 
sures that  the  provision  is  limited  to  its  intended  beneficiaries — low- 
and  moderate-income  taxpayei-s. 

Effective  date 
The  provision  applies  to  years  beginning  after  December  31,  1975. 

Revenue  effect 
The  revenue  decrease  from  this  provision  is  expected  to  be  negligible. 

3.  Retirement  Deductions  for  Members  of  Armed  Forces 
Reserves,  National  Guard  and  Volunteer  Firefighters  (sec. 
1503  of  the  Act  and  sec.  219(c)  of  the  Code) 

Prior  law 

Prior  law  provided  that  a  participant  in  a  governmental  plan  was 
not  allowed  a  deduction  for  an  IRA  contribution,  so  that  the  deduction 
was  not  allowed  to  members  of  the  Armed  Forces  Reserves  or  National 
Guard  covered  by  a  military  retirement  plan  or  to  members  of  a  volun- 
teer fire  department  covered  by  a  governmental  plan  for  firefighters. 

Reasons  for  change 
The  rule  prohibiting  contributions  to  IRAs  by  a  participant  in  a 
governmental  plan  denied  IRA  deductions  to  member's  of  the  National 
(iruard  and  Armed  Forces  Reser\es  because  tl:ey  were  covered  by  the 
U.S.  military  retirement  plan.  Generally,  under  this  plan,  members  of 
the  Reserves  or  Guard  who  serve  for  less  than  20  years  are  not  entitled 
to  benefits.  Consequently,  many  members  of  the  Reserves  or  Guard 
were  denied  individual  retirement  account  deductions  even  though 
they  will  not  obtain  benefits  undei-  the  (rovernment's  plan. 

The  rule  of  prior  law  also  denied  the  deduction  to  a  person  who 
would  otherwise  qualify  but  who  was  covered  by  a  governmental  plan 
for  volunteer  firefighters.  These  plans  generally  provide  very  small 
benefits ;  yet  under  prior  law  they  precluded  participants  from  estab- 
lishing IRAs. 

Explanation  of  provision 
The  Act  allows  a  member  of  the  Armed  Forces  Reserves  or  National 
Guard  to  qualify  for  an  IRA  deduction  for  a  year  (if  otherwise  quali- 
fied) despite  participation  in  the  military  retirement  plan  if  the  mem- 
ber has  90  or  fewer  days  of  active  duty  (other  than  for  training) 
during  the  year.  It  also  extends  the  deduction  for  contributions  to  an 
IRA  to  an  individual  who  would  be  eligible  for  the  deduction  but  for 
membership  in  a  volunteer  fire  department  or  in  a  governmental  plan 
foi-  volunteer  firefighters.  The  deduction  is  limited  to  firefighters  who 
have  not  accrued  an  annual  benefit  in  excess  of  $1,800  (when  expressed 
as  a  single  life  annuity  payable  at  age  65)  under  a  firefighters'  plan. 

Effective  date 
The  provision  applies  to  taxable  years  beginning  after  December  31, 
1975. 


433 

Revenue  effect 
Tlie  Armed  Forces  Reserves  and  National  Guard  provisions  are 
expected  to  decrease  revenue  by  $6  million  in  fiscal  1977  and  $5  mil- 
lion annually  thereafter.  The  firefighters'  provision  is  expected  to  have 
a  negligible  revenue  impact. 

4.  Tax-Exempt  Annuity  Contracts  in  Closed-End  Mutual  Funds 

(sec.  1504  of  the  Act  and  sec.  403(b)  of  the  Code) 

Pnor  law 
Under  prior  law,  amounts  contributed  by  certain  tax-exempt  orga- 
nizations and  educational  institutions  to  provide  annuities  for  em- 
ployees were  excluded  from  the  income  of  the  employees  but  only  if  the 
contributions  were  invested  in  open -end  mutual  funds  (and  used  to 
provide  a  retirement  benefit),  or  used  to  purchase  annuity  contracts. 
(An  open-end  mutual  fund  is  a  regulated  investment  company  which 
issues  redeemable  shares.)  Contributions  invested  in  a  closed-end  in- 
vestment company  (a  regulated  investment  company  which  does  not 
issue  redeemable  shares)  did  not  qualify  for  this  exclusion. 

Reasons  for  change 
Closed-end  investment  companies  are  regulated  investment  com- 
panies subject  to  the  same  regulation  by  the  Securities  and  Exchange 
Commission  and  the  Internal  Revenue  Service  as  are  open-end  funds, 
and  they  similarly  offer  professional  asset  management  of  a  diversified 
investment  portfolio.  In  addition,  a  closed-end  investment  company 
can  offer  a  retirement  benefit  by  providing  a  stock  disposition  arrange- 
ment under  which  stock  is  sold  by  the  company  on  behalf  of  the  share- 
holders on  a  monthly  basis  without  commissions  and  the  proceeds  are 
remitted  to  the  shareholders  at  a  nominal  charge.  Such  an  arrange- 
ment is  similar  to  the  stock  redemption  arrangements  offered  by  certain 
open-end  mutual  funds  and  can  be  used  to  provide  a  retirement  bene- 
fit. Consequently,  the  exclusion  of  closed-end  investment  companies 
which  provide  retirement  benefits  under  these  rules  did  not  appear  to 
be  appropriate. 

Explanation  of  provision 
The  Act  allows  contributions  for  tax-sheltered  annuities  to  be  made 
to  closed-end  as  well  as  to  open-end  mutual   funds  and  annuity 
contracts. 

Effective  date 
The  provision  applies  to  taxable  years  beginning  after  December  31, 
1975. 

Revenue  effect 
This  provision  is  expected  to  decrease  revenues  by  a  negligible 
amount, 

5.  Pension    Fund    Investments   in    Segregated    Asset    Accounts 

of  Life  Insurance  Companies  (sec.  1505  of  the  Act  and  sec. 
801(g)  of  the  Code) 

Prior  law 
A  segregated  asset  account  can  serve  as  a  life  insurance  company's 
investment  account  and  reserve  for  an  insurance  contract  providing 


434 

for  annuities  under  which  the  premiums  or  benefits  depend  on  the 
performance  of  the  assets  in  the  account.  However,  tlie  Internal  Re- 
venue Service  had  taken  the  position  that  a  segregated  asset  account 
could  be  used  as  the  basis  for  a  reserve  for  a  contract  by  a  particular 
life  insurance  company  only  if  that  life  insurance  company  provided 
annuities  under  the  contract. 

Reasons  for  change 
An  employer  who  wished  to  have  its  qualified  pension  fund  invested 
in  a  segregated  asset  account  held  by  a  particular  life  insurance  com- 
pany but  wished  to  purchase  annuities  from  another  life  insurance 
company  (or  to  provide  annuity  benefits  directly  from  an  employee 
trust)  was  unable  to  do  so  under  the  prior  IRS  position  without  incur- 
ring the  cost  of  compensating  the  holder  of  the  account  for  annuity 
purchase  rate  guarantees  that  would  not  be  utilized.  This  cost  is  unnec- 
essary and  would  not  be  incurred  in  these  circumstances  if  the  holder 
of  the  account  were  not  required  by  the  tax  law  to  provide  annuity 
contracts  with  respect  to  the  account. 

ExplaTiation  of  provision 
The  Act  clarifies  present  law  by  allowing  a  qualified  pension  plan 
to  invest  in  an  insurance  contract  with  a  segregated  asset  account  even 
though  the  contract  does  not  provide  annuities.  Under  the  Act,  a  pen- 
sion fund  can  invest  assets  in  such  an  account  in  lieu  of  a  trust  if  the 
investment  is  otherwise  permitted  under  law.  The  Act  also  clarifies 
the  treatment  of  pension  fund  investments  in  nonsegregat^d  accounts. 
The  provision  does  not  in  any  way  modify  the  requirements  of  title  I 
of  the  Employee  Retirement  Income  Security  Act  which  requires  cer- 
tain pension  plan  assets  to  be  held  in  a  trust. 

Effective  date 
The  provision  applies  for  taxable  years  beginning  after  December  31, 
1975. 

Revenue  effect 
There  is  expected  to  be  no  levenue  effect  from  this  provision. 
6.  Study  of  Salary  Reduction  Pension  Plans  (sec.  1506  of  the  Act) 

Prior  law 
On  December  6,  1972,  the  IRS  issued  proposed  regulations  which 
would  have  changed  the  tax  treatment  of  salary  reduction,  cafeteria, 
and  cash  or  deferred  profit-sharing  plans.  In  order  to  allow  time  for 
Congressional  study  of  these  areas,  section  2006  of  ERISA  provided 
for  a  temporary  freeze  of  the  status  quo  until  December  31,  1976. 

Reasons  for  change 
The  Congress  believes  it  is  not  possible  to  study  adequately  the  ques- 
tions involved  in  order  to  enact  j^ermanent  legislation  regarding  salary 
reduction  and  cash  and  deferred  profit-sharing  plans  prior  to  the  Jan- 
uary 1,  1977  end  of  the  temporary  freeze  of  the  status  quo  provided 
for  in  section  2006  of  ERISA.  Tlie  Congress  therefore  decided  to  ex- 
tend the  time  for  the  Congressional  review  of  the  treatment  of  these 
plans. 


4B5 

Expla')%ation  of  provisimi 
Under  the  Act,  the  temporary  freeze  of  the  status  quo  (under  which 
plans  in  existence  on  June  27,  1974,  are  governed  by  the  law  in  effect 
prior  to  the  1972  proposed  regulations)  is  extended  until  January  1, 
1978. 

Effective  date 
This  provision  is  effective  upon  enactment. 

Revenue  effect 
riiis  provision  has  no  effect  on  revenues. 

7.  Consolidated  Returns  for  Life  and  Mutual  Insurance  Com- 
panies (sec.  1507  of  the  Act  and  sees.  1504(c),  821(d),  and 
1503(c)  of  the  Code) 

Prior  law 
Under  prior  law,  life  insurance  companies  could  not  file  consoli- 
dated returns  with  non-life  companies.  In  addition,  mutual  casualty 
insurers  were  effectively  precluded  from  filing  consolidated  returns 
with  other  types  of  companies. 

Reasons  for  change 

The  present  ban  on  life  companies  filing  consolidated  returns  with 
other  companies  historically  has  been  based  on  the  fact  that  life  insur- 
ance companies  have  been  taxed  quite  differently  from  other  companies. 
In  their  case,  Congress  has  been  concerned  that  in  any  event  a  tax 
should  be  imposed,  at  the  regular  rate,  on  an  amount  approximately 
equal  to  their  taxable  investment  income.  For  this  reason,  for  example, 
limitations  were  imposed  on  the  extent  to  which  policyholder  dividends 
could  in  effect  reduce  taxable  investment  income.  As  a  result,  Congress 
in  the  past  has  not  allowed  life  insurance  companies  to  file  consoli- 
dated returns  with  other  types  of  companies  and  in  this  manner  offset 
their  taxable  investment  income  against  losses  realized  from  other 
types  of  operations. 

It  is  recognized,  however,  that  consolidated  returns  and  offsets  of 
losses  are  allowed  in  the  case  of  many  diverse  types  of  businesses,  some 
of  which  are  also  subject  to  special  tax  provisions.  Moreover,  it  is 
recognized  that  the  recent  recession  and  inflation  in  prices  has  caused 
many  casualty  insurance  companies  to  incur  large  losses.  If  a  stock 
casualty  company  and  a  noninsurance  company  are  affiliated,  they 
can  file  a  consolidated  return  on  which  the  losses  of  the  casualty  com- 
pany are  applied  against  the  other  company's  profits.  However,  if  the 
other  company  is  a  life  insurance  company,  the  losses  of  the  casualty 
company  can  only  be  applied  against  the  casualty  company's  income 
(by  means  of  loss  carryovers  and  carrybacks) ;  they  cannot  be  applied 
against  the  life  company's  income.  Consequently,  the  ban  on  life-non- 
life  consolidations  has  been  a  hardship  for  casualty  companies  which 
are  affiliated  with  life  companies. 

For  these  reasons  Congress  adopted  a  provision  which  preserves 
the  concept  that  some  tax  be  paid  with  respect  to  the  life  insurance 
company's  investment  income  (except  where  the  company  itself  has 


436 

an  overall  loss  from  operations),  but  which  at  the  same  time  provides 
substantial  relief  in  the  future  for  casualty  companies  with  losses. 

Explmiation  of  pravision 

The  Act  allows  mutual  or  stock  life  companies  and  other  mutual 
insurance  companies  to  elect  to  join  in  the  tiling  of  consolidated  re- 
turns with  other  types  of  corporations  which  are  under  the  same 
common  control  and  which  meet  the  stock  ownership  requirements 
of  an  "affiliated  group."  Consolidations  of  life  and  nonlife  com- 
panies however,  are  subject  to  certain  limitations  as  to  the  extent  of 
the  loss  oli'sets  as  indicated  below.  The  filing  of  a  consolidated  return  by 
an  affiliated  group  which  includes  a  life  company  and  a  property-liabil- 
ity company  will  permit  the  tax  savings  from  the  property-liability 
company's  losses  to  be  taken  into  account  sooner  in  computing  its  statu- 
tory surplus. 

Election. — The  Act  provides  that  under  regulations  prescribed  by 
the  Treasury  Department,  the  connnon  parent  of  an  affiliated  group 
which  includes  a  life  company  or  other  mutual  insurance  company 
may  elect  to  include  such  a  company  in  the  filing  of  a  consolidated  re- 
turn with  other  corporations  for  any  taxable  year  beginning  on  or 
after  January  1,  1981.  Once  this  election  is  made,  all  insurance  com- 
panies in  the  affiliated  group,  as  well  as  other  members  of  the  group, 
must  continue  to  tile  consolidated  returns  unless  the  group  obtains  the 
right  to  revoke  its  election  under  the  applicable  I'reasury  Depart- 
ment regulations.  If  this  election  is  not  made,  prior  law  will  continue 
to  apply.  That  is,  in  such  cases  the  life  and  other  mutual  insurance 
companies  will  continue  to  be  treated  as  "nonincludible"  corporations, 
but  under  the  Act  (as  under  prior  law)  two  or  more  life  companies 
(which  meet  the  definition  of  an  "affiliated  group")  may  still  continue 
to  file  a  consolidated  return  with  each  other. 

It  is  understood  that  although  generally  companies  will  probably 
desire  to  file  consolidated  returns  with  life  or  other  mutual  insur- 
ance companies,  some  may  choose  to  continue  to  file  separate  returns 
as  they  did  under  prior  law.  Where  this  occurs,  it  is  likely  to  arise 
from  the  fact  that  the  parent  corporation  (whose  year  the  other  mem- 
bers joining  in  the  filing  of  the  consolidated  return  must  follow)  usCvS 
a  fiscal  year  as  its  taxable  year.  Some  life  companies  may  not  v/ant  to 
adopt  a  taxable  year  other  than  a  calendar  year  since  filings  with  State 
insurance  commissioners  are  required  by  these  life  companies  on  a 
calendar  year  basis. 

To  facilitate  the  filing  of  consolidated  returns  with  life  companies 
where  the  common  parent  has  a  fiscal  year,  the  Act  waives  in  this  case 
the  general  requirement  of  the  tax  law  (sec.  843  of  the  Code)  that 
insurance  companies  must  use  the  calendar  year  as  their  taxable  year. 
However,  the  use  of  a  fiscal  year  by  an  insurance  company  is  not  in- 
tended to  affect  the  applicable  method  of  accounting  required  of  the 
insurance  company  by  the  tax  law  (sulx*hapter  L).  In  this  case  it  is 
expected  that  the  regulations  will  require  the  insurance  companies 
to  maintain  adequate  records  reconciling  all  of  the  items  on  its  fiscal 
year  tax  return  with  the  corresponding  items  on  its  calendar  year 
statements  filed  with  the  State  insurance  commissioners. 


437 

Limitation  on  certain  losses. — Vov  reasons  previously  indicated,  the 
Act  imposes  limitations  on  the  amount  of  consolidated  net  operating 
loss  which  can  be  applied  against  the  income  of  a  life  company.  Under 
the  limitations,  the  amount  of  the  loss  which  may  be  taken  into  account 
in  any  one  year  is  limited  to  ^5  percent  of  the  taxable  income  of  the 
life  companies  included  in  the  group  or  to  bb  percent  of  the  sum  of  the 
losses  for  the  current  year  and  tor  prior  years,  whichever  is  less. 
(For  1981  and  1982,  the  percentages  are  25  percent  and  30  percent, 
respectively.)  The  taxable  income  of  each  life  company  for  this  pur- 
pose is  its  '4ife  insurance  company  taxable  income"  (as  defined  in 
sec.  802  (b)  of  the  Code) ,  but  determined  without  regard  to  its  so-called 
phase  111  income.  Any  portion  of  a  loss  which  is  not  taken  into  account 
because  of  the  limitations  may  be  offset  against  the  income  of  a  life 
company  member  as  a  carryforward,  but  not  as  a  carryback. 

The  limitations  outlined  above  can  be  illustrated  by  an  example. 
Assume  a  life  insurance  company  has  a  subsidiary  (1)  which  is  not 
an  insurance  company,  and  (2)  which  incurs  a  net  oj)erating  loss  of 
$120  in  1985  ($20  of  which  is  absorbed  by  a  carryback  against  the 
subsidiary's  own  prior  year  s  income).  Assume  further  that  the  parent 
company  s  life  insurance  company  taxable  income  for  1985  (deter- 
mined without  regard  to  its  phase  ill  income  under  sec.  802(b)  (3) )  is 
$150.  The  amount  of  the  subsidiary  s  loss  which  can  be  applied  against 
the  parent's  income  for  1985  is  $85  (85  percent  of  the  available  loss), 
since  this  is  less  than  85  percent  of  the  parents  income  for  the  year. 
If  in  1986  the  subsidiary  has  a  net  operating  loss  of  $00  and  the  parent 
lias  taxable  investment  income  of  i|)200  (without  regard  to  its  phase 
ill  income),  the  amount  of  the  loss  offset  for  1986  would  be  $44  (35 
percent  of  the  sum  of  the  curi-ent  year's  loss  and  the  loss  carryover), 
riie  losses  whicli  can  be  carried  over  to  subsequent  years  in  this  case 
follow  the  usual  rules  applicable  to  loss  carryovers  so  that,  for  example, 
the  loss  carryover  to  1987  would  consist  of  a  $65  loss  from  1985  and 
a  $16  loss  from  1986.  (In  subsequent  years,  these  carryovers  would 
be  applied  under  the  usual  rules  so  that  the  carryover  from  1985 
would  be  applied  before  the  carryover  from  1986.) 

If  in  the  above  example  the  parent  had  $80  of  income  in  1986  (rather 
than  $200) ,  the  amount  of  the  loss  oft'set  for  that  year  would  be  limited 
to  $28  (85  percent  of  the  parent's  income  for  the  year),  which  is  less 
than  $44. 

Other-  tmles. — Under  the  Act  the  details  of  the  computation  of  the 
tax  liability  of  an  affiliated  group  which  includes  life  or  other  mutual 
insurance  companies  are  to  be  determined  under  regulations  issued  by 
the  Treasury  Department.  Also,  an  election  to  consolidate  life  and  non- 
life  companies  cannot  be  revoked  without  the  consent  of  the  Internal 
Revenue  Service.  (This  is  the  same  approach  as  is  generally  taken 
under  the  tax  law  with  respect  to  other  affiliated  groups.) 

The  Act  also  provides  that  a  life  company  cannot  file  a  consolidated 
return  w^th  another  type  of  company  unless  they  have  been  affiliated 
for  the  preceding  5  years.  If  a  nonlife  company  joins  in  a  consolidated 
return  with  an  affiliated  group  tliat  includes  a  life  company,  the  losses 
of  that  nonlife  company  cannot  be  offset  against  the  income  of  the  life 
company  unless  the  nonlife  company  has  been  a  member  of  the  group 
for  the  preceding  5  years. 


234-120  O  -  77  -  29 


438 

For  other  mutual  insurance  companies  included  in  the  affiliated 
group  and  included  in  consolidated  returns,  the  Act  requires  that  the 
regular  normal  corporate  tax  rates  apply  rather  than  the  special  rates 
provided  for  small  companies. 

Another  special  rule  makes  it  clear  that  the  enactment  of  the  new 
provisions  is  not  to  result  in  tlie  termination  of  an  affiliated  group.  For 
example,  assume  that  a  life  company  owns  100  percent  of  a  subsidiary 
which  in  turn  owns  100  percent  of  a  second  subsidiary.  Assume  further 
that  the  first  and  second  subsidiaries  are  not  life  companies  but  elect  to 
file  consolidated  returns  under  this  provision.  If  the  life  company  also 
elects  to  join  in  the  filing  of  a  consolidated  return,  then  the  affiliated 
group  of  the  two  subsidiaries  would  not  be  treated  as  having  been 
terminated  (as  a  result,  any  deferred  intercompany  transactions  be- 
tween the  subsidiaries  would  not  be  treated  as  giving  rise  to  taxable 
income). 

Effective  date 

The  Act  is  effective  for  taxable  years  beginning  after  December  31, 
1980.  However,  a  transitional  rule  is  provided  to  limit  the  use  of  carry- 
over of  losses  and  credits  for  pre- 1981  years.  These  carryovers  are 
to  be  treated  as  if  the  Act  had  not  been  enacted.  This  means  that  the 
ability  to  absorb  these  losses  or  credits  is  not  to  be  changed  as  a  result 
of  the  new  election  to  include  life  or  other  mutual  insurance  com- 
panies in  a  consolidated  return  with  other  companies.  The  same  prin- 
ciples also  apply  with  respect  to  losses  and  credits  which  could  other- 
wise be  carried  back  to  pre-1981  years. 

To  illustrate  this  rule,  assume  that  a  noninsurance  company  owns 
both  another  noninsurance  company  and  also  a  life  company.  Assume 
that  the  two  noninsurance  companies  presently  file  consolidated  re- 
turns. If  this  affiliated  group  has  consolidated  net  operating  losses  in 

1980  which  can  be  carried  to  1981,  even  though  an  election  is  made  for 

1981  to  include  the  life  company  in  the  consolidated  return,  the  absorp- 
tion of  this  loss  is  to  be  determined  as  if  the  new  consolidation  rules  do 
not  apply.  This  means  that  the  life  company's  profits  are  not  to  be 
available  to  offset  any  part  of  this  carryover  loss.  In  addition,  if  in 
1981  the  parent  noninsurance  corporation  were  to  acquire  a  profitable 
property-liability  company  (or  other  company  not  directly  affected  by 
the  new  rules)  and  under  normal  consolidated  return  rules  these  profits 
could  be  utilized  in  determining  how  much  of  the  1980  loss  could  be 
absorbed,  the  use  of  these  profits  in  this  manner  would  not  be  affected 
by  the  new  rules.  However,  if  the  life  company  were  to  acquire  this 
profitable  corporation,  its  profits  would  not  be  available  to  offset  the 
noninsurance  company  1980  loss,  because  the  profitable  member  in  this 
case  would  be  a  subsidiary  of  the  life  company  and  would  not  be  treated 
as  a  member  of  the  nonlife  insurance  group. 

Revenue  effect 
There  is  no  revenue  effect  through  fiscal  1981. 

8.  Guaranteed  Renewable  Life  Insurance  Contracts  (sec.  1508  of 
the  Act  and  sec.  809(d)(5)  of  the  Code) 

Prior  law 
Generally,  a  life  insurance  company  can  deduct  10  percent  of  the 
increase  in  its  reserves  for  nonparticipating  contracts  for  a  taxable 


439 

year  or,  if  greater,  3  percent  of  the  premiums  for  the  year  (excluding 
the  portion  of  the  premiums  which  was  allocable  to  annuity  features) 
attributable  to  nonparticipating  contracts  (other  than  group  con- 
tracts)  if  the  policies  are  issued  or  renewed  for  at  least  5  years. 

Reasons  for  change 

Under  prior  law,  controversy  had  arisen  where,  for  example,  a  one- 
year  nonparticipating  tei-m  life  insurance  policy  was  guaranteed  by  the 
life  insurance  company  to  be  renewable  by  the  policyholder  for  five 
years.  The  Internal  Revenue  Service  had  contended  that  because  such 
a  policy  was  issued  and  renewed  for  a  one-year  period,  the  deduction 
for  nonparticipating  policies  was  not  allowable.  Taxpayers  contended 
that  because  of  the  five-year  renewable  right,  the  policy  should  be 
treated  as  a  five-year  policy  and  that  the  deduction  was  therefore 
allowable. 

Explanation  of  provision 

The  Act  provides  that  the  time  for  which  a  policy  is  issued  or  re- 
newed includes  the  period  for  which  the  insurer  guarantees  that  the 
policy  is  renewable  by  the  policyholder. 

Effective  date 
The  provision  is  effective  as  of  the  general  effective  date  of  the  Life 
Insurance  Company  Income  Tax  Act  of  1959;  that  is,  it  applies  to 
taxable  years  beginning  after  December  31, 1957. 

Revenue  effect 
The  revenue  effect  of  this  provision  is  expected  to  be  negligible. 

9.  Study  of  Expanded  Participation  in  Individual   Retirement 
Accounts  (sec,  1509  of  the  Act) 

Prior  7 a  10 
An  individual  who  is  an  active  participant  in  a  qualified  pension, 
etc.,  plan,  a  tax-sheltered  annuity,  or  a  governmental  plan  generally 
cannot  make  deductible  contributions  to  an  IRA. 

Reasons  for  change 
If  an  employee  is  an  active  participant  in  a  qualified  pension  plan, 
he  or  she  is  not  allowed  to  make  deductible  contributions  to  an  IRA  or 
to  the  plan.  Even  though  the  benefits  provided  by  such  a  plan  may  be 
less  than  the  employee  could  provide  under  an  IRA,  the  employee  is 
not  allowed  to  make  up  the  difference  through  deductible  IRA  con- 
tributions or  by  making  deductible  contributions  to  the  plan.  The 
Congress  understands  that,  as  a  result,  some  employees  under  such 
plans  have  withdraAAii  from  active  ])lan  participation  and  additional 
employees  may  begin  to  withdraw  in  the  near  future.  In  some  cases, 
however,  plan  participation  is  mandatory,  and  the  employees  are 
unable  to  withdraw.  It  appears  that  the  problem  may  be  most  acute  for 
plans  established  before  enactment  of  ERISA  because  those  plans 
were  designed  without  taking  IRAs  into  account. 

Explanation  of  provision 
The  Act  provides  that  the  staff  of  the  Joint  Committee  on  Taxation 
is  to  study  the  concept  of  allowing  an  IRA  deduction  to  a  participant 
in  a  qualified  plan  or  tax-sheltered  annuity.  The  staff  is  to  report  its 


440 

findings  to  the  Ways  and  Means  Committee  of  the  House  and  the 
Finance  Committee  of  the  Senate. 

Elective  date 
The  provision  is  effective  upon  enactment. 

Revenue  effect 
This  provision  has  no  revenue  effect. 

10.  Taxable  Status  of  Pension  Benefit  Guaranty  Corporation  (sec. 

1510  of  the  Act  and  sec.  4002(g)(1)  of  the  Employee  Retire- 
ment Income  Security  Act  of  1974) 

Prior  laio 
A  corporation  organized  under  an  Act  of  Congress  is  not  generally 
exempt  from  Federal  taxation  unless  that  Act  so  provides.  The  Pension 
Benefit  Guaranty  Corporation  was  not  specifically  exempted  from 
Federal  taxation  by  ERISA  (The  Employee  Retirement  Income  Se- 
curity Act  of  1974)  .^ 

Reasons  for  change 
The  Congress  intended  the  PBGC  to  be  exempt  from  Federal  taxa- 
tion, but  this  exemption  was  apparently  deleted  from  the  final  bill 
through  an  oversight. 

Explanation  of  provision 

The  Act  amends  ERISA  to  clarify  the  intent  of  Congress  that  the 
Pension  Benefit  Guaranty  Corporation  is  to  be  exempt  from  all  Fed- 
eral taxation  except  taxes  imposed  under  the  Federal  Insurance  Con- 
tributions Act  (social  security  taxes)  and  the  Federal  Unemployment 
Tax  Act  (unemployment  taxes)  .^ 

The  exemption  extends  to  the  PBCxC  both  in  its  corporate  capacity 
and  in  its  capacity  as  a  trustee  for  terminated  retirement  plans.  The 
exemption  extends  to  the  corporation's  property,  franchise,  capital  re- 
serves, surplus,  and  to  its  income.  The  exempt  income  includes,  of 
course,  the  income  earned  by  corporate  investments  out  of  premium 
payments  and  income  earned  by  plans  for  which  the  PB(tC  is  acting 
as  a  fiduciary. 

Effective  date 
The  exemption  applies  from  September  2,  1974  (the  date  of  enact- 
ment of  ERISA) . 

Revenue  effect 
This  provision  is  expected  to  have  no  effect  on  revenue. 

11.  Level  Premium  Plans  Covering  Owner-Employees  (sec.  1511 

of  the  Act  and  sec.  415(c)  of  the  Code) 

Prior  laiu 
An  owner-employee  covered  by  an  H.R.  10  plan  can  contribute  each 
year  an  amount  in  excess  of  the  general  H.R.  10  percentage  limit  (15 


» As  a  practical  matter,  the  PBGC's  Federal  income  tax  liabilities  would  have  been 
primarily  on  account  of  premiums  paid  for  plan  termination  insurance^  coverage  and  in- 
vestment Income  earned  on  these  premiums,  as  well  as  on  account  of  the  investment  income 
earned  through  the  operation  of  terminated  plans  in  the  PBGC's  fiduciary  capacity. 

2  Imposed  under  chapters  21  and  23,  respectively,  of  the  Code. 


441 

percent  of  earned  income)  to  a  plan  funded  with  level  premium  annu- 
ity contracts,  if  the  fixed  premium  does  not  exceed  $7,500  and  does  not 
exceed  the  ownei'-emploj^ee's  three-year  average  of  deductible  amounts. 
The  amount  in  excess  of  15  percent  of  the  owner-employee's  earned 
income  is  not  deductible.  Under  prior  law,  a  separate  provision  for  all 
qualified  plans,  including  level  premium  H.K.  10  plans,  limited  con- 
tributions to  25  percent  of  earned  income. 

Reasotis  for  change 
The  25-percent  overall  limitation  frustrated  the  H.R.  10  plan  provi- 
sions regarding  level  premium  annuity  contracts  which  would  other- 
wise have  permitted  nondeductible  plan  contributions  to  be  made  even 
though  they  exceeded  15  percent  of  the  owner-employee's  earned 
income.  The  Congress  was  concerned  that  if  the  25-percent  rule  had 
not  been  modified,  many  H.R.  10  plans  Avould  not  have  been  able  to 
continue  in  their  present  form. 

Explanation  of  provision 

The  Act  allows  an  owner-employee  to  make  level  payments  to  an 
H.R.  10  plan  under  the  o-year-a^eraging  rules  for  annuity  contracts 
under  an  H.R.  10  plan  witJiout  regard  to  tlie  overall  25  ])ercent  limita- 
tion. The  Act  also  adds  rules  regarding  the  treatment  of  contributions 
under  the  anti-discrimination  rules  applicable  to  ])ension  plans. 

Under  the  provision,  no  other  amounts  can  l)e  added  to  the  owner- 
employee's  account  for  the  year  under  any  other  defined  contribution 
plan  or  tax-sheltered  annuity  maintained  by  the  employer  or  a  related 
employer,  and  the  employee  may  not  be  an  active  participant  for  the 
year  in  a  defined  benefit  plan  maintained  by  the  employei'  or  a  related 
employer.  However,  the  Act  does  not  change  the  overall  limitations 
which  apply  where  an  employee  participates  in  both  a  defined  contri- 
bution plan  and  a  defined  benefit  plan. 

Effective  date 
The  rule  applies  for  years  beginning  after  December  31,  1975  (the 
effective  date  of  the  overall  25-percent  limitation) . 

Revenue  effect 
This  pi^ovision  is  expected  to  decrease  revenues  by  a  negligible 
amount. 

12.  Lump-Sum  Distributions  from  Pension  Plans  (sec.  1512  of 
the  Act  and  sec.  402(e)  (4)  of  the  Code) 

Prior  law 
Under  the  law  as  amended  by  the  Employee  Retirement  Income 
Security  Act  of  1974,  the  part  of  a  lump-sum  distribution  earned 
before  1974  is  treated  as  capital  gain  and  the  post-1973  part  is  taxed,  if 
the  taxpayer  elects,  as  ordinary  income  in  a  "separate  basket'',  with 
10-year  income  averaging.  If  the  election  is  not  made,  the  post-1973 
part  of  the  distribution  is  taxed  as  ordinary  income  under  the  usual 
rules. 

Reasons  for  change 
In  1974,  the  Congress  provided  for  a  phase-out  of  capital  gains 
treatment  for  lump-sum  distributions  and  for  a  phase-in  of  ordi- 


442 

nary  income  treatment  with  10-year  income  averaging.  However, 
because  of  the  changes  made  by  this  Act  (Sec.  301)  in  the  minimum 
tax  provisions,  which  reduce  the  taxpayer's  preference  income  exemp- 
tion and  increase  the  rate  of  minimum  tax  on  all  preference  income, 
including  the  cupital  gains  portion  of  a  lump-sum  distribution,  the 
tax  on  a  lump-sum  distribution  which  is  treated  as  capital  gain  in- 
come could  be  greater  than  if  the  entire  distribution  were  treated  as 
ordinary  income  subject  to  the  10-year  averaging  provisions. 

Both  capital  gains  treatment  and  the  10-year  averaging  rules  are 
intended  to  provide  relief  where  large  pension  distributions,  earned 
over  a  period  of  years,  are  received  in  a  single  year.  These  distribu- 
tions are  made  to  low  paid  employees  as  well  as  high  paid  employees 
and  the  Congress  concluded  that  where  capital  gains  treatment  creates 
a  burden  instead  of  relief,  it  is  appropriate  to  allow  a  taxpayer  to 
elect  to  treat  a  distribution  as  ordinary  income  rather  than  capital 
gains. 

Explanation  of  'provision 
Under  the  Act,  a  taxpayer  who  has  not  treated  any  part  of  a  post- 
1975  lump-sum  distribution  as  capital  gains  may  irrevocably  elect 
to  treat  all  post-1975  lump-sum  distributions  as  if  they  were  earned 
after  1973,  so  that  they  will  be  taxed  as  ordinary  income  and  will 
qualify  for  10-year  income  averaging. 

Effective  date 
The  election  applies  to  distributions  made  after  1975  in  taxable  years 
beginning  after  December  31, 1975. 

Revenue  effect 
This  provision  is  expected  to  decrease  revenue  by  $10  million  an- 
nually in  fiscal  1977  and  1978,  by  $9  million  annually  in  fiscal  1979  and 
1980,  and  by  $8  million  in  fiscal  1981. 


O.  REAL  ESTATE  INVESTMENT  TRUSTS 

Prior  law 

Real  estate  investment  trusts  ("REITs")  are  provided  with  the 
same  general  conduit  treatment  that  is  applied  to  mutual  funds. 
Therefore,  if  a  trust  meets  the  qualifications  for  REIT  status,  the 
income  of  the  REIT  which  is  distributed  to  the  investors  each  year 
generally  is  taxed  to  them  without  bein^  sub j ex-ted  to  a  tax  at  the  REIT 
level  (the  REIT  bein^  subject  to  tax  only  on  the  income  which  it 
retains  and  on  certain  income  from  property  which  qualifies  as  fore- 
closure property).  Thus,  the  REIT  serves  as  a  means  whereby  nu- 
merous small  investors  can  have  a  practical  opportunity  to  invest  in 
the  real  estate  field.  This  allows  these  smaller  investors  to  invest  in  real 
estate  assets  under  professional  management  and  allows  them  to  spread 
the  risk  of  loss  by  the  greater  diversification  of  investment  which  can 
be  secured  through  the  means  of  collectively  financing  projects. 

In  order  to  qualify  for  conduit  treatment,  a  REIT  must  satisfy 
four  tests  on  a  year-by-year  basis :  organizational  structure,  source  of 
income,  nature  of  assets,  and  distribution  of  income.  These  tests 
are  intended  to  allow  the  special  tax  treatment  for  a  REIT  only 
if  there  really  is  a  pooling  of  investment  arrangement  which  is 
evidenced  by  its  organizational  structure,  if  its  investments  are  ba- 
sically in  the  real  estate  field,  and  if  its  income  is  clearly  passive  in- 
come from  real  estate  investment,  as  contrasted  with  income  from 
the  operation  of  business  involving  real  estate.  In  addition,  substan- 
tially all  of  the  income  of  the  REIT  must  be  passed  through  to  its 
shareholders  on  a  current  basis. 

With  respect  to  the  organizational  structure,  a  REIT,  under  prior 
law,  had  to  be  an  unincorporated  trust  or  association  (which  would  be 
taxable  as  a  corporation  but  for  the  REIT  provisions)  managed  by  one 
or  more  trustees,  the  beneficial  ownership  of  which  was  evidenced  by 
transferable  shares  or  certificates  of  ownership  held  by  100  or  more 
persons,  and  which  would  not  be  a  personal  holding  company  even 
if  all  its  adjusted  gross  income  constituted  personal  holding  company 
income. 

With  respect  to  the  incx)me  i-equirements,  at  least  75  percent  of  the 
income  of  tlie  REIT  bad  to  be  from  rents  from  real  property,  interest 
on  obligations  secured  by  real  property,  gain  from  the  sale  or  other 
disposition  of  real  property  (or  interests  therein,  including  mort- 
gages), distributions  from  other  REITs,  gain  from  the  disposition  of 
shares  of  other  REITs,  abatements  or  refunds  of  taxes  on  real  prop- 
erty and  income  and  gain  derived  from  property  which  qualifies  as 
foreclosure  property.  An  additional  15  percent  of  the  REIT's  income 
had  to  come  from  these  sources,  or  from  other  interest,  dividends,  or 
gains  from  the  sale  of  stock  or  securities.  Income  from  the  sale  or  otlier 

(443) 


444 

disposition  of  stock  or  securities  held  less  than  6  months,  or  real 
property  held  less  than  4  years  (except  in  the  case  of  involuntary  con- 
versions), had  to  be  less  than  30  percent  of  the  REIT's  income. 

With  respect  to  the  asset  requirements,  at  the  close  of  each  quarter 
of  its  taxable  year,  a  REIT  had  to  have  at  least  75  percent  of  the  value 
of  its  assets  in  real  estate,  cash  and  cash  items,  and  Government  secu- 
rities. Furthermore,  not  more  than  5  percent  of  the  REIT's  assets  can 
be  in  securities  of  any  one  nongovernment-non  REIT  issuer,  and  such 
holdings  may  not  exceed  10  {percent  of  the  outstanding  voting  securi- 
ties of  such  issuer.  Also,  no  property  of  the  REIT,  other  than  fore- 
closure property,  may  be  held  primarily  for  sale  to  customers. 

In  addition,  a  REIT  is  required  to  distribute  at  least  90  percent  of 
its  income  (other  than  capital  gains  income,  and  certain  net  income 
from  foreclosure  property  less  the  tax  imposed  on  such  income  by 
section  857)  to  its  shareholders  during  the  taxable  year  or,  under  cer- 
tain circumstances,  the  following  taxable  year. 

If  all  of  these  conditions  are  met,  then  the  REIT  generally  is  quali- 
fied for  the  special  conduit  treatment  which  allows  the  income  that  is 
distributed  to  the  shareholders  to  be  taxed  to  them  without  being  sub- 
jected to  a  tax  at  the  trust  level,  so  that  the  REIT  is  only  taxed  on  the 
undistributed  income  and  certain  income  from  foreclosure  property. 
A  REIT  that  does  not  meet  the  requirements  for  qualification  would 
be  taxed  as  a  regular  corporation. 

Reasons  for  change 

Although  the  provisions  have  been  amended  from  time  to  time,  until 
1974  the  basic  rules  with  respect  to  REITs  have  remained  the  same 
since  their  enactment  in  1960.  Since  1960,  the  REIT  industry  has 
grown  enormously  in  size  and  is  responsible  for  a  large  portion  of  the 
investment  in  the  real  estate  field  in  the  United  States  today.  There 
are,  however,  certain  problems  that  have  arisen  with  respect  to  the 
REIT  provisions  which  could  significantly  affect  the  industry  if  these 
provisions  are  not  modified. 

In  1974,  as  part  of  Public  Law  93-625,  the  Congi^ess  dealt  with  one 
of  these  problems,  i,e,,  the  difficulty  which  a  REIT  may  have  in  meet- 
ing the  income  and  asset  tests  if  it  must  foreclose  on  a  mortgage  that  it 
owns  or  reacquire  property  which  it  owms  and  has  leased.  Undei-  that 
Act,  in  general,  a  REIT  is  not  disqualified  because  of  income  it  receives 
from  foreclosure  property,  since  acquisition  of  property  on  foreclosure 
generally  is  inadvertent  on  the  part  of  the  mortgagee.  k.t  the  election 
of  a  REIT,  a  two-year  grace  period  (generally  subject  to  two  one- 
year  extensions)  is  allowed  so  that  the  REIT  can  liquidate  the  fore- 
closed property  in  an  orderly  manner  or  negotiate  changes,  {e.g.,  in 
leases  on  the  property)  so  that  income  from  the  property  becomes 
qualified.  However,  during  the  grace  period  the  REIT  must  pay  the 
corporate  tax  on  the  otherwise  nonqualified  income  received  from 
property  acquired  on  foreclosure. 

Certain  other  problems  remained  in  this  area,  however.  Basically, 
these  problems  related  to  the  fact  that,  under  prior  law,  if  a  REIT 
did  not  meet  the  various  income,  asset,  and  distribution  tests,  the 
REIT  would  be  disqualified  from  using  the  special  tax  provisions  even 
in  cases  where  the  failure  to  meet  a  test  occurred  after  a  good  faith. 


44i5 

reasonable  effort  on  the  part  of  the  EEIT  to  comply.  Disqualification 
would  have  the  effect  of  not  only  changing  the  tax  status  of  the  EEIT 
itself,  subjecting  its  income  to  'tax  at  corporate  rates,  but  also  could 
adversely  affect  the  interests  of  the  public  shareholders  of  the  REIT. 
The  Congress  believed  that  it  is  not  appropriate  to  disqualify  a  REIT 
in  such  circumstances. 

Explanation  of  provifiioris 
1.  Deficiency  Dividend  Procedure  (sec.  1601  of  the  Act  and  sec. 
859  of  the  Code) 

As  described  above,  to  qualify  as  a  REIT  a  trust  must  operate  as  a 
conduit  for  the  income  it  earns,"distributing  at  least  90  percent  ^  of  its 
annual  income  to  its  sliareholders.  However,  under  prior  law,  even 
wliere  a  REIT  believed  in  good  faith  that  it  has  satisfied  this  test,  it 
could  be  disqualified  as  a  result  of  an  audit  by  the  Internal  Revenue 
Service  which  increased  the  amount  of  income  that  foi-ms  the  base  for 
the  90-percent  distribution  requirement.  For  example,  a  REIT's  de- 
preciation allowance  for  an  asset  may  be  unclear  (e.g.,  because  of  a 
problem  in  determining  the  useful  life  of  an  asset  or  in  allocating  the 
cost  of  rental  property  between  land  and  improvements)  and  the  de- 
preciation taken  by  the  REIT  may  be  determined  to  be  too  high  by  the 
Internal  Revenue*  Service  in  a  subsequent  year.  In  such  a  case,  the 
REIT  would  liave  lost  its  qualification  if  its  real  estate  investnient 
trust  taxable  income  was  increased  to  such  an  extent  that  its  previous 
dividend  distributions  for  tlie  year  in  question  became  less  than  90 
percent  of  its  real  estate  investment  trust  taxable  income  as  deter- 
mined after  audit.  On  disqualification  as  a  REIT,  the  trust  would 
have  been  subject  to  tax  as  any  other  corporation,  even  though  it  pre- 
viously may  have  distributed  "most  of  its  income  for  the  year  in  ques- 
tion to  its  shareholders. 

The  Congress  believed  that  where  a  REIT  originally  acted  without 
fraud  in  determining  and  reporting  its  income  and  dividend  distribu- 
tions, the  sanction  of  disqualification  was  too  severe.  For  this  reason, 
the  Congress  believed  that  if  a  REIT  is  audited  by  the  Internal  Rev- 
enue Service  and  there  is  a  resulting  adjustment  that  would  increase 
the  amount  of  dividends  that  must  be  paid  for  the  year  under  audit 
for  the  trust  to  meet  the  90-percent  distribution  requirement,  the  trust 
should  be  allowed  to  pay  out  deficiency  dividends  to  its  shareholders 
and  thereby  avoid  disqualification.  This  deficiency  dividend  procedure 
is  only  to  be  available  where  failure  of  the  REIT  to  meet  the  90  per- 
cent distribution  requirement  was  not  due  to  fraud  with  intent  to 
evade  tax  or  to  willful  failure  to  file  an  income  tax  return  within  the 
required  time. 

The  Act  provides  that  where,  as  a  consequence  of  an  audit  hy  the 
Internal  Revenue  Service,  there  has  been  a  "determination"  that  an 
adjustment  is  to  be  made,  the  trust  may  pay  a  deficiency  dividend  to 
its  shareholders  and  receive  a  deduction  for  such  distributions.  If  the 
proper  amount  is  distributed  as  a  deficiency  dividend,  the  REIT  would 

1  As  described  below,  the  Act  increases  the  distribution  requirement  to  95  percent  for 
taxable  years  beginning  after  December  1,  1979.  In  this  explanation,  the  requirement  Is 
referred  to  as  the  '•90-percent  distribution  requirement". 


446 

not  be  disqualified  or  be  subject  to  tax  on  the  amounts  distributed 
(other  than  interest  and  penalties,  as  described  below)  ? 

For  these  purposes,  an  "adjustment",  which  will  allow  a  REIT  to 
follow  the  deficiency  dividend  procedure,  is  defined  under  the  Act 
to  include  an  increase  in  the  sum  of  the  REIT's  real  estate  investment 
trust  taxable  income  (determined  without  regard  to  the  deduction 
for  dividends  paid)  and  the  net  after-tax  income  from  foreclosure 
property.  An  "adjustment"'  also  is  defined  to  include  any  decrease  in 
the  deduction  for  dividends  paid  (determined  without  regard  to  capi- 
tal gains  dividends).  Any  change  on  audit  in  these  amounts  either  may 
increase  the  amount  of  dividends  that  must  be  paid  to  meet  the  90- 
percent  distribution  requirement  or  may  decrease  the  amount  of 
dividends  previously  thought  to  have  been  paid,  affecting  the  ability 
of  the  REIT  to  meet  the  distribution  requirement.^ 

Such  an  increase  in  income,  etc.,  need  not  cause  the  REIT  to  fail 
the  90-percent  distribution  requirement  for  the  deficiency  dividend 
procedure  to  be  available.  The  deficiency  dividend  procedure  also  is 
to  be  available  to  enable  a  trust  to  maintain  the  level  of  distribution 
that  it  originally  had  thought  it  had  achieved.  On  the  other  hand,  a 
deficiency  dividend  cannot  exceed  the  net  adjustment  that  occurs  on 
audit. 

For  example,  assume  that  a  REIT  reported  real  estate  investment 
trust  taxable  income  of  $100  for  the  year,  and  had  distributed  divi- 
dends of  $90  with  regard  to  that  year,  but  on  audit  it  was  determined 
that  the  REIT  had  $110  of  real  estate  investment  trust  taxable  income 
for  that  year.  In  this  case,  the  REIT  could  pay  a  deficiency  dividend 
of  up  to  $10,  which  is  the  amount  of  the  adjustment,  though  only  a 
$9  deficiency  dividend  would  be  required  to  enable  the  REIT  to  meet 
the  income  distribution  requirements  for  that  year.  Thus,  the  REIT 
could  pay  a  deficiencv  dividend  sufficiently  large  so  it  would  not  have 
to  pay  any  additional  corporate  income  tax  (as  opposed  to  interest  and 
penalties)  as  a  result  of  the  determination.  However,  the  REIT  could 
not  receive  a  deficiency  dividend  deduction  for  $11  since  this  is  greater 
than  the  amount  of  the  adjustment  and  would  decrease  the  corporate 
tax  previously  paid  on  the  $10  originally  reported  and  treated  as 
taxable.* 

Capital  gains. — A  REIT  is  required  to  pay  a  capital  gains  tax  on 
any  excess  of  net  long-term  capital  gains  over  the  sum  of  net  short- 
tenn  capital  loss  and  the  deduction  for  capital  gains  dividends  paid 
to  its  shareholders.  Capital  gains  dividends  must  be  designated  as  such 
within  30  days  after  the  close  of  the  taxable  year  in  which  the  income 

-  Following  the  personal  holding  company  provisions  of  present  law,  the  Act  provides 
that  a  "determination"  is  to  be  a  decision  by  the  Tax  Court  (or  order  by  any  other  court 
of  competent  jurisdiction)  which  has  become  final,  a  closing  agreement  under  section 
7121,  or  an  agreement  (under  regulations)  between  the  Internal  Revenue  Service  and 
the  trust  regarding  the  liability  of  the  trust  for  tax. 

2  In  addition,  if  on  audit  it  is  determined  that  there  is  an  Increase  In  the  net  long-term 
capital  gains  over  net  short-term  capital  loss  and  over  the  deduction  for  capital  gains 
dividends,  this  Increase  will  be  an  adjustment  for  purposes  of  the  capital  gains  rules  of 
the  REIT  provisions,  as  discussed  below. 

*  Also,  if  this  REIT  had  originally  paid  out  a  dividend  of  $99,  it  would  be  able  to  pay  a 
deficiency  dividend  of  up  to  $10,  for  a  total  distribution  of  up  to  $109.  In  this  way.  the 
REIT  would  not  be  subject  to  tax  on  additional  income  determined  on  audit.  However,  in 
this  case,  the  REIT  would  not  have  to  pay  any  deficiency  dividend  to  avoid  disqualification 
since  it  still  would  have  met  the  90-percent  distribution  requirement  even  after  the  adjust- 
ment and,  therefore,  may  chose  not  to  pay  any  additional  amounts  under  the  deficiency 
dividend  procedure. 


447 

is  recognized.  Consequently,  under  prior  law,  if  it  were  determined  on 
audit  that  a  REIT  had  additional  capital  gains,  the  REIT  would  not 
be  able  to  make  a  timely  designation  of  a  capital  gains  dividend,  dis- 
tribute this  income,  and  aA^oid  paying  capital  gains  tax.  Also,  even  if 
the  REIT  had  previously  reported  this  income  as  ordinary  income 
and  distributed  90  percent  of  it  as  dividends  fo  shareholders,  the 
REIT  still  was  subject  to  capital  gains  tax  on  this  amourit  upon  a 
determination  that  the  income  was  capital  gains  (since  a  timely  desig- 
nation of  capital  gains  dividends  could  not  be  made). 

To  correct  this  situation,  the  Act  provides  that  an  "adjustment" 
which  will  allow  the  deficiency  dividend  procedure  to  be  used  is  to  in- 
clude an  increase  (by  a  determination)  in  the  excess  of  the  net  long- 
term  capital  gains  over  the  simi  of  the  net  short-term  capital  loss  and 
the  deduction  for  capital  gains  dividends  paid.  Therefore,  if  net  long- 
term  capita]  gains  are  increased  as  the  result  of  an  audit,  the  REIT  can 
choose  to  distribute  up  to  the  amount  of  this  increase  to  its  sharehold- 
ers and  avoid  paying  capital  gains  tax  on  this  amount.  Also,  if  the 
REIT  had  originally  reported  this  amount  as  ordinary  income  and 
previously  had  made  a  timely  distribution  of  this  income,  the  REIT 
is  to  be  able  to  redesignate  the  previous  distribution  as  a  capital  gains 
distribution  and  avoid  paying  the  capita]  gains  tax. 

Where  there  is  a  redesignation  of  a  prior  distribution  as  either 
ordinary  income  or  capital  gain,  the  shareholder  is  rex]uired  to  re- 
compute his  tax  accordingly  so  long  as  the  statute  of  limitations  has 
not  expired  for  that  shareliolder.  In  addition,  the  Act  provides  that 
the  deficiency  dividend  will  be  treated  as  a  dividend  by  both  the  trust 
and  the  shareholder  even  though  the  trust  does  not  have  sufficient  earn- 
ings and  profits  at  the  time  of  the  distribution. 

Fraud. — Under  the  Act,  tlie  deficiency  dividend  deduction  is  to  be 
available  only  if  the  entire  amount  of  the  adjustment  was  not  due  to 
fraud  with  intent  to  evade  tax  or  to  v\'iriful  failure  to  file  an  income  tax 
return  within  the  required  time.  The  question  of  whether  the  failure 
to  meet  the  dividend  distribution  requirement  is  due  to  fraud  will  de- 
pend on  all  the  facts  and  circumstances. 

Interest  and  Penalties. — Tlie  interest  and  penalty  provisions  of  the 
Act  with  respect  to  deficiency  dividends  are  designed  to  recover  lost 
revenues  to  tlie  government  as  well  as  to  assure  that  a  REIT  (1)  will 
be  operated  as  a  conduit  of  income  to  its  shareholders  and  (2)  will  not 
reduce  its  distributions  of  income  in  reliance  on  the  availability  of  the 
deficiency  dividend  procedure.  Under  the  Act,  interest  and  penalties 
are  determined  with  respect  to  the  amount  of  the  adjustment,''  but  only 
to  the  extent  that  the  deficiency  dividend  deduction  is  allowed.  For 
example,  assume  that  the  REIT's  real  estate  investment  tru^t  taxable 
income  was  reported  at  $100,  that  the  REIT  had  distributed  $98.  and 
that  after  audit  it  was  determined  that  tlie  correct  amount  of  real  estate 
investment  trust  taxable  income  was  $120  so  that  the  REITsl)ould  have 
distributed  at  least  $108.  If  the  REIT  utilizes  the  deficiency  divided 
procedure  and  distributes  an  additional  $10.  tlie  interest  and  penalty 

^  For  this  purpose,  the  amount  of  the  adjustment  would  include  adjustments  attributa- 
ble  both  to  ordinary  Income  and  capital  pains.  However,  no  interest  and  penalty  are 
assessed  in  the  event  of  the  late  designation  of  a  capital  gains  dividend  where  the  amount 
was  distributed  previously  as  an  ordinary  income  distribution. 


448 

will  be  based  upon  $10,  the  amount  for  which  a  deficiency  dividend 
deduction  is  allowed. 

By  usin.^  the  amount  of  the  deficiency  dividend  as  the  base,  the 
Act  assures  that  the  net  cost  to  the  REIT  of  borrowing  money  from 
its  shareholders  (that  is,  the  net  cost  of  underdistributions)  is  high 
enough  to  discourage  such  action  and  to  encourage  the  distribution 
of  earnings  to  shareholders  currently. 

Under  the  Act,  interest  on  the  amount  of  the  deficiency  dividend 
is  to  run  from  the  last  day  (without  extension  of  time)  for  the  REIT 
to  file  a  tax  return  for  the  year  in  question  until  the  date  the  claim 
for  the  deficiency  dividend  deduction  is  filed.  In  addition,  a  non- 
deductible penalty  equal  to  the  amount  of  interest  is  to  be  paid.  How- 
ever, the  total  penalty  is  not  to  exceed  one-half  the  amount  of  the 
•deficiency  dividend  deduction.^  Under  the  Act,  the  (deductible) 
interest  charge  is  to  be  the  same  as  in  the  case  of  other  deficiencies 
and  the  penalty  is  to  be  the  same  amount,  for  an  approximate  net- 
after-tax  total  (under  current  interest  rates)  of  lOi^  percent  of  the 
deficiency  dividend  deduction  per  annum. 

Ejfect  on  otlier  years. — The  Act  provides  that  the  amount  of  the 
deficiency  dividend  is  taxable  to  the  shareholder  for  the  shareholder's 
taxable  year  in  which  the  distribution  is  made  (not  the  year  for 
which  it  is  made).  For  example,  if  a  shareholder  receives  a  deficiency 
dividend  in  1980,  with  respect  to  the  year  1977,  this  dividend  is  includ- 
ible in  income  for  1980,  and  shareholders  are  not  to  file  amended  re- 
turns for  1977  to  take  account  of  the  dividend.  It  is  expected  that, 
in  this  case,  the  deficiency  dividend  will  be  paid  to  the  1980  share- 
holders, even  if  they  were  not  shareholders  in  1977. 

To  avoid  double  counting,  deficiency  dividends  are  not  to  count 
toward  the  dividends  paid  deduction  for  the  year  in  which  the  defi- 
ciency dividends  are  actually  paid,  but  are  only  to  count  toward  the 
year  affected  by  the  determination.  Also,  deficiency  dividends  are  not 
to  count  toward  the  dividend  deduction  (under  section  858)  for  the 
taxable  year  preceding  the  year  of  payment.  For  example,  if  $10  of 
deficiency  dividends  are  paid  in  1980  on  account  of  a  determination 
involving  the  year  1977,  the  deficiency  dividends  are  not  to  count 
toward  the  dividends  paid  deduction  for  1980  or  for  1979,  but  are 
to  be  treated  only  as  dividends  paid  with  respect  to  1977. 

Technical  requirements. — For  the  deficiency  dividend  deduction  to 
be  available,  the  trust  must  pay  the  deficiency  dividend  to  its  share- 
holders within  90  days  after  the  determination.  To  qualify  as  a  defi- 
ciency dividend,  the  dividends  paid  must  be  of  the  same  type  that 
would  qualify  for  the  dividends  paid  deduction  under  section  561,  if 
they  had  been  distributed  during  the  taxable  year  in  issue.  Also,  the 
trust  must  (under  regulations)  file  a  claim  for  the  deduction  within 
120  days  after  the  determination.  (These  provisions  are  similar  to  the 
provisions  of  existing  law  with  respect  to  personal  holding  company 
deficiency  dividends. ) 

Under  the  Act,  a  REIT  will  have  two  years  after  the  date  of  a 
determination  to  file  a  claim  for  refvmd  for  the  taxable  year  in  issue 

*  Under  the  Act  payment  of  the  penalty  portion  decreases  the  base  for  the  90-percent 
distribution  requirement  In  the  year  the  interest  and  penalty  are  paid.  The  interest  portion 
is  automatically  taken  into  account  in  computing  the  base  since  it  is  deductible. 


449 

where  alloAvance  of  a  deficiency  dividend  results  in  an  overpayment 
of  tax.  Also,  if  a  REIT  files  a  claim  for  a  deficiency  dividend  deduc- 
tion, the  runninji-  of  the  period  of  limitations  for  making  assessments, 
bring^ing  a  suit  for  collection,  etc.,  is  to  be  suspended  for  two  years 
after  the  date  of  the  determination. 

Where  there  is  a  deitermination  of  a  deficiency  under  these  provi- 
sions, collection,  interest,  penalties,  etc.,  are  to  be  stayed  for  120  days 
after  the  determination  (except  in  cases  of  jeopardy).  Also,  as  in  the 
case  of  deficiency  dividends  paid  by  a  pei^onal  holding  conipany,  if 
a  claim  for  a  deficiency  dividend  deduction  is  filed,  collection  of  the 
remaining  deficiency  is  to  be  stayed  until  the  claim  is  disalloAved. 

Increase  in  dhtnhuUon  rcgmrement. — Since  the  deficiency  dividend 
procedure  will  eliminate  the  risk  of  inadvertent  disqualification 
through  failure  to  meet  tlie  distribution  te^,  the  Act  increases  the  por- 
tion of  its  income  which  a  REIT  must  distribute  from  90  to  95  per- 
cent for  taxable  yeare  ending  after  December  31,  1979.  Tlie  Congress 
believes  it  is  appropriate  to  delay  the  effective  date  of  this  increase  in 
order  t-o  allow  REITs  which  may  have  restrictions  in  their  credit 
agreements  relating  to  dividend  distiibutions  an  opportunity  to  nego- 
tiate modifications  of  such  agreements. 

2.  Distributions  of  REIT  Taxable  Income  After  Close  of  Taxable 
Year  (sees.  1604  and  1605  of  the  Act  and  sees.  858,  860,  4981 
of  the  Code) 

Excise  fax  on  REIT  taxahle  income  not  distributed  during  the  tax- 
able yea?'.— Under  prior  LaA\,  a  REIT  was  required  to  declare  a  divid- 
end for  a  taxable  year  by  the  due  date  for  filing  the  return  for  that 
year,  but  the  RP^IT  could  delay  actual  payment  of  the  dividend  for  12 
months  after  the  close  of  the  taxable  year.  For  example,  if  a  REIT 
were  on  a  calendar  year  basis,  dividends  for  1973  did  not  have  to  be 
paid  until  December  31,  1974.  (These  dividends  are  hereafter  called 
"section  858  dividends"  since  a  deduction  Avith  respect  to  sucli  divid- 
ends is  allowed  under  section  858  of  the  Code.) 

In  general,  the  policy  underlying  the  conduit  treatment  of  REITs 
is  that  either  the  REIT  or  its  shareholders  will  be  currently  taxable 
on  the  income  earned  by  the  REIT.  But  this  policy  was  not  fulfilled 
where  there  was  a  substantial  use  of  section  858  dividends  by  the  REIT 
prior  to  distribution  because  no  charge  was  imposed  for  the  one-year 
delay  in  payment  of  the  dividend  even  though,  during  this  year, 
neither  the  REIT  nor  its  shareholders  are  liable  for  tax  on  the  REIT 
income.  Through  a  repeated  use  of  the  section  858  dividends  proce- 
dure, there  could  be  a  permanent  loss  of  revenue  (a  pennanent  one- 
year  delay). 

To  meet  this  situation,  the  Act  establishes  an  excise  tax  on  late 
distributions  of  income  in  order  to  prevent  this  loss  of  revenue  to  the 
Treasury.  In  order  to  avoid  the  excise  tax,  a  REIT  is  required  to  dis- 
tribute at  least  75  percent  of  its  real  estate  investment  trust  taxable 
income  as  reported  on  its  return  by  the  close  of  its  taxable  year.  If, 
by  the  end  of  its  taxable  year,  the  REIT  has  distributed  less  than 
75  percent  of  its  real  estate  investment  trust  taxable  income  (as  re- 
ported on  its  return),  it  is  to  be  subject  to  a  nondeductible  3  percent 
excise  tax  on  the  difference  between  75  percent  of  this  income  and  the 


450 

amount  distributed.  For  example,  if  a  REIT  reports  real  estate  in- 
vestment trust  taxable  income  of  $100  for  taxable  year  1980  and  dis- 
tributes $70  of  dividends  by  the  end  of  this  taxable  year,  it  will  be 
subject  to  a  nondeductible  3  percent  excise  tax  on  $5,  which  is  the 
amount  by  which  the  distribution  falls  short  of  75  percent  by  the  end 
of  the  taxable  year,'  The  3-peirent  chai'oe  is  to  be  a  one-time  char<»:e 
without  regard  to  the  date  of  the  later  distribution.  (However,  the 
RETT  must  meet  the  90-percont  distribution  test  within  12  months 
after  the  close  of  the  taxable  year  in  question  if  the  trust  is  to  qualify 
as  a  REIT,)  This  3-percent  excise  tax  is  to  apply  to  taxable  yeai*s 
beginning-  after  December  31, 1979. 

Adoption  of  anmial  accounting  period. — If  a  REIT's  shareholders 
are  on  the  calendar  year  for  reporting  income  and  the  REIT  is  on  a 
fiscal  year,  the  RP^IT,  by  waiting  until  the  end  of  its  year  to  distribute 
income  to  its  shareholders,  in  many  circumstances  could  allow"  its 
shareholders  a  two-year  delay  in  reporting  this  income.  To  avoid 
a  potential  two-year  delay  in  levenue  m  the  future,  the  Act  provides 
that  a  REIT  is  not  to  adopt  in  the  future  (or  change  to  in  the  future) 
any  annual  accounting  period  other  than  the  calendar  year. 

Divi/f^fid.9  paid  hy  REIT  after  close  of  taxahJe  year. — Under  prior 
law,  a  RP^IT  could,  to  a  substantial  extent,  avoid  an  underdistribution 
of  a  prior  year's  income  if  it  made  a  "contingent"  section  858  election. 
Such  a  "contingent"  election  was  made  when  the  REIT  elected  to  have 
a  dividend  relate  to  a  prior  year  only  to  the  extent  to  which  earnings 
and  profits  from  that  prior  year  remain  undistributed.  Thus,  by  de- 
claring a  section  858  dividend,  a  REIT  could  be  "covei^"  for  two 
veal's.  This  may  have  been  needed  under  prior  law  where  there  was  no 
deficiency  dividend  procedure.  However,  this  is  no  longer  ne^^essary 
or  appropriate  with  the  deficiency  dividend  pi-ocedures  established  by 
the  Act.  Moreover,  this  rather  loose  accounting  procedure  facilitated 
the  ]iossibility  that  a  REIT  could  delay  distribution  of  its  income  to 
its  shareholders,  and  thus  delay  the  date  on  which  shareholders  must 
include  such  dividends  in  income. 

With  the  new  deficiency  dividend  procedure  provided  by  the  Act., 
it  is  inappropriate  to  continue  the  use  of  section  858  dividends  as  a 
w^a}^  to  avoid  problems  from  an  underdistribution  of  a  prior  year's 
income.  Consequently,  the  Act  amends  section  858  to  explicitly  pro- 
vide that  the  amount  allowed  as  a  section  858  dividend  is  to  relate  only 
to  the  prior  taxable  year  and  is  not  in  any  event  also  to  relate  to  the 
taxable  year  in  which  the  dividend  is  paid.  Also,  under  the  Act,  a  sec- 
tion 858  dividend  is  to  be  stated  in  a  dollar  amount.  The  amount  so 
stated  is  to  be  the  only  amount  of  dividends  paid  during  the  year  of 
payment  which  relates  ro  the  prior  year,  and  that  amount  is  to  be  a 
dividend  only  for  the  prior  year  and  not  for  the  year  in  which  paid. 

For  example,  in  1977  a  REIT  with  a  calendar  taxable  year  has  $100 
of  real  estate  investment  trust  taxable  income  and  pays  a  dividend  of 
$75  in  1978.  In  order  to  meet  its  90-percent  distribution  requirement 
for  1977,  the  REIT  declares  and  pays  $15  as  a  section  858  dividend. 


^  Ainoniits  counted  toward  the  75-percent  requirement  are  only  to  be  amounts  that 
qualify  for  the  dividends  paid  deduction  for  the  current  year.  Therefore,  any  section  85S 
dividends  or  deliciency  dividends  (which  are  to  relate  only  to  a  prior  year)  are  not  to  be 
counted  toward  this  75-percent  requirement. 


451 

For  the  dividend  to  qualify  under  section  858,  the  REIT  must  specify 
that  the  dividend  is  a  section  858  dividend  for  1977  and  that  it  is  in 
tlie  amount  of  $15.  Tliis  amount,  then,  is  to  relate  only  to  1977  and  not 
to  1978.  The  excise  tax  is  effective  only  after  Decembei-  31,  1979.  In 
1978,  the  REIT  also  has  $100  real  estate  investment  trust  taxable  in- 
come To  avoid  paying  the  excise  tax  on  late  distributions  for  1978, 
the  REIT  nuist  distribute  $75  in  1978.  Therefore,  in  1978,  the  REIT 
would  have  to  distribute  $15  (as  a  section  858  dividend  for  1977)  plus 
$75  (as  a  dividend  foi-  1978)  for  a  total  of  $90  actually  paid  as  divi- 
dends in  1978  in  order  to  me^'t  its  90-percent  distribution  requirements 
for  1977. 

3.  Property  Held  for  Sale  (sec.  1603  of  the  Act  and  sees.  856  and 
857  of  the  Code) 

Prior  law  prohibited  a  REIT  from  holding  property,  other  than 
property  qualifying  as  foreclosure  property,  for  sale  to  customers. 
This  rule  was  difficult  to  apply  because  of  the  absolute  prohibition 
on  holding  such  property  and  because  of  problems  involved  in  deter- 
mining when  a  REIT  holds  property  for  sale. 

Because  of  these  problems,  the  Act  eliminates  tlie  flat  prohibition 
against  a  REIT  holding  property  primarily  for  sale  to  customers  in 
the  ordinary  course  of  its  trade  or  business.  Under  the  Act,  the  sale 
or  other  disposition  of  property  described  in  section  1221(1)  of  the 
Code  is  called  as  a  prohibited  transaction  and  the  net  income  from 
such  transactions  is  taxed  at  a  rate  of  100  percent.  Net  income  or  net 
loss  from  prohibited  transactions  is  determined  by  aggregating  all 
gains  from  the  sale  or  other  disposition  of  property  (other  than  fore- 
closure property)  described  in  section  1221  (1)  with  all  losses  and  other 
deductions  allowed  by  chapter  1  of  the  Code  which  are  directly  con- 
nected with  the  sale  or  other  disposition  of  such  property.  Thus,  for 
example,  if  a  REIT  sells  two  items  of  property  described  in  section 
1221(1)  (other  than  foreclosure  property)  and  recognizes  a  gain  of 
$100  on  the  sale  of  one  item  and  a  loss  of  $40  on  the  sale  of  the  second 
item  (and  has  no  other  deductions  directly  connected  with  prohibited 
transactions) ,  the  net  income  from  prohibited  transactions  will  be  $60. 
Deductions  directly  connected  with  prohibited  transactions  are  those 
deductions,  otherwise  allowed  by  chapter  1  of  the  Code,  which  are 
proximately  and  primarily  connected  with  such  transactions.  (General 
overhead  costs,  for  example,  may  not  be  allocated  to  income  from  pro- 
hibited transactions.) 

Under  the  Act.  since  a  separate  tax  is  applied  to  net  gain  from  pro- 
hibited transactions,  net  gain  (or  net  loss)  from  prohibited  transac- 
tions is  not  taken  into  account  in  determining  real  estate  investment 
trust  taxable  income.^ 

The  100-percent  tax  on  net  income  from  prohibited  transactions  is 
included  in  the  Act  to  prevent  a  REIT  from  retaining  any  profit  from 
ordinary  retailing  activities  such  as  sales  to  customers  of  condominium 
units  or  subdivided  lots  in  a  development  project.  One  transaction  in 
particular  where  questions  have  been  raised  is  whether  a  REIT  holds 


1  However,  to  prevent  a  REIT  which  has  Incurred  a  net  loss  on  prohibited  transactions 
from  having  to  deplete  capita!  In  order  to  meet  the  90-percent  distribution  requirement, 
the  amount  of  income  which  must  be  distributed  to  satisf.y  that  requirement  is  to  be 
reduced  by  the  amount  of  any  net  loss  from  prohibited  transactions. 


452 

property  for  sale  where  it  enters  into  a  j)urchasc  and  leaseback  of  real 
property  with  an  option  in  the  seller-lessee  to  repurchase  the  property 
at  the  end  of  the  lease  period.  Such  a  transaction  frequently  is  a  nonnal 
method  of  financing  real  estate  and  is  used  in  lieu  of  a  mortgage. 
The  Congress  intends  that  with  respect  to  the  real  estate  investment 
trust  provisions,  income  from  a  sale  under  an  option  in  this  type  of 
transaction  is  not  to  be  considered  as  income  from  property  held  for 
sale  solely  because  the  purchase  and  leaseback  was  entered  into  with  an 
option  in  the  seller  to  repurchase  and  because  the  option  was  exercised 
pursuant  to  its  terms.  However,  other  facts  and  circumstances  might 
indicate  that  income  from  the  transactions  described  above  would  be 
income  from  prohibited  transactions.  In  determining  whether  a  par- 
ticular transaction  constitutes  a  prohibited  transaction,  a  REIT's  ac- 
tivities with  respect  to  foreclosure  property  and  its  sales  of  such  prop- 
erty should  be  disregarded.  The  Congress  intends  that  no  inference 
regarding  these  type  of  transactions  is  to  be  drawn  for  any  other  pur- 
pose of  the  tax  laws  because  of  this  treatment  with  respect  to  real 
estate  invevStment  trusts. 

4.  Failure  to  Meet  Income  Source  Tests  (sec.  1602  of  the  Act  and 
sees.  856  and  857  of  the  Code) 

Certain  percentages  of  a  REIT's  income  must  be  from  designated 
sources  for  the  REIT  to  receive  conduit  tax  treatment.  If  the  source 
tests  (that  is,  the  75  percent  or  90^  percent  income  source  tests  de- 
cribed  above)  were  not  met,  under  prior  law,  the  REIT  was  disqualified 
and  paid  taxes  on  its  income  as  if  it  were  a  regular  corporation.  This 
could  cause  hardship  for  a  REIT  which  reasonably  and  in  good  faith 
believed  it  met  the  income  source  tests  and  distributed  substantially 
all  of  its  income  to  its  shareholders,  but  which  did  not  meet  one  of 
these  tests  and  was  required  to  pay  tax  at  regular  corporate  lutes. 
The  Congress  belie\'es  that,  in  this  situation,  the  REIT  should  not 
be  disqualified  but  should  be  required  to  pay  a  100-percent  tax  on  the 
net  income  attributable  to  the  amount  by  which  it  fails  to  mee<t  the 
in<x)me  source  tests. 

Accordingly,  the  Act  provides  that,  where  the  trust  fails  to  meet 
either  the  75-percent  or  90-percent  income  source  test,  the  REIT  will 
not  be  disqualified  if  it  (1)  sets  forth  the  nature  and  amount  of  its 
^ross  income  qualifying  for  such  tests  in  a  schedule  attached  to  its 
income  tax  return,  (2)  the  inclusion  of  any  incorrect  information  in 
this  schedule  is  not  due  to  fraud  with  an  intent  to  evade  tax,^  and  (3) 
the  failure  to  meet  the  income  soui'ce  requirement  is  due  to  reasonable 
cause  and  not  due  to  willful  neglect. 

The  failure  to  meet  an  income  soui-ce  t-est  will  be  due  to  reasonable 
cause  and  not  due  to  willful  neglect  if  the  REIT  exercised  ordinary 
business  oare  and  prudence  in  attempting  to  satisfy  the  tests.  Such 
care  and  prudence  must  be  exercised  at  the  time  each  transaction  is 


J-  As  described  below,  the  Act  increases  the  90-percent  source  of  income  requirement 
to  95  percent  for  taxable  years  beginning  after  December  31,  1979.  In  this  explanation,  the 
requirement  is  referred  to  as  the  yO-percent  income  source  test. 

2  Under  this  provision,  a  REIT  may  commit  fraud  with  intent  to  evade  tax  even  though 
it  has  a  net  loss  and  thus  no  tax  liability  for  the  year  in  question.  This  could  occur  where 
a  REIT  with  a  net  loss  fraudulently  indicated  on  the  schedule  that  it  had  satisfied  the 
gross  Income  tests  so  that  it  could  avoid  being  disqualified  for  the  5-year  period  provided 
under  the  Act. 


453 

entered  into  by  the  REIT.  However,  even  if  the  REIT  exercised 
ordinary  business  care  and  prudence  in  entering  into  a  transaction,  if 
it  is  later  determined  that  the  transaction  is  producing  nonqualified 
income  in  amounts  Avhich,  in  the  context  of  the  REITs  over-all 
portfolio,  could  cause  an  income  source  test  to  be  failed,  the  REIT 
must  use  ordinary  business  care  and  prudence  in  an  effort  to  renegoti- 
ate the  terms  of  the  transaction,  or  alter  other  elements  of  its  port- 
folio. In  any  case,  failure  to  meet  an  income  source  test  will  be  due 
to  willful  neglect  and  not  reasonable  cause  if  the  failure  is  willful.  For 
example,  if  a  REIT  willfully  fails  an  income  source  test  for  a  legiti- 
mate business  purpose,  such  failure  is  nonetheless  due  to  willful 
neglect. 

Under  the  Act,  in  lieu  of  disqualification,  a  100-percent  tax  is 
imposed  on  the  net  income  attributable  to  the  greater  of  the  amount  by 
which  the  REIT  failed  the  90-percent  test  or  the  75-percent  test.  To 
determine  such  net  income,  the  amount  by  which  the  respective  test  is 
failed  is  multiplied  by  a  fraction  which  reflects  the  average  profita- 
bility of  the  REIT,  The  numerator  of  the  fraction  is  real  estate  invest- 
ment trust  taxable  income  for  the  year  in  question  (determined  without 
regard  to  deductions  for  certain  taxes  and  net  operating  losses,  and 
by  excluding  certain  capital  gains) .  The  denominator  of  the  fraction  is 
the  gross  income  of  the  REIT  for  the  year  in  question  (determined 
without  regard  to  gross  income  from  prohibited  transactions,  certain 
gross  income  from  foreclosure  property,  and  certain  capital  gains  and 
losses).  This  fraction  provides  a  simplified  way  to  determine  the 
net  income  of  the  REIT  from  the  nonqualifying  income  in  question 
without  requiring  an  apportionment  or  allocation  of  specific  deduc- 
tions or  expenses. 

It  is  not  necessary  that  the  schedule  attached  to  the  return  referred 
to  above  indicate  that  the  REIT  has  in  fact  satisfied  income  source 
tests.  However,  the  100-percent  tax  will  not  apply  and  REIT  will 
be  disqualified  if  the  REIT  does  not  meet  the  income  source  tests  and 
the  inclusion  of  any  incorrect  evidence  in  the  schedule  is  due  to  fraud 
with  an  intent  to  evade  tax. 

It  is  the  Congress'  intention  that  the  schedule  which  the  REIT 
must  attach  to  its  return  to  avoid  disqualification  contain  a  break- 
down, or  listing,  of  the  total  amount  of  gross  income  falling  under 
each  of  the  separate  subparagraphs  of  section  856(c)  (2)  and  (3). 
Thus,  for  example,  it  is  intended  that  the  REIT,  for  purj^oses  of  list- 
ing its  income  from  sources  described  in  section  856(c)(2),  would 
list  separately  the  total  amount  of  dividends,  the  total  amount  of 
interest,  the  total  amount  of  rents  from  real  property,  etc.  It  is  not 
the  intention  of  the  Congress  that  the  listing  be  on  a  lease-by-lease, 
loan-by-loan,  or  project-by-project  basis.  It  is  expected,  however,  that 
the  REIT  will  maintain  adequate  records  with  which  to  substantiate 
the  total  amounts  listed  in  the  schedule  upon  audit  by  the  Internal 
Revenue  Service. 

5.  Other  Changes  in  Limitations  and  Requirements  (sees.  1604, 
1606-7  of  the  Act  and  sec.  856  of  the  Code) 

9-^-percent  income  source  test. — ITnder  prior  law,  10  percent  of  a 
REIT's  gross  income  could  be  from  nonqualified  sources.  However,  the 


234-120  O  -  77 


454 

provisions  of  the  Act,  as  discussed  below,  remove  a  significant  portion 
of  income  customarily  received  by  REITs  from  the  category  of  non- 
qualified income.  In  addition,  under  other  provisions  of  the  Act,  dis- 
cussed above,  a  REIT  is  no  longer  automatically  disqualified  where  it 
fails  to  satisfy  the  income  source  tests,  so  there  is  less  need  to  allow  a 
REIT  to  have  such  income  as  a  hedge  against  inadvertent  disqualifica- 
tion. Consequently,  the  Act  increases  the  90-percent  income  source 
test  to  95  percent,  so  that,  generally,  nonqualified  income  may  not  ex- 
ceed 5  percent  of  gross  income.  The  Act,  however,  delays  the  effective 
date  until  taxable  years  beginning  after  December  31, 1979,  in  order  to 
give  REITs  an  opportunity  to  negotiate  modifications  of  existing 
arrangements  which  may  be  producing  nonqualified  income.  For  pur- 
poses of  this  test,  as  well  as  the  75-percent  income  source  test,  the  Act 
excludes  gain  from  prohibited  transactions  from  a  REIT's  total  gross 
income  as  well  as  from  gross  income  qualifying  for  the  income  tests. 

Inclusion  in  qualified  income  of  charges  for  customary  services. — 
Generally,  under  prior  law,  amounts  received  by  a  REIT  for  services 
rendered  to  tenants,  where  no  separate  charge  is  made,  would  have 
qualified  for  the  75-percent  and  90-percent  source  tests  if  the  services 
were  customary  and  furnished  by  an  independent  contractor.  How- 
ever, if  a  separate  charge  was  made  for  customary  services  furnished 
by  an  independent  contractor,  the  income  tax  regulations  took  the 
position  that  the  amount  of  the  charge  must  be  received  and  retained 
by  the  independent  contractor  and  not  by  the  REIT.  This  restriction 
on  separate  charges  for  customarily  furnished  services  often  did  not 
follow  normal  commercial  practice.  Consequently,  the  Act  provides 
that  amounts  received  by  a  REIT  as  charges  for  services  customarily 
furnished  or  rendered  in  connection  with  the  rental  of  real  property 
will  be  treated  as  rents  from  real  property  whether  or  not  the  charges 
are  separately  stated.  The  Congress  intends  that,  with  respect  to  any 
particular  building,  services  provided  to  tenants  should  be  regarded 
as  customary  if,  in  the  geographic  market  within  which  the  building 
is  located,  tenants  in  buildings  which  are  of  a  similar  class  (for  exam- 
ple, luxury  apartment  buildings)  are  customarily  provided  with  the 
service.  Also,  in  those  situations  where  it  is  customary  to  furnish 
electricity  to  tenants,  the  Congress  intends  that  the  submetering  of 
electricity  to  tenants  be  regarded  as  a  customary  service. 

Inclusion  in  qualified  income  of  rent  from  incidental  personal  p'op- 
erty. — Generally,  under  prior  law,  where  an  amount  of  rent  is  received 
with  respect  to  property  which  consists  of  both  real  and  personal 
property,  such  as  a  furnished  apartment  building,  an  apportionment 
of  the  rent  was  required.  Only  that  part  of  the  rent  which  was  attrib- 
utable to  real  property  was  treated  as  qualifying  income  for  purposes 
of  the  income  source  tests. 

The  Congress  believes  that  where  rents  attributable  to  such  per- 
sonal property  are  an  insubstantial  amount  of  the  total  rents  received 
or  accrued  under  a  lease  covering  both  real  and  personal  property,  the 
rents  should  be  treated  as  qualified  income.  Thus,  the  Act  provides 
that  rents  attribuable  to  personal  pro])erty  which  is  leased  under,  or 
in  connection  with,  the  lease  of  real  property  will  be  treated  as  rents 
from  real  property  (and  thus  qualified  for  purposes  of  the  income 
source  tests)  if  the  rent  attributable  to  the  pei^sonal  property  is  not 
more  than  15  percent  of  the  total  rent  for  the  year  under  the  lease. 


455 

Under  the  Act,  the  15-percent  test  is  to  be  examined  for  each  lease 
of  real  property.  For  each  lease,  the  rent  attributable  to  personal  prop- 
erty is  that  portion  of  the  total  rent  under  the  lease  for  the  year  deter- 
mined by  multiplying  total  rent  times  a  fraction;  the  numerator  of  the 
fraction  is  the  average  of  the  adjusted  basis  of  the  personal  property 
at  the  beginning  and  at  the  end  of  the  taxable  year;  the  denominator 
of  the  fraction  is  the  average  of  the  aggregate  adjusted  bases  of  both 
the  real  property  and  personal  property  at  the  beginning  and  at  the 
end  of  the  taxable  year.  If  the  rent  attributable  to  personal  property 
under  this  formula  is  greater  than  15  percent  of  the  total  rent  under 
the  lease,  then  all  rent  attributable  to  pei-sonal  property  from  the 
lease  will  be  treated  as  nonqualifying  income.  In  order  to  provide  for 
ease  of  administration,  the  Congress  believes  it  would  be  appropriate 
for  a  REIT  which  rents  units  in  a  multiple  unit  project  under  sub- 
stantially similar  leases  (for  example,  an  apartment  building)  to  apply 
the  apportionment  test  on  the  basis  of  the  project  as  a  whole. 

A  similar  problem  of  allocation  existed  with  respect  to  interest  on 
obligations  secured  by  real  property.  While  the  Congress  believes  a 
de  minimis  rule  in  this  area  is  also  appropriate,  the  Act  does  not  pro- 
vide such  a  rule  since  the  Treasury  Department  has  indicated  through 
the  publication  of  proposed  regulations  that  the  issue  can  be  resolved 
administratively. 

Inclusion  in  qimlifled  income  of  commitment  fees. — Under  prior 
law,  compensation  received  for  an  agreement  to  lend  money  where  the 
loan  is  secured  by  real  property,  or  received  in  connection  with  a  pur- 
chase or  lease  of  real  property,  was  not  treated  as  qualifying  income 
for  the  income  source  tests.  Since  these  fees  are  often  part  of  the  lend- 
ing activities  of  a  real  estate  investment  trust  and  are  essentially 
passive  in  nature,  the  Act  includes  such  fees  as  qualifying  income  for 
purposes  of  the  75-percent  and  90-percent  income  source  tests.  The 
Act,  however,  is  not  intended  to  alter  the  law  with  respect  to  whether 
such  fees  constitute  income.  For  example,  a  fee  received  for  agreeing 
to  purchase  real  property  does  not  constitute  income  unless  and  until 
the  right  to  require  the  purchase  expires  unexercised;  if  such  right 
is  exercised,  the  fee  results  in  a  basis  adjustment. 

Inclusion  in  qualifying  assets  of  options  to  purchase  real  property. — 
Under  prior  law,  it  was  not  clear  whether  options  to  purchase  real 
property  constitute  qualified  assets  for  purposes  of  the  75-percent 
asset  test  nor  was  it  clear  whether  gain  from  the  sale  of  options  on  real 
property  was  qualified  income  for  purposes  of  the  75-percent  income 
test.  Since  investment  in  options  to  acquire  real  property  may  be  im- 
portant in  the  operations  of  a  real  estate  investment  trust,  such  options 
are  treated  under  the  Act  as  "interests  in  real  property"  for  purposes  of 
these  tests. 

Use  of  corporate  /orm.— Under  prior  law,  a  real  estate  investment 
trust  could  only  be  an  unincorporated  trust  or  unincorporated  associa- 
tion. The  Congress  underetands  that  this  requirement  caused  operat- 
ing problems  for  some  REITs  under  State  law.  Consequently,  the 
Act  provides  that  REITs  are  to  be  permitted  to  operate  in  corpo- 
rate form.  However,  the  Act  makes  clear  that  banks  and  insurance 
companies,  which  typically  are  engaged  in  other  nonpassive  activities, 
cannot  qualify  as  REITs  under  these  provisions. 


456 

SO-fercent  income  test. — Since  the  Act  permits  REITSs  to  have 
income  from  the  sale  or  other  disposition  of  property  held  for  sale  to 
customers,  the  3()-percent  income  test  is  amended  by  the  Act  to  include 
income  from  the  sale  of  such  property  (not  including  foreclosure  prop- 
erty). In  addition,  tlie  30-percent  test  is  amended  to  include  income 
from  the  sale  of  interests  in  mortgages  on  real  property  held  for  less 
than  four  years  as  well  as  other  interests  in  real  property. 

Definition  of  '"'■'interest''''  for  income  source  tests. — Following  present 
law  with  respect  to  rents,  the  Act  provides  that  "interest"  does  not 
include  any  amount  which  depends,  in  whole  or  in  part,  on  the  in- 
come or  projfit^  of  any  person.  This  is  part  of  the  overall  requirement 
that  a  REIT  be  a  passive  investor  and  not  participate  in  active  busi- 
ness through  a  profit  participation. 

As  in  the  case  of  contingent  rents  (discussed  below),  however,  the 
Act  provides  tliat  where  a  REIT  receives  amounts  which  would  be  ex- 
cluded from  the  term  "interest"  solely  because  tlie  debtor  of  the  REIT 
receives  amounts  based  on  the  income  or  profits  of  any  person,  only  a 
proportionate  part  of  the  amount  received  by  the  REIT  will  fail  to 
qualify  as  interest.  The  Congress  believes  that  the  approach  described 
below  with  respect  to  the  determination  of  the  proportionate  part  of 
contingent  rents  which  do  not  qualify  is  also  a  reasonable  approach  for 
determining  the  propoi'tionate  part  of  contingent  interest  that  does  not 
qualify.  These  intei-est  provisions  will  apply  only  with  respect  to  loans 
made  after  May  27, 1976.  A  loan  is  to  be  considered  as  made  on  or  prior 
to  May  27,  1976,  if  it  was  made  pursuant  to  a  binding  commitment 
entered  into  on  or  before  that  date. 

The  Congress  intends  that  this  provision  is  to  have  no  effect  whatso- 
ever on  the  definition  of  the  term  "interest"  for  any  other  purpose. 

Contingent  rent. — Generally,  under  prior  law,  rent  received  or  ac- 
crued with  respect  to  real  property  which  is  based,  in  whole  or  in  part, 
upon  the  income  or  profits  derived  by  any  ])erson  from  the  leased 
property  does  not  qualify  for  the  income  source  tests.  On  i\\(?  other 
hand,  rent  received  or  accrued  with  respect  to  real  property  which  is 
based  solely  upon  a  fixed  percentage  or  percentages  of  receipts  or  sales 
does  qualify  for  the  income  source  tests.  Where  a  REIT  received  rent, 
a  portion  of  which  is  based  on  a  percentage  of  its  tenant's  gross  re- 
ceipts, and  the  gross  receipts  of  its  tenants  included  amounts  based 
upon  income  or  ])rofits  derived  by  any  party  from  the  property,  the 
entire  amount  of  the  rent  was  non-qualifying  income  (and  not  just 
the  portion  atti-ibutable  to  the  income  or  profit)  under  prior  law.  For 
example,  where  the  REIT  leased  a  sliopping  center  to  a  prime  tenant 
for  a  rent  which  consists  of  a  fixed-dollar  amount  plus  a  percentage 
of  the  prime  tenant's  gross  receipts  and  the  prime  tenant  leased  one 
store  in  the  shopping  center  to  a  subtenant  for  a  rent  which  includes 
a  percentage  of  the  subtenant's  profits,  the  entire  amount  of  rent, 
fixed  and  contingent,  received  by  the  REIT  from  the  prime  tenant 
w^as  nonqualifying  income  since  the  rent  depended,  in  part,  upon  the 
income  or  profits  derived  by  a  person  deriving  income  from  tlie  prop- 
erty (the  subtenant).  The  Congress  believes  that  this  rule  was  unduly 
harsh  since  only  a  portion  of  the  rent  received  by  the  REIT  was 
dependent  upon  the  income  or  profits  derived  from  the  property. 
Moreover,  it  often  is  very  difficult  for  a  REIT  to  control  the  terms  of 
the  leases  which  the  prime  tenant  enters  into  with  its  subtenants. 


457 

Consequently,  the  Act  contains  an  amendment  under  which  only  a 
proportionate  part  of  the  rent  received  by  a  REIT  from  a  prime 
tenant  is  nonqualifying  income  to  the  REIT  where  the  gross  receipts 
of  the  prime  tenant  are  based  upon  the  net  income  of  a  person  derived 
from  the  property.  The  proportionate  part  is  to  be  determined  under 
regulations  to  be  prescribed  by  the  Secretary  of  the  Treasury. 

The  Congress  believes  the  following  is  one  reasonable  approach 
which  the  Secretary  of  the  Treasury  may  wish  to  adopt  in  those  regu- 
lations. Where  a  REIT  rents  property  to  a  prime  tenant  for  a  rental 
which  is,  in  whole  or  in  part,  contingent  on  the  receipts  or  sales  of  that 
prime  tenant,  and  the  rent  which  the  REIT  re^^eives  would  be  non- 
qualified income  solely  because  the  prime  tenant  receives  or  accrues 
from  subtenants  rent  based  on  the  income  or  profits  deriv^ed  by  any 
person  from  such  property,  then  tlie  portion  of  the  rent  received  by 
the  REIT  which  is  non-qualified  is  to  be  the  lesser  of  the  following 
two  amounts:  (a)  the  contingent  rent  received  by  the  REIT,  or  (b)  an 
amount  determined  by  multiplying  the  total  rent  which  the  REIT 
receives  from  the  prime  tenant  by  a  fraction,  the  numerator  of  which 
is  the  rent  received  by  the  prime  tenant  which  is  based,  in  whole  or  in 
part,  on  the  income  or  profits  derived  by  any  person  from  the  prop- 
erty and  the  denominator  of  which  is  the  total  rent  received  by  the 
prime  tenant  from  the  property.  For  example,  assume  a  REIT  owns 
land  underlying  a  shopping  center  which  it  rents  to  the  owner  of 
the  shopping  center  structure  for  an  annual  rent  of  $10x  plus  2  per- 
cent of  the  gross  receipts  which  the  prime  tenant  receives  from  sub- 
tenants which  lease  space  in  the  shopping  center.  Assume  further 
that,  for  the  year  in  question,  the  prime  tenant  derives  total  rent 
from  the  shopping  center  of  $100x  and,  of  that  amount,  $25x  is 
received  from  subtenants  whose  rent  is  based,  in  whole  or  in  part, 
on  the  income  or  profits  derived  from  the  property.^  Accordingly, 
the  REIT  will  receive  contingent  rent  of  $2x  (for  a  total  rent  of  $12x) . 
The  portion  of  that  rent  which  is  qualified  is  the  lesser  of  (a)  $2x  (the 
contingent  rent  received  by  the  REIT) ,  or  (b)  $3x  ($12x  multiplied  by 
$25x/$100x).  Accordingly,  $10x  of  the  rent  received  by  the  REIT  i's 
qualified  income  and  $2x  is  nonqualified  income. 

Net  operating  loss  carryovers. — Under  prior  law,  a  REIT  was  not 
permitted  a  net  operating  loss  deduction.  However,  a  REIT  which 
voluntarily  disqualified  itself  as  a  REIT  could  carry  forward  a  net 
operating  loss  arising  in  a  year  for  which  the  trust  qualified  as  a  REIT 
to  a  year  for  which  the  trust  did  not  so  qualify  and  claim  a  deduction 
in  such  year  for  the  loss.  As  a  result,  a  REIT  which  incurred  a  net 
operating  loss  could  decide  to  voluntarily  disqualify  itself  in  order  to 
use  its  loss  carryover.  The  Congress  believes  that  a  rule  which  forces  a 
REIT  to  disqualify  itself  in  order  to  be  allowed  a  deduction  which 
regular  corporations  are  permitted  imposes  an  unreasonable  restriction 
on  REIT  status.  Consequently,  the  Act  has  added  a  provision  which 

^  It  is  irrelevant  for  purposes  of  this  formula  whether  the  reason  that  rent  received  by 
the  prime  tenant  from  the  subtenant  is  based,  in  whole  or  in  part,  on  income  or  profits  is 
that  (a)  the  lease  between  the  prime  tenant  and  the  subtenant  requires  the  payment  of  a 
percentage  of  profits,  or  (b)  the  lease  between  the  prime  tenant  and  the  subtenant 
requires  the  payment  of  a  percentage  of  sross  receipts  and  a  concession  agreement 
between  the  subtenant  and  a  concessionaire  requires  the  payment  of  a  percentage  of  the 
concessionaire's  profits  to  the  subtenant. 


458 

permits  a  net  operating  loss  carryover  ^  in  computing  real  estate  invest- 
ment trust  taxable  income  for  eight  taxable  years  after  the  year  in 
which  the  loss  was  incurred. 

Ordinary  loss  offsetting  capital  gains.— Vwd^v  prior  law,  a  REIT 
was  taxed  separately  at  a  flat  30-percent  rate  on  the  excess  of  any  net 
long-term  capital  gain  over  the  sum  of  any  net  short-term  capital 
loss  and  the  deduction  for  capital  gains  dividends  paid  to  its  share- 
holders. The  alternative  tax  on  capital  gains  which  permits  a  tax- 
payer to  ofi'set  capital  gains  with  ordinary  losses,  although  generally 
available  to  corporations,  was  not  available  to  REITs  under  prior  law. 
Accordingly,  a  REIT  could  not  use  an  ordinary  loss  incurred  during  a 
taxable  year  to  offset  its  capital  gains.  As  in  the  case  of  the  operating 
loss  carryovers,  this  rule  had  caused  some  REITs  to  intentionally  dis- 
qualify. The  Congress  believes  that  REITs  should  not  be  treatedmore 
harshly  than  regular  corporations  in  this  regard.  Consequently,  the 
Act  adds  an  amendment  which,  in  essence,  allows  ordinary  losses  to 
offset  the  undistributed  excess  of  net  long-term  capital  gains  over  net 
short-term  capital  losses.  Under  the  Act,  a  REIT  will  compute  its  tax 
on  capital  gains  under  two  methods  and  determine  its  tax  under  the 
method  which  produces  the  lower  tax  liability.  Under  the  first  method, 
the  tax  on  the  ca})ital  gain  is  any  additional  tax  arising  from  the  in- 
clusion of  the  excess  of  net  long-term  capital  gain  over  net  sliort-term 
capital  loss  in  the  trust's  real  estate  investment  trust  taxable  income. 
The  second  method  is  identical  to  prior  law,  that  is,  a  flat  30-percent 
tax  on  such  undistributed  excess  capital  gain. 

Voluntary  di^qiialifieation. — Under  prior  law\  an  election  to  be 
taxed  as  a  REIT  was  irrevocable.  If,  however,  a  trust,  either  inten- 
tionally or  unintentionally,  failed  to  qualify  to  be  taxed  as  a  REIT  for 
one  taxable  year,  such  trust  could,  nevertheless,  requalify  to  be  taxed 
as  a  REIT  in  the  next  succeeding  taxable  year.  The  Congress  does  not 
believe  it  should  be  necessary  for  a  REIT  to  contrive  to  fail  one  or 
more  tests  for  qualification  in  order  to  terminate  its  REIT  status. 
Accordingly,  the  Act  provides  tliat  a  taxpayer  may  revoke  its  REIT 
election  after  the  first  taxable  year  for  which  the  election  is  effective. 
The  revocation  must  be  made  in  the  manner  sj>ecified  by  the  Secretary 
of  the  Treasury  in  regulations  and  must  be  made  on  or  before  the  90th 
day  of  the  first  taxable  year  for  which  the  revocation  is  to  be  effective. 

The  Congress  also  believes  that  since  the  net  operating  loss  deduc- 
tion and  the  alternative  tax  with  respect  to  capital  gains  have  been 
made  available  to  REITs,  taxpayers  should  not  intentionally  switch 
between  REIT  and  regular  corporate  status.  Accordingly,  the  Act 
provides  that,  if  an  election  as  a  REIT  has  been  revoked  or  terminated, 
the  corporation,  trust,  or  association  (and  any  successor)  shall  not  l)e 
eligible  to  make  a  new  election  until  the  fifth  taxable  year  following 
the  year  for  which  the  revocation  or  tei'mination  is  effective.  The  five- 
year  disqualification  will  not  apply  in  the  case  of  a  termination,  how- 
ever, if  the  taxpayer  (1)  does  not  willfully  fail  to  file  an  income  tax 


2  Slnoe  REITs  receive  a  (leriiiction  for  income  distributed  to  their  sliareiiolders.  it  would 
not  bt  adminlstrativel.v  feasible  to  allow  a  net  operating  loss  carryback  to  a  year  iot 
which  the  taxpayer  was  taxable  as  a  REIT,  since  allowance  of  a  net  operating  loss  carry- 
back might  have  the  effect  of  recharacterizing  as  a  return  of  capital  amounts  distributed 
as  dividends.  Accordingly,  the  Act  does  not  allow  a  net  operating  loss  to  be  carried  back 
to  a  taxable  year  for  which  the  taxpayer  qualifies  to  be  taxed  as  a  REIT. 


459 

return,  (2)  does  not  commit  fraud  in  its  return,  and  (3)  establishes 
to  the  satisfaction  of  the  Secretary  of  the  Treasury  that  the  failure  to 
qualify  as  a  REIT  was  due  to  reasonable  cause  and  not  due  to  willful 
neglect. 

If  a  REIT  has  revoked  or  terminated  its  election,  the  prohibition 
on  making  a  new  election  applies  with  respect  to  a  successor  of  the 
REIT.  It  is  the  intent  of  the  Congress  that  similar  rules  apply  for 
purposes  of  determining  w^hether  a  corporation,  trust,  or  association  is 
a  successor  for  purposes  of  section  856(g)  (3)  as  apply  for  the  pur- 
pose of  determining  under  section  1372(f)  whether  a  corporation  is  a 
successor  to  an  electing  small  business  corporation. 

Effective  date 

The  provisions  of  the  Act  that  provide  for  a  deficiency  dividend 
procedure  are  to  apply  to  determinations  tliat  occur  after  the  date  of 
enactment  (October  4,  1976). 

The  provisions  that  provide  that  a  REIT  is  not  to  be  disqualified 
in  certain  cases  if  it  fails  to  meet  the  income  source  tests  are  to  apply 
to  taxable  years  beginning  after  October  4, 1976.  Also,  such  provisions 
are  to  apply  to  taxable  years  of  a  REIT  beginning  before  October  4, 
1976,  if,  as  the  result  of  a  determination  occurring  after  October  4, 
1976,  such  trust  does  not  meet  the  income  source  requirements  for  such 
taxable  year.  In  any  case,  however,  the  provisions  requiring  a  schedule 
to  be  attached  to  the  income  tax  return  are  to  apply  only  to  taxable 
years  beginning  after  October  4, 1976. 

The  provisions  for  an  alternative  tax  on  capital  gains  of  REITs  and 
a  deduction  for  net  operating  losses  of  REITs  are  to  apply  to  taxable 
years  ending  after  October  4,  1976.  (However,  the  provision  that  pro- 
hibits the  carryback  of  a  loss  arising  in  a  year  in  which  the  taxpayer 
qualifies  to  be  taxed  as  a  REIT  would  prevent  such  a  loss  which  arose 
in  any  taxable  year  ending  after  October  4,  1976  from  being  carried 
back  to  any  taxable  year  ending  on  or  before  October  4,  1976.) 

The  provision  that  a  REIT  which  intentionally  disqualifies  cannot 
requalify  for  five  years  is  to  apply  to  taxable  years  beginning  after 
October  4,  1976.  However,  the  five-year  prohibition  on  requalification 
will  not  apply  to  a  REIT  unless  it  qualifies  to  be  taxed  as  a  REIT  for 
a  taxaJble  year  ending  after  October  4,  1976  and  subsequently  inten- 
tionally fails  to  qualify. 

The  provisions  that  eliminate  the  requirement  that  a  REIT  not  hold 
any  property  (other  than  foreclosure  property)  primarily  for  sale  to 
customers  in  the  ordinary  course  of  its  trade  or  business  are  to  apply  to 
taxable  years  beginning  after  October  4, 1976.  However,  if  after  Octo- 
ber 4, 1976,  it  is  determined  on  audit  that  a  REIT  violated  the  "holding 
for  sale"  prohibition  for  any  taxable  year  ending  on  or  before  Octo- 
ber 4, 1976,  the  Act  will  permit  the  REIT  to  elect  to  have  the  provisions 
apply  which  prevent  disqualification  but  which  instead  impose  a  100- 
percent  tax  on  net  income  from  prohibited  transactions. 

All  other  provisions  of  the  Act  relating  to  REITs  apply  to  taxable 
years  beginning  after  October  4, 1976. 

Revenue  effect 
These  provisions  are  estimated  not  to  have  any  significant  revenue 
effect. 


p.  RAILROAD  AND  AIRLINE  PROVISIONS 

1.  Treatment  of  Certain  Railroad  Ties  (sec.  1701(a)  of  the  Act 
and  sec.  263  of  the  Code) 

Prior  law 

Business  taxpayers  in  general  are  required  to  capitalize  improve- 
ments and  betterments  to  business  and  productive  assets  and  are  gen- 
erally allowed  to  recover  these  costs  through  depreciation.  The  railroad 
industry,  however,  generally  uses  for  tax  purposes  what  is  called  the 
"retirement-replacement"  method  of  accounting  for  railroad  track 
(rail)  and  ties,  and  other  items  in  the  track  accounts. 

For  assets  accounted  for  under  the  retirement-replacement  method, 
when  new  track  is  laid,  the  costs  (l)oth  materials  and  lalx)r)  of  the 
tra<^'k  and  ties  are  capitalized.  No  depreciation  is  claimed  on  the 
original  installation,  but  these  original  costs  may  be  written  off  if  the 
track  is  retired  or  abandoned.  If  the  original  installation  is  replaced 
with  ti'ack  or  ties  of  a  like  kind  or  quality,  the  costs  of  the  replacements 
(both  materials  and  labor)  are  deducted  as  current  expense.  This  rule 
applies,  for  example,  when  wood  crossties  are  i-eplaced  with  new  wood 
ties.  Wlien  the  replacement  is  of  an  impi-oved  quality,  it  is  treated  as 
a  betterment,  under  which  the  betterment  poition  of  the  replacement 
is  capitalized  and  the  remainder  is  expensed, 

A  replacement  with  a  different  or  improved  ty]3e  or  kind  of  track 
or  tie  is,  on  the  other  hand,  treated  as  a  retirement  and  substitution. 
Under  prior  law,  for  example,  when  existing  wood  railroad  ties  were 
replaced  with  concrete  ties,  the  Service  held  (in  Rev\  Ttul.  68-418, 
1968-2  Cum.  Bull.  115)  that  this  replacement  constituted  a  retirement 
and  substitution.  As  a  result,  the  matei'ial  and  labor  costs  for  the  new 
concrete  ties  were  capitalized  and  the  costs  of  the  old  wood  ties  were 
removed  from  the  asset  account  and  expensed.  The  same  treatment 
applied  where  wood  ties  were  replaced  by  ties  made  of  steel,  j)lastic, 
wood  laminate,  or  other  substitute  materials  of  a  different  or  improved 
type  and  kind. 

Reasons  for  change 

American  railroads  have  traditionally  used  •crossties  made  of  hard- 
wood timber.  During  some  re<'ent  years,  however,  a  shortage  in  hard- 
wood ties  has  developed  due  to  increased  demand  by  competing  usei"S 
of  hardwoods  and  the  cyclical  nature  in  the  level  of  railroad  track 
maintenance.  As  a  result,  the  American  railroads  have  begvui  experi- 
menting with  crossties  made  of  substitute  mateiials,  such  as  concrete 
(and  to  a  lesser  extent,  steel),  both  of  which  are  significantly  more 
expensi  ve  than  hardwood  ties. 

Although  the  use  of  concrete  crossties  has  been  quite  successful  in 
some  foreign  countries  where  such  ties  have  been  used  extensively  for 
a  number  of  years,  the  recent  experience  of  American  railroads  has 

(460) 


461 

shown  that  under  some  conditions  concrete  ties,  as  they  are  presently 
designed,  have  useful  lives  which  are  no  longer,  and  possibly  shorter, 
than  the  useful  life  of  a  typical  wood  tie.  While  it  is  possible  these 
design  problems  will  be  solved,  it  is  difficidt  to  estimate  when  this 
might  occur.  As  a  result,  Congress  believes  that  the  use  of  railroad  ties 
made  of  pressed  wood,  conciete  or  other  substitute  materials  should  be 
accorded  the  same  tax  treatment  as  hardwood  replacements  receive 
under  the  retirement-replacement  method  of  tax  accounting. 

Explanation  of  provision 
Under  the  Act,  an  exception  is  provided  to  the  general  capitaliza- 
tion rules  (sec.  263)  to  require  replacement  treatment  where  a  do- 
mestic railroad,  which  uses  the  retirement-replacement  method  of  ac- 
counting for  depreciation  of  its  railroad  track,  acquires  and  installs 
replacement  ties  which  are  not  made  of  wood.  As  a  result,  current  de- 
ductions will  be  allowed  not  only  where  an  existing  railroad  tie  is  re- 
placed by  a  tie  of  the  same  material  and  quality,  as  under  prior  law, 
but  also  where  an  existing  tie  is  replaced  with  a  tie  of  a  different  ma- 
terial or  improved  quality.  This  will  apply,  for  example,  where  exist- 
ing wood  crossties  are  replaced  with  pressed  wood,  concrete  or  steel 
crossties.  The  current  expense  treatment  applies  to  both  material  and 
labor  costs  involved  in  acquiring  and  installing  replacement  railroad 
ties.  The  current  deduction  for  these  replacement  tie  costs  is,  as  under 
prior  law,  reduced  by  the  salvage  value  of  the  old  tie  which  is  recov- 
ered in  the  I'eplacement  process. 

Effective  date 
The  provision  is  effective  up6n  enactment. 

Revemce  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  less  than  $5  million  annually. 

2.  Limitation  on  Use  of  Investment  Tax  Credit  for  Railroad  Prop- 
erty (sec.  1701(b)  of  the  Act  and  sec.  46  of  the  Code) 

Prior  law 
The  amount  of  the  investment  tax  credit  which  a  taxpayer  may 
take  in  any  one  year  generally  cannot  exceed  the  first  $25,000  of  tax 
liability  (as  otherwise  computed)  plus  50  percent  of  the  tax  liability  in 
excess  of  $25,000.  However,  in  the  case  of  public  utility  property,  the 
Tax  Reduction  Act  of  1975  increased  the  50-percent  limit  to  100  per- 
cent for  1975  and  1976,  90  percent  for  1977,  80  percent  for  1978,  70 
percent  for  1979,  and  60  percent  for  1980. 

Reason  for  change 
Railroads  have  been  investing  heavily  in  equipment  and  facilities 
during  the  past  several  years  in  order  to  expand  the  ability  of  the 
railroad  system  to  handle  an  increasing  volume  of  traffic  and  to  mod- 
ernize the  system  through  replacement  of  obsolete  equipment  and  facil- 
ities. Additional  expansion  of  the  railroad  system  also  is  needed  to 
connect  new  and  reopened  coal  mines  with  principal  railroad  routes 
as  reliance  on  coal  as  a  fuel  and  energy  source  increases  relative  to 
other  sources.  Railroad  equipment  and  facilities  tend  to  be  capital  in- 
tensive and  long-lived. 


462 

In  contrast  with  the  growth  in  investment  requirements,  earnings 
of  railroad  companies  have  been  relatively  small.  Because  the  limita- 
tion on  the  amount  of  investment  credit  that  may  be  claimed  in  a 
given  year  is  expressed  in  terms  of  a  percentage  oi  tax  liability,  the 
railroads  have  not  been  able  to  use  the  credits  as  they  have  been  earned, 
and  substantial  amounts  of  unused  credits  have  accrued  and  been 
carried  forward.  For  this  reason.  Congress  decided  to  modify  the  lim- 
itation with  respect  to  railroads  for  a  temporary  period. 

Explanation  of  provision 

The  Act  provides  a  temporary  increase  in  the  limitation  on  the 
amount  of  investment  tax  credit  which  may  be  used  in  a  taxable  year. 
Qualifying  taxpayers  will  be  allowed  to  apply  investment  tax  credits 
against  up  to  100  percent  of  their  tax  liability  in  taxable  years  that 
end  in  1977  and  1978  to  the  extent  they  invest  in  railroad  property. 
This  limitation  is  then  to  decrease  by  10  percentage  points  in  each  of 
the  subsequent  five  taxable  years  until  the  limitation  returns  to  50 
percent  in  1983. 

In  order  to  be  eligible  for  this  increase  in  the  limitation,  a  minimum 
of  25  percent  of  the  taxpayer's  total  qualified  investment  for  the  tax- 
able year  must  have  been  in  railroad  property.  Kailroad  property 
for  this  purpose  is  defined  as  section  38  property  used  by  the  taxpayer 
directly  in  connection  with  the  trade  or  business  carried  on  by  the 
taxpayer  of  operating  a  railroad  (including  a  railroad  switching  or 
terminal  company).  Thus,  property  which  the  taxpayer  acquires  and 
leases  to  an  unrelated  taxpayer  for  use  in  railroad  operations  is  not 
considered  as  railroad  property  for  this  purpose. 

The  computation  of  the  percentage  limitation  for  railroad  property 
is  to  be  made  on  a  baxpayer-by-taxpayer  basis.  Thus,  a  group  of  cor- 
porations which  file  a  consolidated  return  together  are  to  be  treated  as 
one  taxpayer. 

Congress  intends  that  the  benefit  of  the  relaxation  of  the  50-percent 
limit  go  primarily  t^  railroads.  However,  it  recognizes  thai  many 
railroads  have  vaiying  amounts  of  nonrailroad  property.  In  addition, 
many  railroads  are  members  of  controlled  groups  that  file  consolidated 
returns.  To  achieve  this  objective  in  the  most  ])ra<?tical  way  adminis- 
tratively. Congress  decided  to  prorate  the  increase  in  the  credit 
limit  in  accordance  with  the  extent  to  which  the  company  (or  the 
group  filing  the  consolidated  return)  has  qualified  investment  in  rail- 
road property,  as  compared  to  its  qualified  investment  in  other 
property. 

Thus,  if  in  1977,  50  percent  of  the  company's  qualified  investment  is 
in  i-ailroad  propeiiy.  then  the  applicable  limit  is  to  l)e  75  percent  of 
tax  liability  (the  basic  50-percent  limit  plus  one-half  of  the  maximum 
additional  limit  allowable  in  1977).  If  70  percent  of  the  company's 
qualified  investment  is  in  railroad  propeiiy,  then  the  applicable  limit 
is  to  be  85  percent  of  the  tax  liability.  In  order  to  simplify  such  com- 
putations for  most  companies,  if  75  percent  or  more  of  the  qualified 
investment  for  a  given  year  is  in  railroad  property,  then  the  full  in- 
crease is  to  apply  to  that  company  for  that  year.  Thus,  the  typical  rail- 
road, which  has  relatively  little  qualified  investment  in  other  property, 
is  to  get  the  full  benefit  of  the  increase  in  the  percentage  limitation. 


463 

If  less  than  25  percent  of  the  qualified  investment  consists  of  rail- 
road property,  then  no  part  of  the  additional  limitation  is  to  apply.  In 
such  a  case,  the  company  (or  the  group  filing  the  consolidated  return) 
is  to  be  treated  in  its  entirety  as  not  being  a  railroad  under  this 
provision. 

The  percentage  applicable  to  a  taxpayer  for  a  year  is  to  apply  to  the 
aggregate  of  the  credits  arising  from  that  taxpayer's  railroad  property 
and  that  taxpayer's  other  property;  it  is  not  to  apply  separately  to 
each  category  of  property. 

If  a  taxpayer  has  credit  that  remains  unusable  despite  the  higher 
limits,  any  such  excess  is  to  be  allowed  as  a  carryback  (8  years)  and 
carryover  (generally  7  years),  as  under  present  law.  If  there  is  a 
carryov^er  or  carryback  to  a  year  to  which  these  higher  limits  apply, 
then  the  exact  amount  of  the  applicable  limit  is  to  be  determined  by 
the  relative  investments  in  the  year  to  which  the  excess  credit  is  car- 
ried. For  example,  assume  that  in  1977,  50  percent  of  company  X's 
qualified  investment  is  in  railroad  property.  The  maximum  percentage 
limit  in  this  case,  as  indicated  above,  is  75  percent  of  tax  liability. 
Assume,  further,  that  in  1978,  75  percent  of  company  X's  qualified  in- 
vestment consists  of  railroad  property.  The  maximum  credit  for  1978 
would  then  be  (as  indicated  above)  100  percent  of  tax  liability.  If  any 
of  the  excess  credit  from  1977  would  be  carried  over  to  1978  (after 
having  been  first  carried  back  to  1974, 1975,  and  1976,  as  under  present 
law) ,  the  1978  limit  would  not  be  affected  by  whether  the  amount  car- 
ried over  to  that  year  could  be  traced  originally  to  railroad  prop- 
erty or  to  other  property. 

E-ffectvve  date 
The  temporary  increase  in  the  limitation  is  effective  with  respect  to 
taxable  years  ending  after  December  31,  1976. 

Revenue  effect 
This  provision  will  reduce  budget  receipts  by  $29  million  in  fiscal 
year  1977,  $66  million  in  fiscal  year  1978,  and  $41  million  in  fiscal  year 
1981. 

3.  Amortization  of  Railroad  Grading  and  Tunnel  Bores  (sec.  1702 
of  the  Act  and  sec.  185  of  the  Code) 

Prior  law 

Domestic  railroad  common  carriers  may  amortize  railroad  grading 
and  tunnel  bores  placed  in  service  after  1968  on  a  straight-line  basis 
over  a  50-year  period.  This  amortization  deduction  is  to  be  in  lieu  of 
any  depreciation  or  any  other  amortization  deduction  for  these  grad- 
ing and  tunnel  bores  for  any  year  for  which  the  election  applies. 
If  the  taxpayer  elects  to  use  this  provision,  it  applies  to  all  railroad 
grading  and  tunnel  bores  qualified  for  this  amortization,  unless  the 
Secretary  permits  the  taxpayer  to  revoke  the  election.  The  50-year 
amortization  period  begins  the  year  following  the  year  the  property 
is  placed  in  service. 

Railroad  grading  and  tunnel  bores,  for  which  the  50-year  amortiza- 
tion deduction  is  available,  are  all  improvements  that  result  from 
excavations  (including  tunneling),  construction  of  embankments, 
clearings,  diversions  of  roads  and  streams,  sodding  of  slopes,  and  from 


464 

similar  work  necessary  to  provide,  construct,  reconstruct,  alter,  protect, 
improve,  replace  or  restore  a  roadbed  or  right-of-way  for  railroad 
track.  Expenditures  incurred  for  such  improvements  "to  an  existing 
roadbed  or  railroad  right-of-way  are  treated  as  costs  incurred  for 
property  placed  in  service  in  the  year  in  which  the  costs  are  incurred. 
If  a  railroad  grading  or  turmel  bore  is  retired  or  abandoned  during 
a  year  for  which  this  provision  is  in  eifect  with  respect  to  it,  no  deduc- 
tion is  to  be  allowed  because  of  the  retirement  or  abandonment.  Instead, 
the  amortization  deduction  under  this  provision  is  to  continue  to  apply. 
An  exception  to  this  rule,  however,  is  provided  where  the  retirement  or 
abandonment  is  attributable  primarily  to  fire,  storm,  or  other  casualty. 
In  such  cases,  the  casualty  loss  deduction  will  be  available  in  lieu  of 
any  further  amortization  deduction. 

Reasons  for  change 

Until  the  Tax  Reform  Act  of  1969,  no  depreciation  or  amortization 
deduction  could  be  taken  by  railroads  for  costs  of  railroad 
grading  and  tunnel  bores.  Although  these  expenses  could  be  capital- 
ized, railroads  could  not  depreciate  them  over  any  period  because  the 
length  of  their  useful  life  is  uncertain  and,  it  seemed,  indefinitely  long. 

In  enacting  this  provision  in  1969,  Congress  decided  that  uncertainty 
about  the  expected  useful  life  of  railroad  grading  and  tunnel  bores 
could  be  resolved  by  selecting  an  arbitrary,  long  period  as  the  useful 
life.  Thus,  railroads  slowly  could  recoup  the  costs  of  these  investments 
in  relatively  small  annual  charges. 

Since  approving  the  allowance  for  50-year  amortization  was  a  sig- 
nificant departure  from  existing  tax  policy,  Congress  chose  in  1969 
to  provide  amortization  for  railroad  grading  and  tunnel  bores  only  on 
a  prospective  basis.  As  a  result,  the  cost  of  properties  placed  in 
service  before  1969  has  not  been  depreciable  for  tax  purposes,  unless 
the  taxpayer  has  been  able  to  establish  a  useful  life  for  tax  purposes. 

In  the  intervening  period,  Congress  has  studied  the  desirability 
of  extending  amortization  to  past  investments  in  railroad  property. 
The  basic  issue  of  allowing  amortization  of  this  otherwise  nondepre- 
ciable property  was  lesolved  in  the  1969  Act,  and  fair  valuation  of 
property  placed  in  service  in  the  past  has  been  reached  for  the  vast 
majority  of  grading  and  tunnel  bores  by  the  Interstate  C^ommerce 
Commission  and  counterpart  State  regulatory  bodies.  As  a  result. 
Congress  believes  it  is  now  appropriate  to  extend  the  50-year  amorti- 
zation to  railroad  grading  and  tunnel  bores  placed  in  service  before 
1969. 

In  some  instances  in  recent  years,  taxpayers  have  entered  into  litiga- 
tion with  tlie  Federal  Government  to  establish  a  de])reciable  base  for 
railroad  grading  and  tunnel  bores  under  pre-1969  law.  Conoress  does 
not  intend  that  the  election  for  50-year  amortization  of  pre-1969  pi-op- 
erties  will  prejudice  the  rights  of  a  taxpaver  to  seek  an  administrative 
or  judicial  determination  of  a  depreciable  base  for  such  property. 

Explanation  of  provision 
The  Act  provides  that  taxpayers  may  elect  50-year  amortization 
for  railroad  grading  and  tunnel  bores  placed  in  sei^vice  before  Janu- 
ary 1,  1969  (pre-1969  railroad  grading  and  tunnel  bores).  The  amor- 
tizable  basis  of  pre-1969  grading  and  tunnel  bores  that  were  acquired 


465 

or  constructed  after  February  28,  1913,  is  to  be  the  adjusted  basis  of 
the  property  for  determining  capital  gain  in  the  hands  of  the  taxpayer. 
For  grading  and  tunnel  bores  in  existence  on  February  28,  1913,  the 
amortizable  basis  is  to  be  that  ascertained  by  the  Interstate  Commerce 
Commission  as  the  property's  new  cost  of  reproduction,  i.e.,  the  then 
current  cost  of  reproduction.  If  the  valuation  was  made  by  a  State 
regulatory  agency  that  is  the  counterpart  of  the  ICC,  the  adjusted 
basis  of  the  property  is  to  be  the  value  of  the  property  originally 
determined  by  the  Stat-e  agency.  Where  it  has  not  been  possible  to 
establish  a  valuation  for  amortization  under  either  of  the  procedures 
referred  to,  but  the  taxpayer  or  the  Secretary  can  establish  the  ad- 
justs basis  for  determining  gain  of  the  property  in  the  hands  of  the 
taxpayer,  the  adjusted  basis  of  the  property  in  the  hands  of  the  tax- 
payer for  determining  gain  is  to  be  used. 

The  rules  for  determining  the  basis  of  railroad  grading  and  tunnel 
bores  are  tied  directly  to  existing  procedures  for  that  purpose.  Since 
March  1,  1913,  the  Interstate  Commerce  Commission  has  been  respon- 
sible for  establishing  the  valuation  of  all  railroad  property,  employ- 
ing alternative  valuation  methods  which  include  among  them  the  cost 
of  reproduction  new.  State  governments  generally  have  instructed 
their  regulatory  commissions  to  institute  parallel  evaluations  for  rail- 
road property  that  would  not  be  included  within  the  ICC  jurisdiction. 

Grading  and  tunnel  bores  acquired  or  constructed  since  1913  have 
readily  established  basis  values  because  actual  costs  will  have  been 
established  by  the  ICC  or  a  State  commission.  Similarly,  where  dis- 
putes about  valuations  have  not  yet  been  resolved.  Congress  decided 
that  for  the  purpose  of  this  provision  it  would  utilize  a  valuation 
that  already  had  been  determined  for  another  Federal  tax  purpose, 
namely,  the  basis  for  determination  of  capital  gain  or  loss. 

Effective  date 

This  provision  is  to  be  effective  for  any  taxable  year  that  begins  after 
December  31,  1974. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  $26  million  in  fiscal  year  1977  and  $18  million  a  year 
thereafter. 

4.  Limitation  on  Use  of  Investment  Tax  Credit  for  Airline  Prop- 
erty (sec.  1703  of  the  Act  and  sec.  46  of  the  Code) 

Prior  law 
The  amount  of  the  investment  tax  credit  that  a  taxpayer  may  take  in 
any  one  year  generally  cannot  exceed  the  first  $25,000  of  tax' liability 
(as  otherwise  computed)  plus  50  percent  of  the  tax  liability  in  excess 
of  $25,000.  However,  in  tne  case  of  public  utility  property,  the  Tax 
Reduction  Act  of  1975  increased  the  50-percent  limit  tto  100  percent  for 
1975  and  1976,  90  percent  for  1977,  80  percent  for  1978,  70  percent  for 
1979,  and  60  percent  for  1980. 

Reasons  for  change 
For  the  past  several  years,  many  airlines  have  suffered  losses  or  have 
experienced  substantial  reductions  in  earnings.  As  a  consequence,  in- 
vestment credits  earned  in  those  years  often  could  not  be  utilized  and 


466 

were  carried  forward.  In  some  instances  these  credits  from  previous 
years  may  be  lost  to  these  taxpayers  if  the  carryforward  period  for  un- 
used credits  expires  unless  substantial  income  is  earned  in  the  carry- 
forward years.  Tliis  problem  has  been  magnified  liecause  airline  com- 
panies have  tended  t^  bunch  their  purchases  of  aircraft,  especially 
when  aircraft  with  substantially  new  design  became  available. 

Presently,  U.S.  airline  companies  face  the  prospect  of  replacing 
many  aging  planes  in  their  fleets.  An  important  element  in  the  com- 
panies' ability  to  finance  new  acquisitions  is  their  cash  flow,  which 
depends  in  part  upon  the  prospects  for  using  in  full  the  carryover  of 
past  investment  credits  as  well  as  the  investment  credits  tliat  will  be 
generated  by  the  new  acquisitions. 

Explanation  of  provision 

The  Act  provides  a  temporary  increase  in  the  limitation  on  the 
amount  of  investment  tax  credit  which  may  be  used  in  a  taxable  year. 
As  a  result,  qualifying  taxpayere  will  be  allowed  to  apply  iii vestment 
tax  credits  against  up  to  100  percent  of  their  tax  liability  in  taxable 
years  tliat  end  in  1977  and  lv}78  to  the  extent  they  invest  in  airline 
property.  This  limitation  decieases  by  10  percentage  points  in  each  of 
the  subsequent  five  taxable  years  until  the  limitation  returns  to  50 
percent  in  1983. 

In  order  to  be  eligible  for  this  increase  in  the  liiiiitation,  a  minimum 
of  25  percent  of  the  taxpayers  total  qualified  investment  for  the  tax- 
able year  must  have  been  in  airline  property.  The  Act  provides  that 
airline  property  under  these  p'ovisions  is  defined  as  section  38  property 
used  by  the  taxpayer  directly  in  connection  witli  the  trade  oi-  business 
carried  on  by  the  taxpayer  of  the  furnishing  or  sale  of  transportation 
as  a  common  carrier  by  air  subject  to  the  jurisdiction  of  tlie  Civil 
Aeronautics  Board  or  the  Federal  Aviation  Administration.  Thus,  for 
example,  a  taxpayer  who  acquires  airline  property  which  it  leases  to  an 
unrelated  person  will  not  be  eligible  for  the  increased  limitation  with 
respect  to  that  property. 

The  computation  of  the  percentage  limitation  for  airline  prop- 
erty is  to  be  made  on  a  taxpayer-by-taxpayer  basis.  Thus,  a  group  of 
corporations  which  file  a  consolidated  return  together  are  to  be  treated 
as  one  taxpayer. 

Congress  intends  that  the  benefit  of  the  relaxation  of  the  50-percent 
limit  go  primarily  to  airlines.  However,  it  recognizes  that  airlines  may 
have  varying  amounts  of  nonairline  property.  In  addition,  airlines  may 
be  membei*s  of  controlled  groups  that  file  consolidated  returns.  To 
achieve  this  objective  in  the  most  practical  way  administratively,  Con- 
gress decided  to  prorate  the  increase  in  the  credit  limit  in  accordance 
with  the  extent  to  which  the  company  (or  the  ^roup  filing  the  con- 
solidated return)  has  qualified  investment  in  airline  property,  as  com- 
pared to  its  qualified  investment  in  other  propertj^ 

Thus,  if  in  1977,  50  percent  of  the  comj^any's  qualified  investment  is 
in  airline  property,  then  the  applicable  limit  is  to  be  75  percent  of  tax 
liability  (the  basic  50-percent  limit  plus  one-half  of  the  maximum 
additional  limit  allowable  in  1977).  If  70  percent  of  the  company's 
qualified  investment  is  in  airline  property,  then  the  applicable  limit 


467 

is  to  be  85  percent  of  the  tax  liability.  In  order  to  simplify  such  com- 
putations for  most  companies,  if  75  percent  or  more  of  the  qualified  in- 
vestment for  a  given  year  is  in  airline  property,  then  the  full  increase 
is  to  apply  to  that  company  for  that  year.  Thus,  the  typical  airline, 
which  has  relatively  little  qualified  investment  in  other  property,  is  to 
get  the  full  benefit  of  the  increase  in  the  percentage  limitation. 

If  less  than  25  percent  of  the  qualified  investment  consists  of  airline 
property,  then  no  part  of  the  additional  limitation  is  to  apply.  In  such 
a  case,  the  company  (or  the  group  filing  the  consolidated  return)  is 
to  be  treated  in  its  entirety  as  not  being  an  airline  under  this  provision. 

The  percentage  applicable  to  a  taxpayer  for  a  year  is  to  apply  to  the 
aggregate  of  the  credits  arising  from  the  taxpayer's  airline  property 
and  other  property — it  is  not  to  apply  separately  to  each  category  of 
property. 

If  a  taxpayer  has  credit  that  remains  unusable  despite  the  higher 
limits,  any  such  excess  is  to  be  allowed  as  a  carryback  (3  years)  and 
carryover  (generally  7  years) ,  as  under  present  law.  If  there  is  a  carry- 
over or  carryback  to  a  year  to  which  these  higher  limits  apply,  then  the 
exact  amount  of  the  applicable  limit  is  to  be  determined  by  the  relative 
investments  in  the  year  to  which  the  excess  credit  is  carried.  For  ex- 
ample, assume  that  in  1977,  50  percent  of  company  X's  qualified  in- 
vestment is  in  airline  property.  The  maximum  percentage  limit  in 
this  case,  as  indicated  above,  is  75  percent  of  tax  liability.  Assume, 
further,  that  in  1978,  75  percent  of  company  X's  qualified  investment 
consists  of  airline  property.  The  maximum  credit  tor  1978  would  then 
be  (as  indicated  above)  100  percent  of  tax  liability.  If  any  of  the 
excess  credit  from  1977  would  be  carried  over  to  1978  (after  having 
been  first  carried  back  to  1974,  1975,  and  1976,  as  under  present  law) , 
the  1978  limit  would  not  be  affected  by  whether  the  amount  carried 
over  to  that  year  could  be  traced  originally  to  airline  property  or  to 
other  property. 

Effective  date 
The  temporary  increase  in  the  limitation  to  100  percent  is  to  be 
effective  with  raspect  to  taxable  years  ending  after  December  31, 
1976. 

Revenue  effect 
This  provision  will  reduce  budget  receipts  by  $32  million  in  fiscal 
year  1977,  $55  million  in  fiscal  year  1978,  and  $21  million  in  fiscal 
year  1981. 


Q.  INTERNATIONAL  TRADE  AMENDMENTS 

1.  United  States  International  Trade  Commission  (sec.  1801  of 
the  Act) 

Prior  law 

Under  prior  law  (section  330(d)  of  the  Tariff  Act  of  1930),  if  a 
majority  of  the  Commissioners  on  the  International  Trade  Commis- 
sion voting  on  an  escape  clause  or  market  disruption  case  under  section 
201  or  406  of  the  Trade  Act  of  1974,  respectively,  could  not  agree  on 
an  injury  determination  or  a  remedy  finding  or  recommendation,  then 
the  President  could  consider  the  "findings"  agreed  upon  by  one-half 
the  number  of  Commissioners  voting  to  be  the  "findings"  of  the  Com- 
mission. If  the  Commission  was  equally  divided  into  two  groups,  the 
President  could  consider  the  finding  of  either  grouj)  to  be  the  find- 
ing of  the  Commission,  Also  under  prior  law,  a  Commissioner  was 
required  to  leave  office  on  the  day  his  term  expired  whether  or  not  his 
successor  was  ready  to  take  office. 
Reasons  for  change 

The  amendment  with  respect  to  voting  procedures  was  adopted  to 
correct  a  defect  in  prior  law  which  had  prevented  i\\%  operation  of  the 
Congressional  ovei-ride  mechanism  in  cases  where  a  plurality  of  three 
Commissioners  reached  agreement  on  a  particular  remedy  but,  because 
a  majority  of  the  Commissioners  voting  did  not  agree  on  a  remedj', 
there  was  no  "recommendation"  by  the  Commission  which  Congress 
could  implement  under  the  override  provisions  in  the  Trade  Act  of 
1974.  The  amendment  with  respect  to  Commissioner's  terms  was 
adopted  to  ensure  that  the  Commission  at  all  times  has  a  full  comple- 
ment of  Commissioners. 

Explanation  of  provisions 
Under  the  Act,  if  a  majority  of  the  Commissioners  voting  on  an  es- 
cape clause  or  market  disruption  case  cannot  agree  on  a  remedy  find- 
ing, then  the  remedy  finding  agreed  upon  by  a  plui'ality  of  not  less 
than  3  Commissioners  is  to  be  treated  as  the  remedy  finding  of  the 
Cormnission  for  the  purposes  of  the  Congressional  override  in  sec- 
tions 202  and  203  of  the  Trade  Act  of  1974.  If  the  Commission  is  tied 
on  the  remedy  vote,  and  each  voting  group  includes  not  less  than  3 
Commissioners,  then  (1)  if  the  President  takes  the  action  recom- 
mended by  one  of  those  groups,  the  remedy  finding  agreed  upon  by 
the  other  group  shall,  for  purposes  of  the  Congressional  override,  be 
treated  as  the  remedy  finding  of  the  Commission,  or  (2)  if  the  Presi- 
dent takes  action  which  differs  from  the  action  agreed  upon  by  both 
such  groups,  the  remedy  finding  agreed  upon  by  either  such  group  may 
be  considered  by  the  Congress  as  the  remedy  finding  of  the  Commis- 
sion for  purposes  of  the  Congressional  override.  It  is  the  intention  of 

(468) 


469 

the  conferees  that  this  apply  only  for  purposes  of  implementing  the 
Congressional  override  in  sections  202  and  203  of  the  Trade  Act  of 
1974.  It  is  not  intended  that  this  provision  affect  in  any  way  the  rules 
of  procedure  of  the  International  Trade  Commission. 

Further,  Congress  strongly  urges  the  Commissioners  to  reach 
majority  agreement  on  all  determinations,  findings,  and  recommenda- 
tions in  all  cases. 

Also  under  the  Act,  a  Commissioner  may  continue  to  serve  as  a 
Commissioner  after  the  expiration  of  his  term  of  office  until  his  suc- 
cessor is  appointed  and  qualified. 
Effective  date 

These  provisions  are  to  apply  to  determinations,  findings,  and  rec- 
ommendations made  after  the  date  of  enactment  (after  October  4, 
1974). 

Revenue  ejfect 

These  provisions  will  have  no  effect  on  revenues. 

2.  Trade  Act  of  1974  Amendments  (sec.  1802  of  the  Act) 

Prior  law 
Under  Title  V  of  the  Trade  Act  of  1974,  eligible  articles  imported 
into  the  United  States  from  beneficiary  developing  countries  are  duty 
free.  Under  section  502  of  the  Trade  Act,  certain  countries  are  pro- 
hibited from  being  designated  as  beneficiary  developing  countries.  The 
prohibitions  apply  to  (1)  Communist  countries,  generally;  (2) 
members  of  OPEC;  (3)  countries  which  have  expropriated  U.S. 
property  without  prompt,  adequate,  and  effective  compensation;  (4) 
countries  whicli  do  not  cooperate  with  the  United  States  to  prevent 
narcotics  from  unlawfully  entering  the  United  States;  (5)  countries 
which  do  not  eliminate  reverse  preferences;  and  (6)  countries  which 
do  not  recognize  arbitral  awards  to  U.S.  citizens.  Prohibitions  (4),  (5) 
and  (6)  may  be  waived  by  the  President  if  he  determines  that  such 
a  waiver  will  be  in  the  national  economic  interest  of  the  United  States. 

Reasons  f&r  change 
The  Congress  believed  that  the  problem  of  international  terrorism 
has  grown  to  proportions  that  parallel  those  problems  relating  to  ex- 
propriations, drug  trafficking,  etc.,  for  which  prohibitions  have  been 
provided  under  Title  V  of  the  Trade  Act  of  1974. 

Explanation  of  provision 
Under  the  Act,  a  new  prohibition  is  added  to  the  definition  of  bene- 
ficiary developing  country  which  provides  that  a  country  may  not  be  so 
designated  if  it  aids  or  abets,  by  granting  sanctuary  from  prosecution 
to,  any  individual  or  group  which  has  committed  an  act  of  interna- 
tional terrorism.  This  prohibition  may  be  waived  by  the  President  if 
he  determines  that  the  waiver  will  be  in  the  national  economic  interest 
of  the  United  States. 

Effective  date 
The  provision  is  effective  upon  enactment  (October  4,  1976). 

Revenue  effect 
The  provision  will  not  have  any  effect  on  Federal  revenues. 


234-120  O  -  77  -  31 


R.  "DEADWOOD"  PROVISIONS 
(Repeal  and  Revision  of  Obsolete,  etc.,  Provisions  of  the  Code) 

The  provisions  provided  in  this  title  reflect  a  series  of  changes  which 
have  been  developed  over  a  number  of  years  as  an  attempt  to  simplify 
the  tax  laws  by  removing  from  the  Internal  Revenue  Code  those  pro- 
visions which  are  no  longer  used  in  computing  current  taxes  or  are 
little  used  and  of  minor  importance.  These  changes  have  be^n  popu- 
larly referred  to  as  the  "deadwood"  provisions. 

Title  19  repeals  almost  150  sections  of  the  Internal  Revenue  Code; 
it  amends  about  850  other  sections.  These  provisions  contain  approxi- 
mately 2,370  amendments  to  the  Code  (including  the  repealer  pro- 
visions and  changes  where  one  section  of  the  Code  is  amended  several 
times). 

This  title  deletes  provisions  in  prior  law  which  dealt  only  with  past 
years,  situations  which  were  initially  narrowly  defined  and  are  unlikely 
to  recur,  as  well  as  provisions  which  have  largely,  if  not  entirely,  out- 
lived their  usefulness.  In  addition,  several  amendments  eliminate  sex 
discrimination  from  the  Code. 

These  provisions  also  make  simplifying  changes  in  Code  language, 
such  as  the  substitution  of  the  term  "ordinary  income"  for  "gain  from 
the  sale  or  exchange  of  property  which  is  neither  a  capital  asset  nor 
property  described  in  section  1231  (b) ."  The  term  "the  excess  of  the  net 
long-term  capital  gain  for  the  taxable  year  over  the  net  short-term 
capital  loss  for  such  year"  is  replaced  by  "net  capital  gain."  In  another 
simplifying  change,  all  references  to  "the  Secretary  or  his  delegate"  are 
amended  to  refer  only  to  "the  Secretary"  (which  term  includes  his  dele- 
gates) ,  except  where  an  act  or  regulation  is  required  to  be  done  or  issued 
by  the  Secretary  of  the  Treasury  personally,  in  which  case  the  Code 
will  refer  specifically  to  "the  Secretary  of  the  Treasury." 

While  these  provisions  are  an  attempt  to  simplify  the  Code  by  delet- 
ing "deadwood,"  they  do  not  attempt  to  achieve  simplification  through 
substantive  changes  in  the  tax  law. 

SUBTITLE  A— AMENDMENTS  OF  INTERNAL  REVENUE 
CODE  GENERALLY 

SEC.    1901.    AMENDMENTS    OF    SUBTITLE    A;    INCOME 
TAXES 

Chapter  1.  Normal  Taxes  and  Surtaxes 

Subchapter  A.  Determination  of  tax  liability 

Sec.  1901  {a)  (1)  {amends  sec.  2  of  the  Code) — definitions  and  special 
rules 
This  amendment  makes  it  easier  to  read  a  provision  relating  to 
the  tax  status  of  certain  married  individuals  living  apart. 

(470) 


471 

Sec.  1901  {a)  (2)  {repeals  sec.  35  of  the  Code) — partially  tax-exempt 
interest  received  by  individuals 

This  amendment  repeals  section  35  of  the  Code  (relating  to  partially 
tax-exempt  interest  received  by  individnals)  because  there  are  no 
longer  any  outstanding  Federal  obligations  producing  interest  which 
is  partially  tax-exempt  under  that  section. 

Section"  242  of  the  Code,  relating  to  such  interest  received  by  cor- 
porations, is  repealed  by  section  1901(a)  (33)  of  the  Act.  Appropriate 
conforming  amendments  striking  out  references  to  Code  sections  35  and 
242  and  to  partially  tax-exempt  interest  in  other  Code  sections  are  also 
made  by  the  Act. 

Sec.  1901(a)  (S)  (amends  sec.  39  of  the  Code) — credit  for  taxes  paid 
on  gasoline.,  special  fuels.,  and  hibricating  oil 
These  amendments  strike  out  a  transitional  rule  for  the  years  1965, 
1966,  and  1967  and  conform  the  last  sentence  in  Code  section  39  to  an 
amendment  made  by  section  1906  (a)  (30)  (B)  of  the  Act. 

Sec.  1901  (a)  (Jf)  (amends  sec.  ^.6  of  the  Code) — investment  credit 

Subparagraph  (A)  corrects  a  clerical  error  in  the  Employee  Retire- 
ment Income  Security  Act  of  1974  ("ERISA").  Subparagraph  (B) 
changes  a  citation  to  conform  with  current  practice. 

Sec.  1901  (a)  (6)  (amends  sec.  4S  of  the  Code) — definitions  and  special 
ndes 
These    amendments    change    citations    to    conform    with    current 
practices. 

Sec.  1901  (a)  (6)  (amends  sec.  50A  of  the  Code) — work  incentive  credit 
This  amendment  corrects  a  clerical  error  in  ERISA. 

Sec.  1901(a)  (7)  (repeals  sec.  61  of  the  Code) — tax  surcharge 

This  amendment  repeals  tax  surcharge  provisions  applicable  to  1968, 

1969,  and  1970. 

Subchapter  B.  Computation  of  taxable  income 

Sec.  1901(a)  (8)  (amends  sec.  62  of  the  Code) — Penalties  for  early 
withdrawal  of  funds  from,  certain  savings  accounts 
Section  62  contains  two  paragraphs  numbered  (11).  In  1974,  Public 
Law  93-483  added  to  section  62  a  new  paragraph  (11)  (allowing  a 
deduction  from  gross  income  for  interest  "penalties"  incurred  upon 
early  withdrawals  from  time  savings  ac<'ounts  or  deposits).  A  few 
months  earlier,  ERISA  had  also  added  a  new  paragraph  (11)  (per- 
taining to  lump  sum  distributions  from  certain  pension  plans).  Sub- 
paragraph (A)  of  the  present  bill  redesignates  the  paragraph  added 
by  Public  Law  93-483  as  paragraph  (12) . 

Sec.  1901(a)(9)    (additional  amendment  of  sec.  62  of  the  Code)  — 

penalties  for  early  witlulrawal  of  funds  from  certain  savings 

accounts 

This  paragraph  corrects  a  clerical  error  in  the  paragraph  of  the 

Code  which  is  redesignated  as  paragraph  (12)  of  section  62  by  section 

1901(a)(8)  of  the  Act. 


472 

Sec.  1901  {a)  {10)  {adds  sec.  6^  to  the  Code)— definition  of  ordinary 
income 

This  paragraph  adds  a  new  section  to  the  Code  to  replace  the  cum- 
bersome and  lengthy  terminology-  of  present  law  which  describes  cer- 
tain gams  from  sales  or  exchanges  of  property  which  do  not  qualify 
as  capital  gains.  Many  provisions  of  present  law  describe  these  gains 
as :  "gam  from  the  sale  or  exchange  of  property  which  is  not  a  capital 
asset  or  property  described  in  section  1231  (b) ." 

For  this  language,  the  Act  substitutes  a  shorter  term:  "ordinary 
income." 

"Ordinary  income"  is  defined  as  including  "any  gain  from  the  sale 
or  exchange  of  property  which  is  neither  a  capital  asset  nor  property 
described  in  section  1231(b).  Any  gain  from  the  sale  or  exchange  of 
property  which  is  treated  or  considered,  under  other  provisions  of 
this  subtitle,  as  'ordinary  income'  shall  be  treated  as  gain  from  the  sale 
or  exchange  of  property  which  is  neither  a  capital  asset  nor  property 
described  in  section  123i  (b) ." 

Sec.  1901  {a)  {M)  {adds  sec.  65  to  the  Code) — definition  of  ordinary 
loss 

Tliis  paragraph  is  the  counterpart  to  section  1901(a)  (10),  which 
defines  "ordinary  income."  This  paragraph  provides  a  brief  definition 
of  "ordinary  loss"  to  replace  "loss  from  the  sale  or  exchange  of  prop- 
erty which  is  not  a  capital  asset."  The  new  definition  provides  that 
"ordinary  loss"  includes  "any  loss  from  the  sale  or  exchange  of  prop- 
erty which  is  not  a  capital  asset."  In  the  case  of  property  which  is  a 
capital  asset,  the  new  term  also  includes  loss  from  the  sale  or  exchange 
of  property  which  is  treated  or  considered,  under  other  provisions  of 
the  Code,  as  "ordinary  loss." 

Sec.  1901  {a)  {12)    (amends  sec.  72  of  the  Code) — annuities;  certain 
'proceeds  of  endowment  and  life  insurance  contracts 
Subparagraph  (A)  strikes  out  an  internal  effective  date  (January  1, 
1954)  and  a  reference  to  prior  laws  no  longer  needed. 

Sec.  1901  (a)  {13)  {additional  amendment  of  sec.  72  of  the  Code)— 
annuities;  certain  proceeds  of  endoic-ment  and  life  insurance 
contracts 

This  paragraph  corrects  a  clerical  error  made  in  ERISA. 

Sec.  1901  {a)  {IJf,)  {amends  sec.  76  of  the  Code) — mortgages  made  or 
ohJigation^  issued  hy  joint-stock  land  hanks 

This  amendment  repeals  an  obsolete  provision  relating  to  the  tax- 
ation of  income  (except  interest)  from  ioint-stock  land  bank  mortgages 
or  obligations.  Joint-stock  land  banks  have  not  been  peiTnitted  to 
make  new  loans  after  May  12,  1933.  and  it  is  imderstood  that  there 
are  no  joint-stock  land  bank  mortgages  or  obligations  currently  out- 
standing. 

Sec.  1901(a)  (15)  {amends  sec.  83  of  the  Code) — property  transferred 
in  connection  with  performance  of  se^niices 
This  amendment  strikes  out  an  internal  effective  date   ("30  days 
after  the  date  of  the  enactment  of  the  Tax  Reform  Act  of  1969")  relat- 
ing to  a  date  by  which  a  certain  election  could  be  made. 


473 

Sec.  1901  (a)  (16)  {amends  sec.  101  of  the  Code)— certain  death  lensps 

This  amendment  strikes  out  an  internal  effective  date. 
Sec.  1901  {a)  {17)   {amends  sec.  103  of  the  Code)— interest  on  certain 
governmental  ohligatimis 

These  amendments  strike  out  provisions  relating  to  the  tax-exempt 
status  of  the  interest  on  United  States  obligations,  since  there  are  no 
outstanding  obligations  of  the  United  States  or  of  any  United  States 
instrumentality  which  pay  interest  that  is  exempt  f  ix>m  tax  under  this 
section.  Also,  tlie  list  of  cross  references  in  section  103(e)  of  the  Code 
is  updated. 

Sec.  1901  {a)  {18)   {amends  sec.  10^  of  the  Code)— compensation  for 
injuries  or  sickness 

This  amendment  makes  conforming  changes  in  citations  to  other 
titles  of  the  United  States  Code. 

Sec.  1901  {a)  {19)   {amends  sec.  115  of  the  Code)— income  of  States., 
municipalities^  etc. 

This  amendment  repeals  subsections  (b)  and  (c)  relating  to  certain 
contracts  entered  into  before  September  8,  1916,  and  May  29,  1928 
(relating  to  certain  public  utilities  and  certain  bridge  acquisitions, 
respectively) ,  since  it  appears  that  no  such  contracts  are  still  in  effect. 

Sec.  1901  {a)  {20)  {a.mends  sec.  116  of  the  Code)— partial  exclmion  of 
dividends  received  hy  individ/uals 
This  amendment  strikes  out  an  internal  effective  date. 

Sec.  1901  {a)  {21)   {amends  sec.  124  of  the  Code)— cross  references  to 
other  Acts 
This  amendment  updates  a  list  of  cross  references  to  other  Acts. 

Sec.  1901  {a)  {22)  {amends  sec.  14S  of  th£  Code) — determination  of 
marital  status 
This  amendment  makes  section  143  (relating  to  determination  of 
marital  status)  applicable  for  purposes  of  part  V  (deductions  for 
personal  exemptions)  of  subchapter  B,  as  well  as  for  purposes  of  part 
IV  (standard  deduction)  of  that  subchapter.  As  a  result  of  this 
amendment,  section  153  becomes  redundant  and  is  repealed  by  section 
1901(b)  (7)  (A)  (i)  of  this  title. 

Sec.  1901  {a)  {23)  {amends  sec.  151  of  the  Code) — allowance  of  deduc- 
tions for  personal  exemptions 
This  amendment  replaces  the  definition  of  "educational  institution" 
with  a  cross  reference  to  a  similar  definition  in  section  170(b)  (1)  (A) 
(ii).  This  consolidates  in  one  section  the  definition  of  an  "educational 
organization."  The  amendment  makes  conforming  amendments  to  11 
other  Code  sections  to  reflect  this  change.  (Note  that  an  educational 
organization  described  in  clause  (ii)  of  section  170(b)  (1)  (A)  may  be 
a  private,  for-profit  school.  However,  even  though  such  a  school  could 
satisfy  the  requirements  of  the  dependency  provisions,  relating  to 
full-time  students,  it  could  not  be  an  eligible  donee  of  deductible 
charitable  contributions,  because  it  could  not  satisfy  the  requirements 
of  any  of  the  paragraphs  of  subsection  (c)  of  section  170). 


474 

Sec.  lP0J(a){24)  {amends  sec.  152  of  the  Code) — definition  of 
dependent 

Subparagraph  {X)  deletes  the  "sick  cousin  rule,"'  which  includes  as 
dependents  certain  distant  relatives  receiving  institutional  care  who 
previously  had  resided  with  the  taxpayer.  This  provision  was  added 
to  the  Code  to  cover  an  unusual  situation  unlikely  to  recur. 

Subparagraph  (B)  eliminates  another  provision  allowing  depend- 
ency deductions  under  two  rarely  used  rules.  Under  one  of  these  rules, 
a  child  residing  in  the  Philippine  Islands  qualifies  as  a  dependent  if 
lie  was  born  to,  or  adopted  by,  the  taxpayer  in  the  Philippines  before 
January  1,  1956,  if  the  taxpayer  was  then  a  member  of  the  U.S. 
Armed  Forces.  Under  the  other  rule,  a  resident  of  the  Canal  Zone  or 
Panama  may  be  claimed  as  a  dependent  although  he  is  not  a  citizen 
or  national  of  the  United  States. 

Sec.  1901  {a)  {25)  {amends  sec.  I6J4.  of  the  Code) — deduction  for  taxes 
These  amendments  strike  out  an  effective  date  provision  (sales  after 
December  31,  1953)  and  an  obsolete  transitional  rule,  both  of  which 
relate  to  the  apportionment  of  taxes  on  real  property  between  seller 
and  purchaser. 

Sec.  1091  {a)  {26)  {amende  sec.  165  of  the  Code) — losses 

These  amendments  strike  out  the  provision  that  treats  Cuban  ex- 
propriation losses  of  individuals  on  personal-use  assets  as  casualty 
losses,  since  this  provision  applies  only  to  losses  sustained  before  Janu- 
ary 1, 1964. 

Sec.  1901  {a)  {27)  {ameiuls  sec.  167  of  the  Code) — depreciation 

Subparagraph  (A)  substitutes  "August  16,  1954,"  for  "the  date  of 
enactment  of  this  title"  as  the  effective  date  of  a  provision. 

Subparagraph  (B)  substitutes  "October  16,  1962"  for  "the  date  of 
enactment  of  the  Revenue  Act  of  1962"  as  the  effective  date  of  a 
provision. 

Subparagraph  (C)  substitutes  the  exact  date  ("before  June  29, 
1970,")  for  "within  180  days  after  the  date  of  enactment  of  this  sub- 
paragraph," as  the  date  by  which  an  election  must  have  been  made 
under  a  provision. 

Sec.  1901  {a)  {28)  {amends  sec.  170  of  the  Code) — charitable.,  etc.,  con- 
tributio7is  and  gifts 

Subparagraph  (A)  strikes  out  the  unlimited  deduction  for  charita- 
ble contributions,  which,  by  its  own  terms,  expires  for  taxable  years 
beginning  after  December  31, 1974. 

Subparagraph  (B)  deletes  a  special  percentage  rate  by  which  excess 
charitable  contributions  from  a  contribution  year  beginning  before 
January  1, 1970,  could  be  carried  over  to  subsequent  taxable  years. 

Subparagraphs  (C)  and  (D)  eliminate  an  unnecessary  citation  and 
bring  up  to  date  statutory  citations  in  the  cross  references  at  the  end 
of  section  170. 

Sec.  1901  {a)  {29)   {amends  sec.  172  of  the  Code) — net  operating  loss 
deduction 
Subparagraph  (A)  deletes  the  special  five  year  loss  carryback  per- 
mitted to  American  Motors  Corporation  in  1967  (sec.  172(b)  (1)  (E) ), 
which  has  now  expired  by  its  own  terms. 


475 

Subparagraph  (B)  strikes  out  an  obsolete  effective  date  provision 
(taxable  years  ending  after  December  31,  1953)  relating  to  the  defini- 
tion of  net  operating  loss. 

Subparagraphs  (C)  and  (E)  delete  obsolete  transitional  rules  for 
1953  and  1954,  for  1957  and  1958,  and  for  1955  and  1956.  Subpara- 
graph (D)  deletes  a  reference  to  the  date  of  January  1,  1954,  which 
is  no  longer  necessary. 

Sec.  1901(a)  (SO)   {ainends  sees.  17 If.  and  175  of  the  Code) — research 
and  experbnental  expenditures  and  soil  and  water  conservation 
expenditures 
These  amendments  delete  "the  date  on  which  this  title  is  enacted" 

and  substitute  the  exact  date,  August  16,  1954. 

Sec.  1901  [a)  {31)  {repeals  sec.  187  of  the  Code) — rapid  amortization 
for  certain  coal  miiie  safety  equipment 
Section  187  of  the  Code  is  repealed  because  it  is  applicable,  by 
definition,  only  to  coal  mine  safety  equipment  placed  in  service  be- 
fore January  1,  1976.  The  special  60-month  rapid  amortization  for 
qualifying  property  placed  in  service  before  January  1,  1976,  is  not 
to  be  affected  by  this  repeal. 

Sec.  1901  {a)  {32)   {amends  sec.  219  of  the  Code) — disqucdiflcation  of 
governmental  plan  participants  from  distributing  to  individual 
retirement  accounts 
This  provision  corrects  a  clerical  error  in  ERISA. 

Sec.  1901  {a)  {33)  {repeals  sec.  242  of  the  Code) — partially  tax-exempt 
interest  received  hy  eorp07'atio7is 
Section  242  of  the  Code  is  repealed  because  there  are  no  longer  any 
outstanding  Federal  obligations  that  pay  interest  that  is  partially 
exempt  from  income  tax  under  that  section.  (See  the  corresponding- 
repeal  of  sec.  35  of  the  Code,  by  sec.  1901  (a)  (2)  of  this  title.) 

Sec.  1901  {a)  {34)  {amends  sec.  243  of  the  Code) — dividends  received 
hy  corporations 

Subparagraph  (A)  adds  a  citation  to  the  Investment  Act  of  1958. 

Subparagraph  (B)  strikes  out  a  parenthetical  clause  which  applies 
only  in  certain  cases  in  which  the  taxable  year  of  a  member  corpora- 
tion in  an  affiliated  group  began  in  1963  and  ended  in  1964. 

Sec.  1901  {a)  {35)   {amends  sec.  247  of  the  Code) — dividends  paid  on 
certain  preferred  stock  of  pxdjlic  utilities 
This  provision  revises  section  247(b)  (2)  of  the  Code  (defining  pre- 
ferred stock)  to  make  it  easier  to  read.  The  substance  of  the  definition 
is  unchanged. 

Sec.  1901  {a)  {36)   {amends  sec.  24S  of  the  Code) — organizational  ex- 
penditures 
This  amendment  substitutes  "August  16,  1954"  for  "the  date  of  en- 
actment of  this  title"  as  the  effective  date  of  this  provision. 

Sec.  1901  {a)  {37)  {amends  sec.  265  of  the  Code) — expenses  and  inter- 
est relating  to  tax-exempt  income 
This  amendment  strikes  out  an  obsolete  reference  to  tax-exempt  in- 
terest from  obligations  of  the  United  States  issued  after  September  24, 


476 

1917,  and  originally  subscribed  for  by  the  taxpayer.  No  such  obliga- 
tions paying  tax-exempt  interest  nve  outstanding. 

Sec,  1901(a)  (38)  {amends  sec.  269  of  the  Code) — acquisitions  tnade 
to  evade  or  avoid  income  tax 

This  amendment  repeals  the  presumption  of  a  tax  avoidance  pur- 
pose in  certain  cases  where  the  consideration  paid  for  stock  or  assets 
of  a  corporation  is  disproportionate  to  the  total  of  the  adjusted  basis 
of  the  assets  of  the  acquired  corporation  plus  the  amount  of  tax  bene- 
fits obtained  through  the  acquisition  (sec.  269  (c) ) . 

This  presumption  seems  to  be  contrary  to  the  purpose  of  the  provi- 
sion; i.e.,  usual!)'  tax  avoidance  motives  would  be  more  apt  to  be  pres- 
ent where  the  value  of  "'tax  benefits"  was  paid  for,  than  they  would  be 
where  the  "tax  benefits"  were  not  given  weight.  Moreover,  under  gen- 
eral tax  litigation  principles,  the  Commissioners  determination  of  a 
tax  avoidance  motive  is  presumptively  correct  and  the  burden  of  pro- 
duction of  evidence  is  already  on  the  taxpayer. 

Sec.  1901  {a)  {39)  {amends  sec.  275  of  the  Code) — nondeductible  taxes 
This  amendment  deletes  the  obsolete  reference  to  corresponding  pro- 
visions of  prior,  i.e.,  pre-1954  Code,  laws  in  the  provision  denying  a 
deduction  for  income  tax  withheld  from  wages. 

Sec.  1901  (a)  (40)  {amends  sec.  281  of  the  Code) — tenninaJ  railroad 
corporations 

Subparagraph  (A)  inserts  a  citation  to  the  Interstate  Commerce 
Act. 

Subparagraph  (B)  strikes  a  transitional  provision  applicable  to 
taxable  years  ending  before  October  23,  1962. 

Subchapter  C.  Corporate  distributions  and  adjustments 

Sec.  1901(a)  (41)  {amends  sec.  301  of  the  Code) — corporate  distribu- 
tions 
This  provision  repeals  section  301(e)  of  the  Code,  which  relates  to 
distributions  out  of  certain  earnings  and  profits  by  corporations  which 
were  classified  as  pei-sonal  service  corporations  under  the  Revenue 
Acts  of  1918  or  1921.  It  is  not  believed  that  there  are  any  such  corpo- 
rations that  have  not  already  distributed  the  earnings  and  profits  to 
which  this  section  applies. 

Sec.  1901  (a)  (42)  (amends  sec.  311  of  the  Code) — taxability  of  cor- 
poration on  distrihution 

Subparagraph  (A)  corrects  a  clerical  error  in  subsection  (d)(1) 
which  occurred  in  1969  when  the  two  words  "a  gain"  were  erroneously 
printed  as  "again". 

Subparagraph  (B)  strikes  out  one  of  the  exceptions  to  the  general 
rule  of  subsection  (d)  (1)  requiring  recognition  of  gain  at  the  corpo- 
rate level  on  a  redemption  distribution  of  appreciated  property.  The 
deleted  exception  relates  to  certain  distributions  required  to  be  made 
before  December  1, 1974. 

Subparagraph  (C)  strikes  out  two  unnecessary  statutes- at-large 
citations. 


477 

Sec.  1901  {a)  (43)  (amends  sec.  312  of  the  Code) — effect  of  distribu- 
tions on  earnings  and  profits 

Subparagraph  (A)  makes  two  clerical  corrections  in  replacing  ref- 
erences to  "this  Code"  with  references  to  "this  title." 

Subparagraph  (B)  deletes  a  subsection  providing  rules  for  comput- 
ing earnings  and  profits  with  respect  to  distributions  by  personal  serv- 
ice corporations  under  the  1939  code.  Since  earnings  and.  profits  adjust- 
ments for  a  taxable  year  are  based  on  the  law  applicable  to  that  year, 
this  amendment  does  not  affect  the  current  taxable  year  and  future 
years. 

Subparagraphs  (C)  and  (D)  strike  out  effective  dates  that  do  not 
apply  to  current  taxable  years. 

Sec.  1901(a)  (Jf4)  (amends  sec.  333  of  the  Code) — election  as  to  recog- 
nition of  gain  in  certain  liquidations 
This  amendment  strikes  out  an  obsolete  effective  date  proA'ision 
(June  22,  1954)   relating  to  adoption  of  a  plan  of  liquidation  of  a 
corporation. 

Sec.  1901  (a)  (4S)  (amends  sec.  33^  of  the  Code) — hasis  of  property  re- 
ceived in  liquidations 

These  amendments  delete  obsolete  effective  date  provisions  (June  22, 
1954)  relating  to  adoption  of  a  plan  of  corporate  liquidation. 

Sec.  1901(a)  (46)  (amends  sec.  337  of  the  Code) — gain  or  loss  on  sales 
or  exchanges  in  connectio^i  with  certain  liquidations 

These  amendments  delete  obsolete  effective  date  provisions  (June  22, 
1954,  and  January  1, 1958)  relating  to  adoption  of  a  plan  of  corporate 
liquidation. 

Sec.  1901  (a)  (47)  (repeals  sec.  342  of  the  Code)  — liquidation  of  certain 
foreign  personal  holding  companies 
This  amendment  repeals  the  provision  taxing,  as  short-term  capital 
gain,  gain  on  the  liquidation  of  certain  corporations  that  were  foreign 
personal  holding  companies  in  1937.  The  corporations  affected  by  this 
provision  were  given  a  chance  to  liquidate  at  long-term  capital  gain 
rates  for  a  period  after  this  provision  was  enacted,  and  again  in  1954 
through  1956.  Moreover,  the  rule  does  not  apply  to  sales  of  stock,  and 
long-term  capital  gain  rates  could  be  obtained  by  selling  the  stock 
rather  than  liquidating  the  corporation.  It  seems  likely  that  the  pro^d- 
sion  will  rarely,  if  ever,  be  applied,  and  therefore  is  deleted  as  unim- 
portant and  rarely  used. 

Sec.  1901  (a)  (48)  (amends  sec.  351  of  the  Code) — transfer  to  controlled 
corporations 

These  amendments  strike  out  an  obsolete  effective  date  (June  30, 
1967)  and  a  transitional  rule.  They  also  make  explicit  the  rule  of 
present  law  that  a  transfer  to  an  investment  company  (a  so-called 
"swap  fund")  is  not  accorded  tax-free  exchange  treatment  under  sec- 
tion 351. 

Sec.  1901(a)  (49)   (repeals  sec.  363  of  the  Code) — effect  on  ear-nings 
and  profits 
This  provision  repeals  an  unnecessary  cross  reference  provision  re- 
lating to  the  effect  on  earnings  and  profits  of  corporate  organizations 
and  reorganizations. 


478 

Sec.  1901  {a)  {50)   {amends  sec.  371  of  the  Code) — reorganization  in 
certain  receivership  and  hanJcmptcy  proceedings 
These  amendments  strike  out  unnecessary  citation  references  and 
insert  a  citation  to  the  U.S.  Code. 

Sec.  1901  {a)  {51)  {amends  sec.  372  of  the  Code) — hasis  in  connection 
with  certain  receivership  and  bankruptcy  proceedings 
This  amendment  strikes  out  an  unnecessary  citation  reference  to  the 
Statutes  at  Large. 

Sec.  1901  {a)  {52)  {repeals  sec.  373  of  the  Code) — loss  not  recognized 
in  certain  railroad  reorganizations 
This  provision  repeals  the  provisions  for  nonrecognition  of  loss  on 
transfers  made  before  August  1,  1955,  in  certain  railroad  reorganiza- 
tions, pursuant  to  a  court  order.  The  related  basis  provisions  are  moved 
to  section  374(b)  of  the  Code  by  section  1901(b)  (14)  (B)  of  the  title. 

Sec.  1901  {a)  {53)  {atnend^  sec.  37 Jf.  of  the  Code) — gain  or  loss  not  rec- 
ognized in  certain  railroad  reorganizations 
This  amendment  revises  a  citation  to  the  Bankruptcy  Act  to  con- 
form to  current  practice. 

Sec.  1901  {a)  {54)  {amends  sec.  381  of  the  Code) — carry o^^ers  in  cer- 
tain corporate  acquisitions 
This  amendment  deletes  an  obsolete  provision  dealing  with  the 
deduction  by  the  acquiring  corporation  of  contributions  to  a  pension 
plan  made  by  its  wholly-owned  subsidiary  whose  assets  were  acquired 
in  a  liquidation  subject  to  the  1939  Code. 

Sec.  1901  {a)  {55)  {repeals  sees.  391  through  395  of  the  Code)— effec- 
tive date  of  subchapter  C 
This  section  strikes  out  the  effective  date  provisions  of  subchapter  C 
of  chapter  1  of  subtitle  A.  These  provisions  are  not  needed  for  trans- 
actions occurring  after  the  effective  date  of  the  repeal  (i.e.,  taxable 
years  beginning  after  December  31, 1975) . 

Subchapter  D.  Deferred  compensation,  etc. 

Sec.  1901  {a)  {56)  {aTnends  sec.  Jfil  of  the  Code) — relating  to  require- 
ments for  qualification  of  certain  retirenient  plans 
Subparagraphs  (A),  (B),  and  (C)  replace  references  to  "the  date 
of  enactment  of  the  Employee  Retirement  Income  Security  Act  of 
1974"  or  to  "enactment  of  the  Employee  Retirement  Income  Security 
Act  of  1974''  with  that  date  of  enactment  (September  2,  1974).  Sub- 
paragraph (D)  corrects  an  error  in  margination. 

Sec.  1901  {a)  {57)  {amends  sec.  Ifi2  of  the  Code) — taxability  of  bene- 
ficiary of  employees''  tinist 

Subparagraph  (A)  replaces  an  obsolete  citation  and  it  replaces  four 
references  to  "basic  salary"  by  references  to  "basic  pay",  in  conform- 
ing Code  provisions  relating  to  Civil  Service  retirement  laws  to 
changes  in  those  laws  made  by  Public  Law  89-554  in  1966. 

Subparagraph  (B)  deletes  from  the  Code  subsection  (d)   of  sec- 


479 

tion  402,  an  absolete  provision  pertaining  to  certain  trust  agreements 
made  before  October  21,  1942. 

Subparagraph  (C)  amends  section  402(e)  (4)  (A)  to  make  clear  the 
intent  of  Congress  in  enacting  the  Employee  Retirement  Income  Se- 
curity Act  of  1974  that  the  distribution  of  an  annuity  contract  is  not 
in  and  of  itself  to  be  treated  as  a  taxable  lump  sum  distribution,  al- 
though the  value  of  the  contract  can  affect  the  amount  of  tax  imposed 
on  account  of  distributions  of  other  pronerty.  This  amendment  is  made 
retroactive  to  the  effective  date  of  the  lump  sum  distribution  taxation 
provisions  of  the  1974  Act. 

Sec.  1901  (a)  (58)  {ameiids  sec.  JfiS  of  the  Code) — rollover  of  emfloyee 
annuities 
This  pix)vision  corrects  an  error  in  margination  made  in  ERISA. 

Sec.  1901  {a)  {59)  {miwnds  sec.  Jfilj.  of  the  Code) — certa/ln  deductiotis 
foi'  contributions  to  a  periston  pla/n. 
This  provision  repeals  section  404(d),  which  permits  limited  carry- 
overs of  certain  pension  plan  contribution  deductions  from  1939  Code 
years  to  1954  Code  years  if  the  carryover  deductions  would  have  been 
allowable  if  the  1939  Code  provisions  had  remained  in  effect.  It  is 
believed  that  any  such  eligible  carryovers  have  by  now  been  used  or 
lost. 

Sec.  1901  (a)  (60)   (amends  sec.  1^09  of  the  Code) — rollover  contribu- 
tions from  individual  retirement  accounts  or  individual  retirement 
minuities 
This  provision  corrects  a  typographical  error  in  ERISA. 

Sec.  1901(a)  (61)  (amends  sec.  Ii.10  of  the  Code) — minim/am,  partici- 
pation standards 
Subparagraph  (A)  is  a  clerical  amendment  to  conform  to  current 
drafting  style.  Subparagraph  (B)  su'bstitutes  "September  2,  1974," 
for  "the  date  of  enactment  of  the  Employee  Retirement  Income  Secu- 
rity Act  of  1974".  Subparagraph  (C)  substitutes  "September  1, 1974" 
for  "the  day  before  the  date  of  the  enactment  of  this  section". 

Sec.  1901  (a)  (62)  (  amends  see.  Jfll  of  the  Code) — minim/iim  vesting 
standards 
Subparagraph  (A)  makes  a  change  in  wording  to  confonn  to  cur- 
rent drafting  style.  Subparagraph  (B)  in  three  places  substitutes  Sep- 
tember 2,  1974,  for  references  to  the  date  of  enactment  of  ERISA, 
Subparagraph  (C)  corrects  a  typographical  error  in  a  heading.  Sub- 
paragraph (D)  also  twice  substitutes  September  2, 1974,  for  references 
to  the  date  of  enactment  of  ERISA.  Subparagraph  (E)  substitutes 
"September  1, 1974"  for  a  reference  to  the  day  before  the  date  of  enact- 
ment of  ERISA. 

Sec.  1901(a)  (63)  (amends  sec.  1^.12  of  the  Code) — minimum  funding 
standards 
Subparagraph  (A)  substitutes  "September  1,  1974"  for  a  reference 
to  the  day  before  the  date  of  enactment  of  ERISA.  Subparagraph  (B) 
substitutes  "September  2,  1974"  for  a  reference  to  the  date  of  enact- 
ment of  ERISA. 


480 

Sec.  1901  (a)  (64)    {amends  sec.  4H  of  the  Code) — definitions  and 
special  rules 
Subparagraph  (A)  corrects  a  typographical  error  in  ERISA.  Sub- 
paragraph (B)  substitutes  "September  2,  1974"  for  a  reference  to  the 
date  of  enactment  of  ERISA. 

Sec.  1901  (a)  (65)  (amends  sec.  J4.15  of  the  Code) — limitations  on  bene- 
fits and  conti^ihutions  ufoder  qualified  plans 
These  amendments  correct  clerical  errors  in  ERISA. 

Subchapter  E.  Accounting  periods  and  methods  of  accounting 

Sec.  1901  {a)  {66)  {amends  sec.  J^53  of  the  Code) — installm,ent  method 
Subparagraph  (A)  is  a  clerical  amendment  substituting  a  reference 

to  the  1954  Code  for  an  erroneous  reference  to  the  1939  Code. 

Subparagraph   (B)   corrects  a  grammatical  error  by  striking  the 

words  "or  section"  which  improperly  appear  in  a  list  of  Code  sections. 

Sec.  1901  {a)  {67)  {amends  sec.  455  of  the  Code)  — prepaid  subscription 
income 
This  amendment  strikes  out  an  obsolete  effective  date  provision  (tax- 
able years  beginning  after  December  31,  1957)  relating  to  an  election 
to  have  section  455  of  the  Code  apply  to  certain  prepaid  subscription 
income  of  the  taxpayer. 

Sec.  1901  {a)  {68)  {amends  sec.  Jf56  of  the  Code) — prepaid  dues  income 
of  certain  membership  organizations 
This  amendment  deletes  an  obsolete  effective  date  provision  (tax- 
able years  beginning  after  December  31,  1960)  relating  to  an  election 
to  have  section  456  of  the  Code  apply  to  certain  prepaid  dues  income 
of  the  taxpayer. 

Sec,  1901  {a)  {69)  {amends  sec.  461  of  the  Code)  — general  rule  for  tax- 
able year  of  deduction 

Subparagraph  (A)  deletes  the  obsolete  transitional  rule  relating  to 
deduction  by  an  accrual  basis  taxpayer  of  real  property  taxes  deduct- 
ible under  the  Internal  Revenue  Code  of  1939  or  deductible  for  the 
taxpayer's  first  taxable  year  which  began  after  December  31,  1953. 

Subparagraph  (B)  deletes  an  obsolete  effective  date  provision  (tax- 
able years  beginning  after  December  31,  1953)  relating  to  an  election 
with  respect  to  the  deduction  of  real  property  taxes  by  a  taxpayer  using 
an  accrual  method  of  accounting. 

Sec.  1901  {a)  {70)  {amends  sec.  481  of  the  Code) — adjustments  re- 
quired by  changes  in  method  of  accounting 
These  amendments  delete  special  provisions  which  provide  that 
certain  adjustments  attributable  to  pre-1954  Code  years  resulting  from 
a  change  in  method  of  accounting  be  taken  into  account  over  a  10-year 
period  beginning  with  the  year  of  change.  These  provisions  do  not 
apply  with  respect  to  changes  in  methods  of  accounting  made  in  tax- 
able years  beginning  after  December  31,  1963,  and  are  therefore 
obsolete. 


481 

Sec.  1901  {a)  {71)  {amends  sec.  508  of  the  Code) —special  i^les  for 
cei'taln  exempt  orgamzations 

Subparagraph  (A)  strikes  provisions  stating  tliat  the  time  for  new 
organizations  to  give  the  required  notice  to  the  Secretary  regarding 
section  501(c)  (3)  status  and  private  foundation  status  shall  not  ex- 
pire before  the  90th  day  after  the  day  on  which  regulations  first  pre- 
scribed under  section  508  (a)  and  (b)  become  final.  Those  regulations 
became  final  on  December  21, 19T2. 

Subparagraph  (B)  deletes  a  special  rule  for  private  foundations 
organized  before  January  1,  1970.  This  rule  applies  to  taxable  years 
beginning  before  January  1,  1972.  Subparagraph  (C)  is  a  conforming 
amendment  to  the  changes  made  by  subparagraph  (B) . 

Sec.  1901  {a)  {72)  {amends  sec.  614  of  the  Code) — unrelated  deht- 
financed  mcome 

Subparagraph  (A)  strikes  out  a  transitional  rule  that  applied  to 
taxable  years  beginning  before  January  1 ,  1972. 

Subparagraph  (B)  strikes  out  the  lengthy  definitions  of  "business 
lease"  and  '"business  lease  indebtedness".  These  definitions  are  needed 
only  in  connection  with  a  rule  of  limited  application  set  forth  in  sec- 
tion 514(b)  (3)  (C)  (iii)  and  in  the  rule  deleted  by  subparagraph  (A). 
Tliese  definitions  are  replaced  in  subparagrapli.  (C)  with  an  appropri- 
ate reference  to  prior  law. 

Subparagraph  (T)  strikes  the  term  "premises"  from  a  definitional 
section  because  that  term  is  no  longer  used  in  section  514. 

Subchapter  G.  Corporations  used  to  avoid  income  tax  on 

shareholders 

Sec.  1901  {a)  {73)  {amends  sec.  534  of  the  Code) — hurden  of  proof 
with  respect  to  the  accumulated  earnings  tax 
These  amendments  delete  the  obsolete  transitional  rules  providing 
for  the  retroactive  application  of  the  1954  Code  burden  of  proof  re- 
quirement with  respect  to  the  accumulated  earnings  tax  to  proceedings 
involving  1939  Code  years. 

Sec.  1901  {a)  {74)  {amends  sec.  535  of  the  Code) — accumulated  taxable 
income 
This  amendment  strikes  out  a  reference  to  1939  Code  excess  profits 
taxes  that  have  been  repealed. 

Sec.  1901  {a)  {75)  {amends  sec.  537  of  the  Code) — reasonable  needs  of 
the  business 
These  amendments  strike  out  an  internal  effective  date  provision 
(May  26,  1969)  relating  to  the  definition  of  excess  business  holdings 
redemption  needs. 

Sec.  1901  (a)  {76)   {amends  sec.  542  of  the  Code) — definition  of  per- 
sonal holding  company 
Subparagraph   (A)   strikes  out  a  pro\nsion  that  prevents  certain 
exempt  organizations  from  beincf  treated  as  individuals  for  purposes  of 
the  personal  holding  company  definition.  The  provision  applies  only  if 


4=82 

the  organization  owned  all  of  the  corporation's  common  stock  and  80 
percent  of  its  other  stock  at  all  times  on  or  after  July  1, 1950.  It  is  likely 
that  these  corporations  have  been  liquidated  since  1955,  when  this  pro- 
vision was  enacted,  because  income  from  investments  would  be  taxable 
if  held  in  such  a  corporation,  but  Avould  be  tax-free  if  held  by  the 
exempt  organization  directly. 

Subparagraph  (B)  amends  a  provision  limiting  the  ability  of  a 
consolidated  group  to  compute  its  personal  holding  company  tax  on  a 
consolidated  basis.  The  amendment  strikes  out  an  exception  for  groups 
of  railroad  corporations  that  would  be  eligible  to  file  a  consolidated 
return  under  the  provisions  of  the  1939  Code  before  its  amendment 
in  1942.  It  appears  that  this  exception  is  no  longer  needed,  since  it 
would  apply  only  to  a  group  of  railroad  corporations  that  files  con- 
solidated returns  and  meets  the  five-or-fewer-shareholders  test. 

Subparagraph  (C)  amends  a  cross  reference  to  confomi  to  the 
amendment  of  section  7701(a)  (19)  by  the  Tax  Reform  Act  of  1969. 

Subparagraph  (D)  adds  a  U.S.  Code  citation  to  conform  to  current 
practice. 

Sec.  1901  {a)  {77)  {amends  sec.  5J^5  of  the  Code) — undistributed  per- 
sonal holding  coTnpany  income 

Subparagraph  (A)  strikes  out  a  reference  to  repealed  1939  excess 
profits  taxes.  It  also  eliminates  a  provision  permitting  a  personal  hold- 
ing company  that  deducted  taxes  on  the  cash  basis  during  1939  Code 
years  to  continue  to  do  so  until  it  makes  an  irrevocable  election  to  use 
the  accrual  basis.  It  seems  unlikely  that  a  significant  number  of  com- 
panies have  not  elected  to  accelerate  their  deductions  by  using  the 
accrual  basis. 

Subparagraph  (B)  strikes  out  a  provision  allowing  the  deduction 
of  amounts  used  or  set  aside  to  retire  indebtedness  incurred  before 
1934.  It  seems  likely  that  virtually  all  of  this  indebtedness  has  now 
been  retired. 

Subparagraph  (C)  strikes  out  "the  date  of  enactment  of  this  sub- 
section" in  section  .545(c)  (2)  (A)  and  substitutes  the  exact  date  (Feb- 
ruary 26, 1976). 

/Sec.  1901  {a)  {78)  {amends  sec.  61^7  of  the  Code) — deduction  for  defi- 
ciency divideiids 
This  amendment  deletes  a  1954  Code  effective  date  provision  that  is 
no  longer  needed. 

Sec.  1901  {a)  {79)    {amends  sec.  551  of  the  Code) — foreign  personal 
holding  companies 
This  clerical  amendment  inserts  a  word   ("income")   erroneously 
omitted  from  this  section. 

Sec.  1901{a)  {80)   {amends  sec.  556  of  the  Code) — undistributed  for- 
eign personal  holding  company  income 
This  amendment  deletes  a  reference  to  1939  Code  excess  profits  taxes 
that  have  been  repealed. 

Sec.  1901  {a)  {81)  {amends  sec.  56 Jf.  of  the  Code) — dividend  carryover 
This  amendment  strikes  out  a  transitional  provision  relating  to 
dividend  carryovei-s  from  pre-1954  Code  yeai-s  for  purposes  of  com- 
puting the  dividends-paid  deduction  of  a  personal  holding  company. 


483 
Subchapter  H.  Banking  institutions 

Sec.  1901  {a)  {8'2)  {re/peaU  sec.  583  of  the  Code) — deductions  of  div- 
idends paid  on  certain  preferred  stock 
This  amendment  strikes  out  provisions  relating  to  deductions  of 
dividends  paid  on  certain  preferred  stock  by  banks  or  trust  companies. 
It  appears  that  none  of  this  stock  is  now  outstanding  and  that  these 
provisions  are  no  longer  needed. 

Sec.  1901  {a)  {83)  {repeals  sec.  592  of  the  Code) — deduction  for  repay- 
ment of  certain  loans 
This  paragraph  repeals  the  provision  allowing  certain  mutual  sav- 
ings banks  to  deduct  certain  repayments  of  pre-September  1,  1951, 
loans.  All  the  loans  described  in  the  section  have  been  repaid  and  there- 
fore the  provision  is  no  longer  applicable. 

Sec.  1901  {a)  {84)  {amends  sec.  593  of  the  Code) — resei^ves  for  Josses 
on  loans 

Subparagraph  (A)  strikes  out  the  applicable  percentages  to  be  used 
by  mutual  savings  banks  in  computing  the  addition  to  reserves  for  bad 
debts  under  the  percentage  of  taxable  income  method  for  years  1969 
through  1975. 

Subparagraph  (B)  deletes  the  obsolete  portions  of  paragraphs  (2) 
through  (5)  of  section  593(c)  which  deal  with  the  required  allocation 
of  the  bad  debts  reserves  of  mutual  savings  banks  on  December  31, 
1962. 

Subparagraplis  (C)  and  (D)  strike  out  a  transitional  rule  for  a 
taxable  year  beginning  in  1962  and  ending  in  1963  that  deals  with  the 
treatment  of  bad  debts  reserves  of  mutual  savings  banks  and  make  an 
internal  conforming  change. 

Sec.  1901  {a)  {85)  {repeals  sec.  601  of  the  Code) — special  deduGtion 
for  tank  affiliates 
This  paragraph  repeals  a  special  deduction  allowed  bank  affiliates  in 
computing  the  accumulated  earnings  tax  and  the  personal  liolding 
company  tax.  The  deduction  is  for  the  amount  of  earnings  and  profits 
required  to  be  invested  in  a  reserve  of  readily  marketable  assets  under 
the  Banking  Act  of  1933.  This  requirement  was  eliminated  in  1966, 
and  there  is  now  no  requirement  that  such  a  reserve  be  maintained. 

Subchapter  I.  Natural  resources 

Sec.  1901  {a)  {86)  {amends  sec.  61 3 A  of  the  Code)— depletion  for  oil 
and  natural  gas  from  secondai^  oi'  tertiary  processes 
Subparagraph  (A)  eliminates  a  reference  to  a  subparagraph  of  the 
Code  that  was  deleted  by  Public  Law  94-12,  the  Tax  Reduction  Act  of 
1975  (sec.  613(b)  (1)  (A)  of  the  Code).  The  present  section  613(b)  (1) 
(A)  was,  prior  to  that  act,  section  613(b)  (1)  (B). 

Sec.  1901  {a)  {87)  {amends  sec.  614  of  the  Code) — definition  of  prop- 
erty 

These  amendments  strike  out  complex  and  seldom  used  provisions 
relating  to  recapture  of  taxes  saved  by  delaying  an  election  to  aggre- 
gate mineral  properties  from  the  date  of  first  exploration  to  the  date 
of  development  of  the  mine. 


484 

Sec.  1901  {a)  (88)  (repeals  sec.  616  of  the  Code)— pre- 1970  exploration 
expenditures 

This  amendment  repeals  section  615  of  the  Code,  which  provided  a 
deduction  for  certain  mineral  exploration  expenditures  paid  or  in- 
curred before  January  1,  1970.  Although  a  taxpayer  could  elect  under 
section  615(b)  to  defer  the  deduction  of  such  pre-1970  expenditures 
until  the  units  of  produced  ores  or  minerals  discovered  by  reason 
of  such  expenditures  were  sold,  it  is  believed  that  no  such  elections 
are  in  effect. 

Conforming  amendments  include  the  addition  of  a  new  subsection 
(i)  to  section  617  of  the  Code.  This  new  subsection  (i)  preserves  the 
rules  (formerly  set  forth  in  section  615(g)  (2))  which  provide  that 
amounts  deducted  under  section  615  with  respect  to  mineral  property 
by  the  transferor  of  such  property  will  be  subject  to  recapture  by  the 
transferee  in  certain  circumstances  under  section  617. 

Sec.  1901(a)  (89)  (amends  sec.  617  of  the  Code) — deduction  and  re- 
capture of  certain  mining  exploration  expenditures 
This  amendment  strikes  out  a  provision  allowing  the  revocation 
without  consent  of  an  election  if  tlie  revocation  was  made  within  3 
months  after  the  month  in  which  final  regulations  were  published 
under  section  617(a)  of  the  Code.  Such  regulations  were  published 
on  June  30, 1972,  so  this  provision  is  no  longer  needed. 

Sec.  1901  (a)  (90)  (repeals  sec.  632  of  the  Code) — maximum  tax  on 
sales  of  certain  oil  or  gas  properties 

This  amendment  strikes  out  a  provision  (sec.  632)  which  limits  to  32 
percent  the  tax  on  sales  of  oil  or  gas  properties  the  principal  value  of 
which  has  been  demonstrated  by  prospecting  or  discovery  done  by  the 
taxpayer  himself.  To  qualify,  the  taxpayer  must  be  an  individual,  not 
a  corporation. 

This  provision  was  enacted  in  1918  to  encourage  oil  and  gas  develop- 
ment and  to  lower  the  tax  rate  on  such  a  sale  in  view  of  the  years  that 
might  be  consumed  in  discovery  work  prior  to  such  a  sale.  This  provi- 
sion was  deleted  in  1934,  but  reinstated  in  1936  to  encourage  individ- 
uals in  competition  with  corporations  and  because  Congress  believed 
that  the  1934  deletion  had  discouraged  sales  of  such  properties. 

Before  1969  this  section  was  probably  seldom  used  because  the  25- 
percent  alternative  capital  gain  rate  was  lower  than  the  maximum  tax 
rate  under  section  632.  In  the  Tax  Reform  Act  of  1969,  Congress  in- 
creased the  maximum  capital  gain  tax  rate  for  individuals  to  35  per- 
cent. Congress  did  not  then  intend  to  create  a  preference  rate  which 
is  less  than  the  general  maximum  capital  gain  rate. 

Subchapter  J.  Estates,  trusts,  beneficiaries,  and  dependents 

Sec.  1901(a)  (91)  (amends  sec.  691  of  the  Code) — income  in  respect 
of  decedents 
This  amendment  strikes  out  a  reference  to  an  obsolete  effective  date 
provision  (sec.  683  of  the  Code).  That  effective  date  provision  is 
eliminated  by  the  amendment  of  section  683  by  section  2131  (e)  of  the 
Act. 


485 

Sec.  1901  {a)  {92)    {amends  sec.  692  of  the^  Code) -^members  of  the 
Armed  Forces  dying  during  an  induction  'peHod 
This  is  a  clerical  amendment  changing  "on"  tx)  "of"  in  the  heading 
of  the  section. 

Subchapter  K.  Partners  and  partnerships 

Sec.  1901  {a)  {93)    {amends  sec.  751  of  the  Code) — properties  to  he 
treated  as  unrealized  receivables. 
This  amendment  eliminates  a  clerical  error  which  retained  an  un- 
necessary word  ("or")  in  a  listing  of  Code  sections. 

Sec.  1901  {a)  {94-)  {repeals  sec.  771  of  the  Code) — effective  date  pro- 
vision of  subchapter  K 
This  provision  deletes  the  obsolete  effective  date  provisions  (gen- 
erally, December  31,  1954)  for  subchapter  K  of  chapter  1  (relating  to 
partners  and  partnerships).  The  repeal  of  Code  section  771(b)(1) 
(relating  to  adoption  of  taxable  year)  does  not  require  any  existing 
partner  or  partnership  to  change  to  a  different  taxable  year  or  change 
his  (or  its)  manner  of  reporting  income.  Thus,  for  example,  if  an 
existing  partnership  adopted  a  fiscal  year  beginning  before  April  2, 
1954,  and  an  individual  who  subsequently  becomes  a  principal  partner 
in  that  partnership  adopts  a  taxable  year  that  is  different  from  that  of 
the  partnership,  the  repeal  of  section  771(b)  (1)  by  the  bill  does  not 
require  either  the  principal  partner  or  that  partnership  to  change  to 
the  taxable  year  of  the  other. 

Subchapter  L.  Insurance  companies 

Sec.  1901  {a)  {95)  {amends  sec.  802  of  the  Code) — tax  on  life  insurance 
companies 

Subparagraph  (A)  deletes  an  obsolete  effective  date  provision  (tax- 
able years  beginning  after  December  31,  1957)  relating  to  the  imposi- 
tion of  tax  on  a  life  insurance  company. 

Subparagraph  (B)  deletes  an  obsolete  effective  date  provision  (tax- 
able years  beginning  after  December  31,  1961)  relating  to  the  alterna- 
tive tax  in  the  case  of  capital  gains  of  a  life  insurance  company. 

Subparagraph  (C)  deletes  an  obsolete  special  rule  for  computing 
the  tax  for  a  taxable  year  of  a  life  insurance  company  beginning  in 
1959  or  1960. 

Sec.  1901  {a)  {96)  {amends  sec.  801^.  of  the  Code) — taxable  investment 
income 

Subparagraph  (A)  strikes  out  a  special  rule  which,  in  effect,  pro- 
vides for  any  adjustment  necessary  to  prevent  a  life  insurance  com- 
pany from  being  taxed  on  tax-exempt  interest  or  dividends  qualifying 
for  a  dividend  received  deduction.  This  special  rule  is  surplusage 
because  the  basic  life  insurance  company  tax  provisions  have  been  held 
to  prevent  the  imposition  of  tax  on  these  items. 

Subparagraph  (B)  strikes  out  an  internal  effective  date  provision 
(taxable  years  beginning  after  December  31,  1958)  relating  to  the 
computation  of  life  insurance  company  gross  investment  income. 


234-120   O  -  77  -  32 


486 

Sec.  1901  {a)  {97)  {amends  sec.  805  of  the  Code) — policy  and  other 
contract  tmhility  requirements 

Subparagraph  (A)  strikes  out  an  obsolete  provision  pertaining  to 
the  earnings  rate  of  life  insurance  companies  for  taxable  years  begin- 
ning before  January  1, 1958. 

Subparagraph  (B)  strikes  out  a  parenthetical  clause  which  pro- 
vides that  the  adjusted  basis  of  certain  assets  which  a  life  insurance 
company  must  take  into  account  in  computing  its  taxable  income  is 
determined  without  regard  to  the  fair  market  value  of  the  assets  on 
December  31,  1958.  This  clause  was  surplusage  when  enacted  and  con- 
tinues to  be  surplusage  since  the  adjusted  basis  of  these  assets  is  not 
affected  by  their  fair  market  value  on  December  31,  1958. 

Subparagraph  (C)  strikes  out  traditional  rules,  relating  to  the 
amount  taken  into  account  as  pension  plan  reserves,  for  taxable  years 
beginning  after  December  31,  1957,  and  before  January  1,  1961. 

Sec.  1901  {a)  {98)  {amends  sec.  809  of  the  Code) — gain  and  loss  from 
operations 

Subparagraph  (A)  strikes  out  a  special  rule  which,  in  effect,  pro- 
vides for  any  adjustments  necessary  to  prevent  a  life  insurance  com- 
pany from  being  taxed  on  tax-exempt  interest  or  dividends  qualifying 
for  a  dividends  received  deduction.  This  special  rule  is  surplusage 
because  the  basic  life  insurance  company  tax  provisions  have  been  held 
to  i3revent  the  imposition  of  tax  on  these  items. 

Subparagraphs  (B)  and  (C)  strike  out  obsolete  provisions  relating 
to  certain  deductions  for  distributions  made  during  the  period  1958 
through  1962. 

Sec.  1901  {a)  {99)  {amends  sec.  812  of  the  Code) — operations  loss 
deduction 

This  amendment  strikes  out  obsolete  transitional  rules  relating  to 
years  before  1958  to  which  operating  losses  of  a  life  insurance  com- 
pany could  be  carried.  An  obsolete  internal  effective  date  (taxable 
years  beginning  after  December  31, 1958)  is  also  deleted. 

Sec.  1901  {a)  {100)  {amends  sec.  817  of  the  Code) — rules  relating  to 
certain  gain^  and  losses 
These  amendments  strike  out  special  rules  re^o^ing  to  capital  losses 
of  life  insurance  companies  incurred  in  taxable  years  beginning  before 
January  1,  1959,  and  reinsurance  transactions  of  life  insurance  com- 
panies occurring  in  1958. 

Sec.  1901  {a)  {101)  {amends  sec.  818  of  the  Code) — accounting  pro- 
insions 

This  amendment  deletes  transitional  rules  applicable  to  changes  in 
a  life  insurance  company's  method  of  accounting  from  its  taxable  year 
1957  to  its  taxable  year  1958. 

Sec.  1901  {a)  {102)  {amends  sec.  819  of  the  Code) — foreign  life  insur- 
ance companies 

Subparagraph  (A)  strikes  out  a  transitional  rule  for  taxable  years 
be.qrinning  before  January  1, 1959. 

Subparagraphs  (B)  and  (C)  make  internal  conforming  amend- 
ments. 


487 

iSec.  1901(a)  {103)  {amends  sec.  820  of  the  Code) — optional  treatment 
of  certain  reinsurance  'policies 
These  amendments  delete  an  obsolete  provision  relating  to  a  life 
insurance  company's  treatment  of  a  reimbursement  of  Federal  income 
tax  for  a  taxable  year  beginning  before  1958. 

Sec.  1901  {a)  {104)  {cumends  sec.  821  of  the  Code) — tax  on  mutual  in- 
surance companies 

Subparagraphs  (A)  and  (B)  strike  out  obsolete  internal  effective 
dates  (taxable  years  beginning  after  December  31,  1963),  relating  to 
the  imposition  of  tax. 

Subparagraph  (C)  strikes  out  an  obsolete  transitional  rule  for  tax- 
able years  beginning  after  December  31,  1962,  and  before  January  1, 
1968,  relating  to  underwriting  losses  of  mutual  insurance  companies. 

Sec.  1901  {a)  {105)  {amends  sec.  822  of  the  Code) — determination  of 
taxable  investment  income 

Subparagraph  {A.)  strikes  out  an  obsolete  reference  to  tax-exempt 
income  from  obligations  of  the  United  States  issued  after  Septem- 
ber 24,  1917,  and  originally  subscribed  for  by  the  taxpayer.  No  such 
obligations  that  pay  tax-exempt  interest  are  outstanding. 

Subparagraph  (B)  strikes  out  an  obsolete  internal  effective  date 
(taxable  years  beginning  after  December  31,  1962)  relating  to  accrual 
of  discount  on  bonds. 

Sec.  1901  {a)  {106)  {amends  sec.  825  of  the  Code) — unused  loss  deduc- 
tions 
These  amendments  strike  out  an  obsolete  transitional  date  (taxable 
years  beginning  before  January  1,  1963)  relating  to  taxable  years  to 
which  or  from  which  certain  unused  losses  may  be  carried. 

Sec.  1901  {a)  {107)    {amends  sec.  831  of  the  Code) — tax  on  certain 
insurance  companies 
This  amendment  makes  a  clerical  change,  changing  the  word  "or" 
to  "on". 

Sec.  1901  (a)  {108)  {amends  sec.  832  of  the  Code) — insurance  company 
taxahle  income 
These  amendments  conform  the  name  of  the  National  Association 
of    Insurance    Commissioners    by    substituting    "Association"    for 
"Convention." 

Subchapter  M.  Regulated  investment  companies  and  real  estate 

investment  trusts 

Sec.  1901(a)  {109)  {amends  sec.  851  of  the  Code) — definition  of  regu- 
lated investmen  t  comfar\y 

Subparagraph  (A)  makes  a  clerical  change  to  conform  a  citation 
to  other  citations  in  the  Code. 

Subparagraph  (B)  strikes  out  an  obsolete  effective  date  (taxable 
years  beginning  after  December  31,  1941)  relating  to  the  time  for 
making  an  election  to  be  a  regulated  investment  company. 


488 

Sec.  1901  {a)  {110)  {amends  sec.  852  of  the  Code) — taxation  of  regu- 
lated investment  companies  and  their  shareholders 

Subparagraph  (A)  strikes  out  a  special  rule,  relating  to  the  deduc- 
tion for  dividends  paid,  that  applies  only  to  taxable  years  beginning 
before  January  1,  1975. 

Subparagraph  (B)  deletes  a  transitional  rule  relating  to  an  adjust- 
ment of  the  basis  of  the  shares  of  a  shareholder  of  a  regulated  invest- 
ment company  based  upon  a  percentage  of  the  amount  of  undistributed 
capital  gains  includible  in  the  shareholder's  income.  The  amendment 
deletes  provisions  relating  to  taxable  years  beginning  before  Janu- 
ary 1,  1971.  A  special  rule  is  provided  so  that  the  amendment  made  by 
subparagraph  (B)  shall  not  be  considered  to  affect  the  amount  of  any 
increase  in  the  basis  of  stock  under  the  provisions  of  section  852  (b)  (3) 
(D)  (iii)  of  the  Code  which  is  based  upon  amounts  subject  to  tax 
under  section  1201  of  the  Code  in  taxable  years  beginning  before  Jan- 
uary 1, 1975. 

Subparagraph  (C)  adds  a  citation  reference  to  the  United  States 
Code. 

Sec.  1901  {a)  {111)  {amends  sec.  856  of  the  Code) — definition  of  real 
estate  investment  trust 

Subparagraph  (A)  strikes  out  an  obsolete  internal  effective  date 
(taxable  years  beginning  after  December  31,  1960)  relating  to  an  elec- 
tion to  be  a  real  estate  investment  trust. 

Subparagraph  (B)  inserts  a  citation  reference  to  the  United  States 
Code. 

Sec.  1901  {a)  {112)    {amends  sec.  857  of  the  Code) — taxation  of  real 
estate  investment  trusts  and  their  heneficiaries 
This  amendment  strikes  out  a  special  rule,  relating  to  the  deter- 
mination of  the  deduction  for  dividends  paid,  for  taxable  years  begin- 
ning before  January  1, 1975. 

Subchapter  N.  Tax  based  on  income  from  sources  within  or 
without  the  United  States 

Sec.  1901  {a)  {113)  {amends  sec.  864-  of  the  Code) — definitions 

These  amendments  and  conforming  amendments  change  the  terms 
"sale"  and  "sold"  to  "sale  or  exchange"  and  "sold  or  exchanged" 
respectively  each  place  they  appear  in  part  I  of  subchapter  N  of  chap- 
ter 1  of  the  Code.  Definitions  of  the  term  "sale"  as  including  "ex- 
change" and  "sold"  as  including  "exchanged"  are  then  eliminated  from 
section  864. 

Sec.  1901  {a)  {114)  {a/mends  sec.  905  of  the  Code) — proof  of  foreign 
tax  credits 
This  amendment  deletes  a  special  foreign  tax  credit  relating  to 
the  treatment  of  taxes  imposed  by  the  United  Kingdom  with  respect 
to  scientific  and  industrial  royalties.  The  treatment  of  these  taxes  is 
dealt  with  in  the  United  States — United  Kingdom  income  tax  conven- 
tion and  accordingly  the  special  Code  provision  is  no  longer  necessary. 


489 

Sec.  1901  {a)  {115)    {amends  sec.  911  of  the  code) — taocatiooi  of  non- 
cash 7'e?nmieratlon  from  sources  roithout  the  United  States 
This  amendment  strikes  out  obsolete  rules  dealing  with  certain  non- 
cash remuneration  received  in  taxable  years  ending  in  1963,  1964,  or 
1965. 

Sec.  1901  {a)  {116)    {amends  sec.  921  of  the  Code)— Western  Hemi- 
sphere Trads  Corporations 
This  amendment  strikes  out  an  obsolete  provision  relating  to  the 
determination  of  whether  corporations  met  certain  requirements  of 
the  1939  Code  in  taxable  years  beginning  before  January  1,  1954. 

Sec.  1901  {a)  {117)    {amends  sec.  931   of  the  Code) — income  from 
sources  unthin  United  States  possessions 
These  amendments  strike  out  an  obsolete  provision  relating  to  citi- 
zens who  were  captured  by  the  Japanese  in  the  Philippine  Islands  dur- 
ing World  War  11. 

Sec.  1901  {a)  {118)  {amends  sec.  9S4  of  the  Code) — tax  liability  in- 
cur-red  to  the  Virgin  Islands 
This  amendment  strikes  out  a  provision  indicating  that  amounts 
received  within  the  United  States  cannot  be  excluded  from  income  by 
Virgin  Island  law  pursuant  to  section  934.  This  was  originally  in- 
tended as  a  source  of  payment  rule,  but,  as  a  result  of  misinterpreta- 
tions, it  no  longer  serves  any  purpose  in  tax  law. 

Sec.  1901  {a)  {119)  {amends  sec.  951  of  the  Code) — araounts  included 
in  gross  income  of  United  States  shareholders 
This  amendment  strikes  out  an  obsolete  effective  date  provision 
(taxable  years  beginning  after  December  31,  1962)  for  this  section. 

Sec.  1901  {a)  {120)  {repeals  sec.  972  of  the  Code)— consolidation  of 
group  of  export  corporations 
This  paragraph  repeals  the  provision  which  allows  the  consolidation 
of  export  trade  corporations  for  purposes  of  the  exception  from  sub- 
part F  treatment  (relating  to  certain  income  of  controlled  foreign  cor- 
porations) which  is  provided  for  certain  export-related  income  of  these 
corporations.  This  provision  has  been  little  used  in  the  past  and  is  not 
currently  being  used. 

Subchapter  O.  Gain  or  loss  on  disposition  of  property 

Sec.  1901  {a)  {121)  {amends  sec.  1001  of  the  Code)— determination  of 
a,mount  of  and  recognition  of  gain  and,  loss 
This  amendment  transfers  to  section  1001(c)  of  the  Code  the  rules 
relating  to  recognition  of  gain  or  loss  now  in  section  1002  of  the  Code. 
A  conforming  amendment  repeals  section  1002. 

Sec.  1901  {a)  {122)  {amends  sec.  1015  of  the  Code)— basis  of  property 
acquired  by  gifts  and  transfers  in  trust 
These  amendments  substitute  "September  2, 1958"  for  the  references 
to  "the  date  of  the  amendment  of  the  Technical  Amendments  Act  of 
1958"  as  the  effective  date  of  section  1015  (d) . 


490 

Sec.  1901  {a)  {123)    {amends  sec.  1016  of  the  Code) — adjustments  to 
basis 

This  amendment  deletes  from  the  Code  section  1016(a)  (19),  which 
requires  adjustments  in  the  basis  of  section  38  property  in  tax  years 
beginning  before  1965.  To  the  extent  future  transactions  involve  prop- 
erty as  to  which  taxpayers  failed  to  make  these  pre-1965  basis  adjust- 
ments, the  repeal  of  section  1016(a)  (19)  does  not  prevent  their  doing 
so  retroactively,  at  least  for  prospective  application,  since  the  law 
governing  adjustment  of  basis  is  the  law  of  the  period  during  which 
the  adjustment  was  required  to  be  made.  (See,  e.g.,  Treas.  Regs. 
§1.1016-3(f).) 

Sec.  1901{a){lU)    {amends  sec.  1018  of  the  Code)— adjustment  of 
capital  stTU€ture  before  September  22, 1938 
This  amendment  strikes  out  an  unnecessary  citation. 

Sec.  1901  {a)  {125)  {repeals  sec.  1020  of  the  Code)— election  in  respect 
of  depreciation  allowed  before  1952 
This  amendment  repeals  an  obsolete  provision  relating  to  an  election 
to  adjust  the  basis  of  property  with  respect  to  depreciation  before 
3952.  Xo  election  could  be  made  or  revoked  under  this  section  after 
December  31,  1954.  The  adjustment  under  section  1016  of  the  Code  to 
the  basis  of  the  property  which  was  the  subject  of  the  election  is  not 
affected  by  prospective  repeal  of  section  1020. 

Sec.  1901  {a)  {126)  {repeals  sec.  1022  of  the  Code)— basis  of  certain 
foreign  personal  holding  company  stock 
Section  1022  of  the  Code  is  repealed  because  it  is  an  unimportant 
and  seldom  used  provision.  This  provision  was  added  to  the  Code  for 
one  case  (in  which  it  was  not  used).  Section  1022  applies  only  with 
respect  to  the  basis  of  stock  or  securities  of  a  corporation  which  was  a 
foreign  personal  holding  companv  for  its  most  re/^ent  taxable  year 
ending  before  the  death  of  a  decedent  dying  after  December  31,  1963, 
from  whom  such  stock  or  securities  are  acquired.  Although  it  is  un- 
likelv  that  this  provision  has  ever  been  u?ed.  a  special  effective  date 
is  provided  so  that  the  repeal  applies  only  with  respect  to  stock  or 
securities  acquired  from  a  decedent  dying  after  the  date  of  the  enact- 
ment of  this  bill. 

Sec.  1901  {a)  {127)   {amends  sec.  1024  of  the  Code) — cross  references 
This  amendment  strikes  out  an  absolete  reference  to  the  Defense 
Production  Act  of  1950. 

Sec.  1901  {a)  {128)  {amends  sec.  1033  of  the  Code) — im^oluntary  con- 
versions 

Subparagi-aph  (A)  strikes  out  an  obsolete  provision  applicable  to 
the  conversion  of  property  into  money  where  the  disposition  of  the 
converted  property  occurred  before  1951. 

Subparagraphs  (B)  and  (D)  conform  sections  1033(a)  (2)  and  (c) 
to  the  change  made  by  subparagi-aph  (A).  Subparagraph  (B)  also 
makes  a  clerical  change  to  include  as  new  subparagi^aplis  necessary 
definitions  of  "control"  and  "disposition  of  the  converted  property'' 
that  would  otherwise  be  deleted  by  the  amendment  made  by  subpara- 
graph (A). 


491 

Subparagraph  (C)  strikes  out  an  obsolete  special  rule  relating  to 
certain  conversions  of  property  before  January  1,  1954. 

Subparagraph  (E)  strikes  out  an  obsolete  effective  date  provision 
(December  31,  1957)  relating  to  the  disposition  of  certain  property. 

Subparagraph  (F)  conforms  section  1033(g)  (4)  (added  by  section 
2140(a)  of  the  Act)  to  the  amendment  made  by  subparagraph  (A). 

Sec.  1901(a)  (129)  (amends  sec.  103^  of  the  Code)— sale  or  exchange 
of  residence 

Subparagraphs  (A)  and  (B)  strike  out  obsolete  internal  effective 
dates  (December  31,  1954)  relating  to  the  sale  of  a  residence. 

Subparagraph  (C)  strikes  out  an  obsolete  reference  to  the  Internal 
Revenue  Code  of  1939. 

Subparagraph  (D)  strikes  out  obsolete  transitional  rules  for  the 
years  1951  through  1957. 

Subparagraph  (E)  strikes  out  an  internal  effective  date  (Decem- 
ber 31, 1950)  which  is  no  longer  needed. 

Sec.  1901  (a)  (ISO)  (amends  sec.  1037  of  the  Code)— certain  exchanges 
of  United  States  obligations 

This  amendment  corrects  an  erroneous  cross  reference. 

Sec.  1901  (a)  (131)  (amends  sec.  1051  of  the  Code)—'pro'perty  acquired 
during  affiliation 
This  amendment  strikes  out  the  sentences  in  section  1051  that  pro- 
vide that  the  basis  of  property  acquired  or  held  during  a  consolidated 
return  year  is  to  be  determined  under  the  consolidated  return  regula- 
tions. This  provision  is  unnecessarv  because  adequate  authority  for 
providing  basis  rules  in  the  consolidated  return  regulations  is  pro- 
vided under  section  1502  and  its  predecessors. 

Sec.  1901  (a)  (132)  (amends  sec.  1081  of  the  Code)— distributions 
required  by  the  Securities  and  Exchange  Comnrdssion 

These  nmendmentsstril-e  out  a  special  rule  for  distributions  of  stock 
and  rights  to  acquire  stock  before  January  1,  1958,  in  pursuance  of  an 
order  of  the  Securities  and  Exchange  Commission. 

Subparagraph   (B)   also  conforms  a  citation  to  current  practice. 

Sec.  1901(a)  (133)  (amends  sec.  1083  of  the  Code) — containing  defini- 
tions of  terms 
These  amendments  eliminate  unnecessary  citations. 

Sec.  1901(a)  (13Jf)  (repeals  sec.  1111  of  the  Code) — distribution  of 
stock  pursuant  to  order  enforcing  the  antitrust  laws 
This  amendment  and  conforming  amendments  repeal  special  pro- 
visions relating  to  the  income  tax  treatment  of  certain  recipients  of 
General  Motors  stock  distributed  pursuant  to  a  court  order  in  the 
DuPont  anti-trust  case  ( United  States  v.  E.  I.  diiPont  deNemours  and 
Com.pany.  et  al.,  353  XLS.  586  (1957)  and  365  U.S.  806  (1961).  Section 
1111  of  the  Code  provides  special  rules  for  individual  shareholders  and 
shareholders  not  entitled  to  the  corporate  dividends  received  deduction 
who  receive  such  stock.  Technical  amendments  relating  to  the  addition 
of  section  1111  were  added  to  sections  301,  312,  535.  543,  545,  553,  556, 
and  561  of  the  Code.  Tlie  distributions  which  are  the  subject  of  these 


492 

provisions  have  been  completed  and  the  rights  of  persons  who  received 
sucli  distributions  are  preserved.  Accordingly,  the  bill  repeals  section 
1111  of  the  Code  and  related  provisions. 

The  repeal  of  these  provisions  is  not  retroactive.  Nor  do  these  re- 
peals alter  the  determinations,  for  purposes  of  future  years,  of  the 
basis  of  stock  with  respect  to  which  the  distributions  were  made. 

Subchapter  P.  Capital  gains 

Sec.  1901  {a)  {135)  {amends  sec.  1201  of  the  Code) — alternative  tax 
on  capital  gains 

Subparagraph  (A)  makes  clerical  amendments  to  eliminate  refer- 
ences to  "net  section  1201  gain"  in  taking  advantage  of  the  new  defini- 
tion of  "net  capital  gain"  (sec.  1901(a)  (136)  (B)  of  this  title.  This 
subparagraph  also  deletes  transitional  rules  for  computing  the  capital 
gains  tax  for  corporations  before  1975.  (The  effective  date  rule  of  the 
bill  will  preserve  rights  and  liabilities  with  respect  to  pre-1975  years 
so  long  as  they  are  open  under  the  statute  of  limitations.) 

Subparagrapli  (B)  also  eliminates  references  to  "net  section  1201 
gain"  made  obsolete  by  the  new  definition  of  "net  capital  gain."  In 
addition,  obsolete  transitional  rules  for  computing  an  individual's 
alternative  capital  gains  tax  in  1970  and  1971  are  deleted. 

Subparagraph  (C)  eliminates  other  transitional  rules  for  noncor- 
porate taxpayers  with  respect  to  years  prior  to  1975.  That  elimination, 
and  a  transfer  to  section  1201  (b)  of  the  mle  limiting  to  25  percent  the 
alternative  tax  on  the  first  $50,000  of  net  capital  gain  permits  subsec- 
tion (d)  to  be  deleted. 

Sec.  1901  {a)  {136)  {amends  sec.  1222  of  the  Code) — terms  relating  to 
capital  gains  and  losses 

Subparagraph  (A)  defines  a  new  term,  "capital  gain  net  income," 
which  replaces  the  former  term  "net  capital  gain."  The  new  term,  like 
the  former  term,  refers  to  the  excess  of  the  gains  from  sales  or  ex- 
changes of  capital  assets  over  the  losses  from  such  sales  or  exchanges 
(sec.  1222(9)). 

Subparagraph  (B)  sets  forth  a  new  definition  of  "net  capital  gain". 
The  term  replaces  the  existing  term,  "net  section  1201  gain,"  in  section 
1222  (11).  The  new  and  former  terms  refer  to  the  excess  of  the  net  long- 
term  capital  gain  for  the  taxable  year  over  the  net  short-term  capital 
loss  for  such  year.  These  definitions  make  it  possible  to  use  these  terms 
throughout  the  Code  instead  of  the  longer  phrases. 

Sec.  1901  {a)  {137)   {amends  sec.  1233  of  the  Code) — gains  and  losses 
from  short  sales 
This  amendment  substitutes  "August  16,  1954"  for  "the  date  of  en- 
actment of  this  title"  as  the  effective  date  of  section  1233(c). 

Sec.  1901  {a)  {138)    {amends  sec.  1237  of  the  Code) — real  property 
subdivided  for  sale 
This  amendment  strikes  out  an  obsolete  effective  date  (December  31, 
1953). 


493 

Sec.  1901  {a)  {139)  {repeals  sec.  12^0  of  the  Code) — taxability  to  em- 
ployee of  certain  termination  payments 

This  amendment  repeals  the  so-called  Tjouis  B.  Mayer  provisions. 
This  provision  permits  capital  gain  treatment  of  a  lump  sum  settle- 
ment of  rights  in  an  employment  contract.  Since  the  provision  contains 
narrow  restrictions,  including  the  requirement  that  the  rights  be  cre- 
ated before  August  16,  1954,  it  is  believed  that  it  has  no  applicability 
today. 

Sec.  1901  {a)  {IJfi)    {amends  sec.  12ItS  of  the  Code)— gain  from  dis- 
positions of  certain  depreciable  property 

This  amendment  deletes  surplus  language  added  through  a  clerical 
error  by  Public  Law  94—81. 

Sec.  1901  {a)  {11^1)   {amends  sec.  IW  of  the  Code)— gain  on  foreign 
investment  company  stock 

This  amendment  strikes  out  an  obsolete  effective  date  (Decem- 
ber 31, 1962). 

Subchapter  Q.  Readjustment  of  tax  between  years  and  special 

limitations 

Sec.  1901  {a)  {14£)    {am.ends  sec.  1311  of  the  Code) — mitigation  of 
effect  of  limitations 

These  amendments  conform  section  1311  to  the  new  name  of  the 
Tax  Court. 
Sec.  1901{a){llt3)    {repeals  sec.  1315  of  the  Code)— effective  date 

This  provision  repeals  the  obsolete  effective  date  provision  (Novem- 
ber 15,  1954)  for  part  II  of  subchapter  Q  of  chapter  1.  An  obsolete 
transitional  rule  relating  to  the  application  of  the  Internal  Revenue 
Code  of  1939  to  certain  determinations  made  before  November  15, 
1954,  is  also  deleted. 

Sec.  1901  {a)  HU^  (repeals  sec.  1321  of  the  Code)— involuntary  liqui- 
dation of  LIFO  inventories 
This  paragraph  repeals  an  obsolete  provision  relating  to  involuntary 
liquidations  of  LIFO  inventories.  The  provision  applies  only  to  inven- 
tories liquidated  in  taxable  years  ending  after  June  30,  1950,  and 
before  January  1,  1955,  and  only  if  the  inventory  was  replaced  in  a 
taxable  year  ending  before  January  1, 1956. 

Sec.  1901{a)  {11^5)  {repeals  sections  1331  through  1337  of  the  Code)  — 
war  loss  recoveries 
This  provision  repeals  the  provisions  dealing  with  World  War  II 
war  loss  recoveries  effective  with  respect  to  recoveries  in  taxable  years 
beginning  after  December  31,  1976.  The  basis  of  property  recovered 
during  prior  taxable  years  will  not  be  affected  by  the  repeal.  Future 
recoveries,  which  appear  unlikelv,  would  be  covered  by  the  general 
tax  benefit  rule,  which  accords  similar  (though  not  identical) 
treatment. 


494 

Sec.  1901{a){lJf.6)  {amends  sec.  134.1  of  the  Code) — restoration  of 
amount  held  under  claim  of  right 
This  amendment  strikes  out  provisions  relating  to  certain  retro- 
active payments  by  a  subcontractor  to  a  prime  contractor,  or  by  a 
subcontractor  to  a  higher  tier  subcontractor.  These  provisions  are  ex- 
pressly limited  to  payments  made  under  a  subcontract  entered  into 
before  January  1,  1958,  and  it  is  believed  that  no  such  contracts  are 
still  outstanding. 

Sec.  1901(a)  {147)   {repeals  sec.  13^2  of  the  Code) — computation  of 
tax  on  certain  amounts  recovered  as  a  result  of  a  patent  infringe- 
ment suit 
This  paragraph  repeals  special  provisions  relating  to  amounts  taken 
into  gross  income  because  of  the  reversal  of  a  lower  court  decision 
in  a  patent  infringement  suit.  Because  of  the  narrow  circumstances 
in  which  this  provision  applies  (e.g.,  the  lower  court  decision  must 
be  reversed  on  tlie  ground  that  such  decision  was  induced  by  fraud  or 
undue  influence) ,  this  provision  is  rarely  used. 

Sec.  1901  {c)  {148)  {repeals  sec.  1346  of  the  Code) — recovery  of  uncon- 
stitutional Federal  taxes 
This  provision  repeals  special  provisions,  no  longer  needed,  relating 
to  the  treatment  of  a  recover^-  during  the  taxable  year  of  a  tax  im- 
posed by  the  United  States  which  has  been  held  unconstitutional. 

Subchapter  S.  Election  of  certain  small  business  corporations 
as  to  taxable  income 

Sec.  1901  {a)  {149)  {amends  sec.  1372  of  the  Code) — election  hy  small 
business  corporation 

Under  the  minimum  tax  provisions  of  the  Tax  Reform  Act  of  1969, 
an  electing  small  business  corporation  is  subject  to  tax  on  certain 
capital  gains.  The  amendment  made  by  subparagraph  A  conforms  sec- 
tion 1372  to  these  provisions  by  inserting  a  reference  to  the  tax  im- 
posed by  section  56  of  the  Code. 

Subparagraph  (B)  strikes  out  a  transitional  rule,  relating  to  the 
time  for  making  an  election  by  a  small  business  corporation,  that 
applies  to  a  taxable  year  beginning  in  1958. 

Subparagraph  (C)  strikes  out  a  special  rule  that  allowed  certain 
shareholders  who  owned  stock  that  was  community  property  to  file 
a  consent  prior  to  May  15,  1961,  to  an  election  by  a  small  business 
corporation. 

Sec.  1901  {a)  {150)  {amends  sec,  1374  of  the  Code) — net  operating 
losses  of  electing  small  business  corporations 
These  amendment?  repeal  an  obsolete  rule  relating  to  carrj^backs  to 
years  before  1958  of  the  net  operating  loss  of  an  electing  small  busi- 
ness corporation  by  striking  out  section  1374(d).  A  rule  of  current 
application  now  in  section  1374(d)(1)  is  transferred  to  section 
1374(b). 

Sec.  1901  (a)  {151)   {amends  sec.  1375  of  the  Code) — special  ndes  ap- 
plicable to  distributions  of  electing  small  busir^ess  corporations 
Subparagraph  (A)  provides  a  new  heading  for  subsection  1375(b) 
to  reflect  the  fact  that  individuals  no  longer  receive  a  dividends  re- 
ceived credit. 


495 

Subparagraph  (B)  strikes  out  a  reference  to  a  subsection  of  section 
1375  that  was  eliminated  in  1966  by  Public  Law  89-389. 

Sec.  1901  {a)  {152)  {amertds  sec.  1378  of  tJie  Code) — tax  imposed  on 
certain  capital  gains  of  electing  small  business  corporations 
This  amendment  strikes  out  a  provision  relating  to  the  determina- 
tion of  the  tax  with  respect  to  certain  capital  gains  of  an  electing  small 
business  corporation  for  certain  taxable  years  beginning  before  Janu- 
ary 1, 1975. 

Subchapter  T.  Cooperatives  and  their  patrons 

Sec.  1901  {a)  {163)  {amends  sec.  1388  of  the  Code) — patronage 
dividends 

Subparagraph  (A)  strikes  out  "the  date  of  the  enactment  of  the 
Revenue  Act  of  1962"  and  substitutes  the  exact  date,  "October  16, 
1962". 

Subparagraph  (B)  strikes  out  "the  date  of  the  enactment  of  this 
subsection"  and  substitutes  the  exact  date,  "November  13, 1966". 

Chapter  2.  Tax  on  Self-Employment  Income 

Sec.  1901  {a)  {154)  {amends  sec.  14-01  of  the  Code) — self-employment 
taxes 
Subparagraph  (A)  deletes  obsolete  rules  providing  rates  of  self- 
employment  tax  (for  old  age,  survivors,  and  disability  insurance)  for 
taxable  years  that  began  before  1973.  Similarly,  subparagraph  (B) 
strikes  out  obsolete  rules  providing  rates  of  self-employment  tax  for 
hospital  insurance  for  taxable  years  that  began  prior  to  1975.  (How- 
ever, the  current  rate  of  hospital  insurance  self -employment  tax  for 
years  beginning  in  1974  and  ending  in  1975  would  be  preserved 
through  the  operation  of  the  effective  date  of  this  title.) 

Sec.  1901  {a)  {155)  {amends  sec.  1402  of  the  Code) — definitions  relat- 
ing to  the  tax  on  self -employment  income 

Subparagraph  (A)  deletes  provisions  relating  to  the  determination 
of  self-employment  income  for  taxable  years  beginning  before  Janu- 
ary 1, 1975.  that  are  no  longer  needed. 

Subparagraph  (B)  deletes  an  obsolete  provision  relating  to  the 
treatment  of  certain  remuneration  erroneously  reported  as  net  earn- 
ings from  self-employment  for  taxable  years  ending  after  1954  and 
before  1962. 

Subparagraph  (C)  strikes  out  a  special  rule  which  allowed  a  request 
for  an  exemption  from  the  tax  on  self-employment  income  for  a  tax- 
able year  ending  before  December  31,  1967,  to  be  filed  on  or  before 
December  31,  1968.  The  general  rule  provides  that  such  request  must 
be  filed  by  the  due  date  of  the  return  for  the  first  taxable  year  in  which 
the  individual  has  self -employment  income. 

Chapter  3.  Withholding  of  Tax  on  Nonresident  Aliens  and 
Foreign  Corporations  and  Tax-Free  Covenants 

Sec.  1901  {a)  {156)  {repeals  sec.  14G5  of  the  Code)— definition  of  with- 
holding agent 
This   section    repeals   section    1465,    which    defines    "withholding 
agent,"  since  that  term  is  defined  in  section  7701(a)  (16). 


496 

Chapter  4.  Rules  Applicable  to  Recovery  of  Excessive  Profits 
on  Government  Contracts 

Sec.  1901  {a)  {157)    (amends  sec.  U81  of  the  Code)— mitigation  of 
effect  of  renegotiation  of  government  contracts 
These  amendments  update  section  1481  by  deleting  obsolete  refer- 
ences to  the  Sixth  Supplemental  National  Defense  Appropriation  Act 
and  to  the  Renegotiation  Act  of  1948. 

Chapter  6.  Consolidated  Returns 

Sec.  1901  {a)  {158)   {amends  sec.  1551  of  the  Code) — disallowance  of 
surtax  exemption  and  accumulated  eaim,ings  credit 
This  amendment  corrects  an  erroneous  cross  reference. 

Sec.  1901  {a)  {159)    {amends  sec.  1552  of  the  Code) — camming s  and 
profits  of  memhers  of  a?i  affiliated  group 
This  amendment  deletes  the  effective  date  for  this  provision  ("tax- 
able years  beginning  after  December  31,  1953,  and  ending  after  the 
date  of  enactment  of  this  title'".) 

Sec.  1901  {b) — confo?V7iing  and  clerical  amendments 

Section  1901(b)  of  the  bill  makes  a  series  of  clerical  and  conform- 
ing amendments  required  by  the  amendments  and  repeals  made  by 
subsection  1901(a)   of  this  title. 

Sec.  1901  {c) — amendments  to  provisions  referring  to  Territories 

This  subsection  of  the  bill  strikes  out  references  to  "Territories"  in 
Code  sections  37,  105,  117,  162,  581,  801,  861,  1014,  and  1221.  The 
United  States  no  longer  has  any  Territories. 

In  general  these  amendments  are  not  intended  to  affect  rights  exist- 
ing mider  present  law  that  were  conferred  because  of  Code  provisions 
regarding  Territories. 

Sec.  1901  {d) — effective  date 

This  subsection  of  the  bill  provides  that  unless  otherwise  expressly 
provided  the  amendments  made  bj'  section  1901  of  this  title  shall  apply 
with  respect  to  taxable  years  beginning  after  December  31, 1976. 

SEC,  1902.  AMENDMENTS  OF  SUBTITLE  B;  ESTATE  AND 
GIFT  TAXES 

Chapter  11.  Estate  Tax 

Sec.  1902 {a)  {1)   {amends  sec.  2012  of  the  Code) — credit  for  gift  tax 
These  amendments  provide  headings  for  several  subsections  and 
paragraphs  in  this  section  and  also  substitute  a  comma  for  a  dash  in 
conforming  to  generally  accepted  drafting  style. 

Sec.  1902{a)  {2)   {amends  sec.  2013  of  the  Code) — credit  for  tax  on 
pnor  transfers 

These  amendments  strike  out  obsolete  references  to  prior  laws. 
Sec.  1902{a)  {3)  {aynends  sec.  2038  of  the  Code) — revocable  transfers 

This  amendment  strikes  out  a  provision  of  limited  application  which 
is  no  longer  needed.  (The  provision  relates  to  a  decedent  who  has  been 
under  a  mental  disability  for  a  continuous  period  since  September, 


497 

1947,  and  has  been  unable  to  relinquish  certain  powers  to  alter  or 
revoke  an  interest  in  property  transferred  by  him.) 

Sec.  1902(a)  (4-)  (amends  sec.  2055  of  the  Code) — transfers  for  jyublic, 
charitable^  and  religious  use 

Subparagraph  (A)  strikes  out  a  provision  of  limited  application 
which  is  no  longer  needed.  This  provision  deals  with  highly  unique 
circumstances  involving  a  bequest  in  trust,  the  income  from  which 
is  payable  for  life  to  the  decedent's  surviving  spouse  (who  must  be 
over  80  years  old  at  the  decedent's  death)  if  such  surviving  spouse  has 
a  power  of  appointment  over  the  corpus  of  such  trust  exercisable  by 
will  in  favor  of,  among  others,  certain  charitable,  religious,  scientific, 
literary,  or  educational  organizations.  No  part  of  the  corpus  of  such 
trust  may  be  distributed  to  a  beneficiary  during  the  life  of  such  sur- 
viving spouse  and  the  surviving  spouse  must  execute  an  affidavit 
within  6  months  after  the  decedent's  death  specifying  the  organiza- 
tions in  favor  of  whom  the  power  will  be  exercised  (and  the  amount 
or  proportion  each  is  to  receive).  If  the  power  of  appointment  is 
exercised  in  accordance  with  such  affidavit,  then  the  bequest  in  trust, 
reduced  by  the  value  of  the  life  estate,  shall,  to  the  extent  the  power  is 
exercised  in  favor  of  such  organizations,  be  deemed  a  trans:^er  to  those 
organizations  by  the  decedent. 

Subparagraph  (B)  strikes  out  several  cross  references  that  are  no 
longer  applicable  and  updates  the  remaining  cross  references. 

Sec.  1902(a)  (S)  (amends  sec.  2106  of  the  Code) — taxable  estate 

Subparagraph  (A)  strike-s  out  several  cross  references  which  are  no 
longer  necessary. 

Subparagraph  (B)  strikes  out  a  provision  that  excludes  from  the 
taxable  estate  obligations  issued  by  the  United  States  before  March  1, 
1941,  if  held  by  a  decedent  who  was  not  engaged  in  business  in  the 
United  States  at  the  tim.e  of  his  death.  It  is  believed  that  no  obligations 
issued  by  the  United  States  before  March  1, 1941,  are  still  outstanding. 

Sec.  1902(a)  (6)  (amends  sec.  2107  and  sec.  2108  of  the  Code)— estate 
tax  on  expatriates  and,  application  of  pre-1967  estate  tax  provi- 
sions 
These  amendments  substitute  "November  13,  1966"  for  "the  date  of 
enactment  of  this  section"  as  the  effective  date  of  these  provisions. 

Sec.  1902(a)  (7)  (relates  to  sec.  2201  of  the  Code) — members  of  the 
Armed  Forces  dying  during  an  induction  period 
In  Public  Law  93-597,  section  6(b)(1)  thereof  provided  for  the 
amendment  of  section  2210  of  the  Code.  There  was  no  section  2210  of 
the  Code,  nor  is  there  such  a  section  now.  The  amendment  was  in- 
tended to  be  to  section  2201  of  the  Code.  This  paragraph  of  the  amend- 
ment corrects  Public  Law  93-597. 

Sec.  1902(a)  (8)  (repeals  sec.  2202  of  the  Code) — missionaries  ?Vi  for- 
eign service 
The  bill  repeals  section  2202  of  the  Code,  which  provides  that  mis- 
sionaries dying  in  missionary  service  will  be  presumed  to  die  as  United 
States  residents,  even  if  they  intended  to  remain  permanently  in  for- 
eign service.  Thus  provision  is  now  unnecessary  since  the  Foreign 
Investors  Tax  Act  of  1966  increased  the  estate  tax  exemption  of  non- 
residents from  $2,000  to  $30,000. 


498 

Sec.  1902 {a)  (9)  (amends  sec.  220 Ji-  of  the  Code)—<}.ischarge  of  fiduci- 
ary from  personal  liability 
This  amendment  corrects  a  typographical  error  in  the  Excise,  Estate, 
and  Gift  Tax  Adjustment  Act  of  1970. 

Chapter  12.  Gift  Tax 

Sec.  1902 {a)  (10)  (amends  sec.  2501  of  the  Code) — imposition  of  gift 
tax 

This  amendment  strikes  out  an  internal  effective  date  (the  first 
calendar  quarter  of  1971)  which  is  no  longer  needed. 

Sec.  1902(a)  (11)    (amends  sec.  2522  of  the  Code) — cross  references 
This  amendment  strikes  out  a  list  of  cross  references  which  also 
appears  in  section  2055(f)  of  the  Code  and  inserts  in  lieu  of  such  list 
a  reference  to  section  2055  (f ) . 

Sec.  1902 (a)  (12)  (amends  sees.  2011,  2016,  2053,  2055,  2056,  2106, 
2522,  and  2523  of  the  Code)—TerntoAes 
These  sections  are  each  amended  by  striking  out  references  to  Terri- 
tories because  there  are  no  longer  any  United  States  Territories. 
Hawaii,  admitted  to  Statehood  in  1958,  was  the  last  Territory.  There 
are  United  States  territories  (in  which  instances  the  word  "territory" 
is  begun  with  a  small  letter  "t"),  of  which  American  Samoa  is  an 
example.  In  contrast  to  Territoi'ies,  territories  are  vmincorporated. 

Sec.  1902 (b)  — conforming  amendments 

This  subsection  of  the  bill  makes  conforming  amendments  to  the 
table  of  sections  for  subchapter  C  of  chapter  11,  and  to  sections  G503 
(e)  and  6167  (h)  (2)  of  the  Code  to  reflect  the  repeal  of  section  2202  and 
the  amendment  of  section  2055  of  the  Code. 

Sec.  1902(c) — effective  dates 

This  subsection  provides  that  the  amendments  made  by  paragraphs 
(1)  through  (8),  and  paragraphs  (12)  (A),  (B),  and  (C)  of  sub- 
section (a),  as  well  as  by  subsection  (b),  shall  apply  in  the  case  of 
estates  of  decedents  dying  after  the  date  of  enactment  of  the  bill,  and 
the  amendment  made  by  paragraph  (9)  of  subsection  (a)  shall  apply 
in  the  case  of  estates  of  decedents  dying  after  December  31,  1970.  The 
amendment  made  by  paragraphs  (10),  (11),  and  (12)  (D)  and  (E) 
of  subsection  (a)  shall  apply  to  gifts  made  after  December  31,  1976. 

SEC.  1903.  AMENDMENTS  OF  SUBTITLE  C;  EMPLOYMENT 
TAXES 

Chapter  21.  Federal  Insurance  Contributions  Act 

Sec.  was  (a)(1)  (a^iiends  sees.  3101  and  3111  of  the  Code)— rates  of 
tax  on  employees  and  etnployers 

Subparagraph  (A)  strikes  out  the  employment  tax  rates  for  em- 
ployees and  employers  for  calendar  years  before  1975.  These  rates  are 
not  effective  for  calendar  years  after  1974. 

Subparagraph  (B)  strikes  out  the  pro-1975  tax  rates  on  employers 
and  employees  for  hospital  insurance  for  the  same  reason. 


499 

Sec.  1903 {a)  {2)  {repeals  sec.  3113  of  the  Code) — application  of  social 
security  tax  to  District  of  Columbia  Credit  Unions 
This  amendment  repeals  a  provision  relating  to  credit  unions  that 
were  chartered  under  the  Act  of  June  23,  1932.  No  credit  unions  are 
now  chartered  under  that  Act.  District  of  Columbia  Credit  Unions  are 
now  Federal  Credit  Unions  and  as  such  are  subject  to  section  3121 
(b)(6)(B)(ii)  of  the  Code. 

Sec.  1903(a)  (3)  (amends  sec.  3121  of  the  Code) — emplo^^-ment  tax 
definitions 

Subparagraph  (A)  strikes  out  a  reference  to  the  Internal  Revenue 
Code  of  1939  that  is  no  longer  needed,  and  also  eliminates  an  obsolete 
internal  effective  date  provision   ("service  performed  after  1954"). 

Subparagraphs  (B)  and  (D)  eliminate  unnecessary  citations. 

Subparagraph  (C)  changes  the  term  "Secretary  of  the  Treasury"  to 
"Secretary  of  Transportation"  in  a  provision  pertaining  to  the 
Coast  Guard.  The  Coast  Guard  is  now  within  the  Department  of 
Transportation. 

Subparagraph  (E)  deletes  provisions  allowing  certain  exempt  or- 
ganizations which  filed  certificates  before  1966  or  between  1955  and 
August  28,  1958  (relating  to  social  security  coverage  for  their  em- 
ployees), to  amend  the  certificate  to  advance  an  effective  date,  or  to 
request  that  the  effective  date  be  advanced,  if  the  amendment  was 
made  before  1967,  or  if  the  request  was  made  before  1960,  respectively. 

Subparagraphs  (F)  and  (G)  strike  out  obsolete  effective  dates 
(January  1, 1955,  and  December,  1956)  relating  to  agreements  entered 
into  by  domestic  corporations  with  respect  to  certain  social  security 
coverage  for  employees  of  foreign  subsidiaries  and  to  service  per- 
formed as  a  member  of  the  uniformed  services,  respectively. 

Sec.  1903(a)  (4)   (amends  sec.  3122  of  the  Code) — Federal  service 

These  amendments  change  references  to  the  "Secretary  of  the  Treas- 
ury" to  the  "Secretary  of  Transportation"  in  provisions  relating  to 
the  Coast  Guard,  since  the  Coast  Guard  is  now  part  of  the  Department 
of  Transportation. 

Se€.  1903(a)  (5)  (amends  sec.  3125  of  the  Code) — returns  in  the  case 
of  certain  governmental  employees 
This  is  a  clerical  amendment  changing  "Commissioners  of  ihe  Dis- 
trict of  Columbia"  to  "Mayor  of  the  District  of  Columbia"  in  order  to 
conform  to  the  District  of  Columbia  Self  Government  and  Govern- 
mental Reorganization  Act. 

Chapter  22.  Railroad  Retirement  Tax  Act 

Sec.  19G3(a)  (6)  (amends  sec.  3201  of  the  Code) — rate  of  tax  on  rail- 
road employees 
These  amendments  strike  out  an  effective  date  (September  30,  1973) 
relating  to  the  imposition  of  taxes  with  respect  to  services  performed 
after  that  date,  and  delete  references  to  the  Internal  Revenue  Code  of 
1954  which  are  not  needed. 

Sec.  1903(a)  (7)   (amends  sec.  3202  of  the  Code) — deductions  of  tax 
from  compensation 
Subparagraph  (A)  strikes  out  an  internal  effective  date  (Septem- 
ber 30,  1973)  relating  to  the  performance  of  services  by  employees 


500 

after  that  date  and  also  deletes  references  to  the  Internal  Revenue  Code 
of  1954  which  are  not  needed. 

Subparagraph  (B)  makes  a  clarifying  change  in  language  with 
respect  to  indenmiiication  of  an  employee. 

Sec.  1903(a)  (8)  (amends,  sec.  3211  of  the  Code) — rate  of  tax  on  em- 
ployee representatives 
These  amendments  correct  a  grammatical  error,  delete  references  to 
the  Internal  Revenue  Code  of  1954  which  are  not  needed,  and  strike 
out  an  obsolete  effective  date  (September  30, 1973) . 

Sec.  1903(a)  (9)    (amends  sec.  3221  of  the  Code) — rate  of  tax  on 
employers 

Subparagraphs  (A)  and  (B)  strike  out  an  internal  effective  date 
(September  30,  1973)  relating  to  the  imposition  of  taxes  with  respect 
to  services  performed  after  tliat  date,  and  also  delete  references  to  the 
Internal  Revenue  Code  of  1954  which  are  no  longer  needed. 

Subparagraph  (C)  deletes  references  to  rates  of  tax  applicable  for 
services  rendered  before  April  1, 1970. 

Sec.  1903(a)  (10)   (amaids  sec.  3231  of  the  Code) — definitions 
This  amendment  deletes  unnecessary  Statutes  at  Large  citations. 

Chapter  23.  Federal  Unemployment  Tax  Act 

Sec.  1903(a)  (11)  (amends  sec.  3301  of  the  Code) — Federal  unemploy- 
ment tax  rate 

These  amendments  strike  out  an  internal  effective  date  (calendar 
year  1970)  and  the  tax  rate  with  respect  to  wages  paid  during  calendar 
year  1973,  which  are  no  longer  needed. 

Sec.  1903(a)  (12)  (ametids  sec.  3302  of  the  Code) — credits  against  tax 

Subparagraphs  (A)  and  (B)  strike  out  references  to  special  tran- 
sitional rules  relating  to  the  10-month  period  ending  October  31,  1972, 
which  are  deleted  by  sections  1903(a)  (14)  (B)  and  1903(a)  (13)  of 
this  title. 

Subparagraph  (C)  (i)  strikes  out  a  transitional  provision  relating 
to  a  limitation  on  credits  against  the  unemployment  tax  if  a  State  has 
not  yet  repaid  an  advance  under  certain  prior  laws.  This  provision  is 
no  longer  applicable  since  all  the  States  have  repaid  the  advances  made 
under  those  laws. 

Subparagraph  (C)(ii)  strikes  out  an  internal  effective  date  (the 
date  of  enactment  of  the  Employment  Security  Act  of  1960)  which  is 
no  longer  needed.  Subparagraphs  (C)  (iii),' (C)  (iv),  (C)(v),  and 
(C)  (vi)  are  in  the  nature  of  amendments  conforming  to  the  amend- 
ment made  by  subparagraph  (C)  (i) . 

Subparagraph  (D)  strikes  out  a  cross  reference  to  a  1958  statute 
(the  Temporary  Unemployment  Compensation  Act  of  1958)  which  is 
no  longer  applicable. 

Sec.  1903(a)  (13)  (amends  sec.  3303  of  the  Code)— conditions  of  addi- 
tional credit  allowance 
This  amendment  deletes  a  transitional  rule  (from  provisions  relat- 
ing to  a  finding  by  the  Secretary  of  Labor  with  respect  to  certain  State 


501 

unemployment  funds)   for  the  10-month  period  ending  October  31, 
1972. 

Sec.  1903 {a)  (U)   {amends  sec.  3304  of  the  Code)—aj)proval  of  State 
laws 
Subparagraph  (A)  deletes  an  unnecessary  citation.  Subparagraph 
(B)  eliminates  a  transitional  rule  regarding  the  10-month  period  end- 
ing October  31,  1972. 

Section  1903 (a)  {15)  {amends  sec.  3305  of  the  Code) — applicability  of 
State  law 

Subparagraphs  (A)  and  (B)  strike  out  an  obsolete  effective  date 
(July  1,  1953)  which  relates  to  service  performed  on  or  after  that  date. 

Subparagraph  (C)  strikes  out  an  obsolete  effective  date  (Decem- 
ber 31,  1971)  relating  to  taxes  imposed  with  respect  to  taxable  years 
after  that  date. 

Sec.  1903 {a)  {16)   {amends  sec.  3306  of  the  Code) — definitions 

Subparagraphs  (A),  (B),  and  (C)  strike  out  unnecessary  citation 

references  and  insert  a  reference  to  the  United  States  Code. 

Subparagraph  (D)  strikes  out  an  obsolete  effective  date  (July  1, 

1953)  relating  to  services  performed  on  or  after  such  date. 

Chapter  24.  Collection  of  Income  Tax  at  Source  on  Wagts 

Sec.  1903 {a)  {17)    {amends  sec.  3^02  of  the  Code) — income  tax  col- 
lected at  the  source 
This  paragraph  is  a  clerical  amendment  to  correct  an  erroneous 
cross  reference. 

Sec.  1903 {h) — conforming  amendment 

This  amendment  conforms  the  table  of  sections  for  subchapter  (B) 
of  chapter  21  to  the  repeal  of  section  3113. 

Sec.  1903 {c) — amendments  to  provisions  relating  to  Territories 

This  amendment  strikes  out  references  to  Territories  in  sections  3401 
and  3404  of  the  Code  because  there  are  no  longer  Territories  of  the 
United  States. 

Sec.  1903 {d)— effective  date 

The  amendments  made  by  section  1903  of  the  bill  are  to  apply  with 
respect  to  wages  paid  after  December  31,  1976,  except  that  the  amend- 
ments made  to  chapter  22  of  the  Code  are  to  apply  with  respect  to  com- 
pensation paid  for  services  rendered  after  December  31,  1976. 

SEC.  1904.  AMENDMENTS  OF  SUBTITLE  D;  MISCELLA- 
NEOUS TAXES 

Chapter  31.  Retailers  Excise  Taxes 

Sec.  1904-{a){l)  {amends  chapter  31  of  the  Code) — retailers  excise 
taxes 
Subparagraph  (A)  changes  the  title  of  chapter  31  from  "Retailers 
Excise  Taxes"  to  "Special  Fuels"  and  strikes  out  obsolete  tables  of  sub- 
chapters and  sections  since  the  whole  chapter,  as  revised,  will  now  have 
only  one  section. 


234-L20  O  -  77  -  33 


502 

Subparagraph  (B)  incorporates  into  section  4041(g)  (relating  to 
exemptions  from  fuel  taxes)  the  existing  provisions  for  exemptions 
from  fuel  taxes  for  State  and  local  governments,  sales  for  export  or 
shipment  to  possessions,  and  nonprofit  educational  organizations  now 
found  in  sections  4055,  4056,  and  4057  of  the  Code.  Code  sections  4055, 
4056,  and  4057  are  repealed  by  subparagraph  (D)  of  this  subsection 
of  the  bill. 

Subparagraph  (C)  amends  section  4041  of  the  Code  by  adding  a  new 
subsection  (i)  which  incorporates  the  provisions  of  existing  Code 
section  4054  (relating  to  sales  by  the  United  States).  Section  4054  is 
repealed  by  subparagraph  (D)  of  this  subsection  of  the  bill. 

Subparagraph  (D)  repeals  Code  section  4042  (a  cross  reference), 
4054,  4055,  4056,  4057  (the  substance  of  which  have  been  incorporated 
into  Code  sections  4041  (i)  and  4041  (g)  (2) ,  (3) ,  and  (4) ,  respectively, 
and  4058  (a  cross  reference) . 

Chapter  32.  Manufacturers  Excise  Taxes 

Sec.  1904{a)  (2)  {amends  sec.  Ji£16  of  the  Code) — definition  of  price 
This  paragraph  is  a  clerical  amendment  redesignating  subsections 
(e),  (f),  and  (g)  as  subsections  (d),  (e),  and  (f),  respectively.  The 
previous  subsection  (d)  was  repealed  in  1958. 

Sec.  190Jf{a)  (3)  {amends  sec.  Ji^l7  of  the  Code) — leases 

This  amendment  strikes  out  a  transitional  rule  for  leases  entered  into 
before  January  1,  1959,  that  are  treated  as  sales  subject  to  manufac- 
turer's excise  taxes. 

Sec.  1904.{a){4-)  {repeals  sec.  Jf.226  of  the  Code) — floor  stock  taxes 
This  provision  repeals  floor  stock  tax  provisions  relating  to  specified 
items  held  in  dealers'  stocks  on  various  past  dates,  the  most  recent  of 
which  are  tires  and  tubes  held  by  manufacturers'  retail  outlets  on 
October  1,1966. 

Sec.  1904{a)  {5)  {amends  sec.  1^227  of  the  Code) — cross  references 
This  amendment  deletes  two  unnecessary  cross  references. 

Chapter  33.  Facilities  and  Services 

Sec.  1904 {a)  {6)  amends  sec.  1^253  of  the  Code) — exemptions  from 
the  tax  on  com-munications  services 
This  amendment  transfei*s  to  section  4253  of  the  Code  (relating  to 
exemptions)  provisions  for  exemptions  for  communications  services 
provided  by  section  4292  of  the  Code  for  State  and  local  governments 
and  by  section  4294  for  nonprofit  educational  organizations.  Sections 
4292  and  4294  are  repealed  by  sections  1904(a)  (9)  and  (10)  of  this 
title. 

Sec.  190Jf.{a)  (7)   {amends  sec.  1^261  of  the  Code) — tax  on  transporta- 
tion of  persons  by  air 
This  amendment  strikes  out  references  to  an  obsolete  internal  effec- 
tive date  (June  30, 1970) . 


503 

Sec.  190^{a)  (8)  {ainends  sec.  ^271  of  the  Code)— tax  on  traTisporta- 
tion  of  froferty  hy  air 
This  amendment  also  strikes  out  a  reference  to  the  obsolete  internal 
ejffective  date  of  June  30, 1970. 

Sec.  190J^{a)  (9)  {repeals  sec.  4£92  of  the  Code)— exemption  for  State 
and  local  goveimments  from  the  communications  services  tax 
This  amendment  repeals  the  provisions  relating  to  exemption  of 
State  and  local  governments  from  the  tax  on  communications  services. 
These  provisions  are  transferred  to  section  4253  of  the  Code  by  section 
1904(a)  (6)  of  this  title.  Section  4258  is  devoted  to  exemptions  from 
the  communications  services  tax. 

Sec.  1904(a)  {10)  {repeals  sec.  4291,.  of  the  Code) — exemption  for  non- 
profit educatio7ial  organizations 

This  amendment  deletes  the  provisions  conferring  exemption  from 
the  tax  on  communications  services  to  nonprotit  educational  organiza- 
tions. These  provisions  are  transferred  by  subsection  1904(a)(6)  to 
section  4253  of  the  Code,  which  is  devoted  to  exemptions  from  this 
tax. 
Sec.  1904. {a)  {11)    {repeals  sec.  4295  of  the  Code) — cross  reference 

This  amendment  repeals  an  unnecessary  cross  reference. 

Chapter  34.  Documentary  Stamp  Taxes 

Sec.  1904 {a)  {12)  {amends  chapter  34  of  the  Code) — docmnentary 
stamp  taxes 

This  amendment  changes  the  title  of  chapter  34  of  the  Code  from 
"Documentary  Stamp  Taxes"  to  "Policies  Issued  by  Foreign  Insur- 
ers", strikes  out  obsolete  tables  of  subchapters  and  sections,  and  revises 
the  remaining  provisions. 

Section  4371  of  the  Code  is  amended  to  confonn  to  the  fact  that 
the  tax  imposed  by  that  section  is  now  paid  by  return  and  not  by 
stamp.  Section  4372  is  amended  to  include  the  pertinent  provisions  of 
present  section  4382(a)  (1)  and  to  make  internal  conforming  amend- 
ments. 

New  Code  section  4373  corresponds  to  the  present  section  4373, 
except  for  the  deletion  of  an  obsolete  reference  to  Territories. 

New  Code  section  4374  corresponds  to  present  Code  section  4384 
except  that  it  is  changed  to  reflect  payment  by  return  rather  than  by 
stamp. 

Present  Code  sections  4374,  4375,  4382,  and  4383  are  repealed  to 
reflect  the  change  from  stamps  to  returns  and  to  reflect  the  repeal  in 
1965  of  other  documentaiy  stamp  taxes. 

Present  Code  sections  4361,  4362,  and  4363,  relating  to  a  tax  on 
conveyances  which  expired  on  January  1, 1968,  are  repealed. 

Chapter  36.  Certain  Other  Excise  Taxes 

Sec.  1904{o){13)    {amends  sec.  4^3  of  the  Code) — certain  persons 
engaged  in  foreign  air  commerce 
These  amendments  strike  out  an  internal  effective  date  (July  1, 
1970)  relating  to  an  election  to  pay  a  tentative  tax  with  respect  to 


SQ4 

taxable  civil  airoraft.  They  also  srrike  out  a  trandtioQsJ  rule  for  a 
year  beirirminfi:  on  July  1. 1970. 

Chapter  37.  Sugrar.  Coconut  and  Palm  Oil 

5w,  1904{a)il4)   («w«Hfe  eA&pt9rS7  of  the  Cod^)~:^         >   ,  :r, 

eocomtt  amd  jm/in  off 

This  ameiKlnient  cliiiTis«:  the  title  of  chapter  37  from  "Suirar.  Coco- 

nnt  and  Palm  Oil**  to  **Su2sr"  to  retleot  the  repeal  in  1962  of  taxes  cm 

coconut  and  palm  oil.  Obsolete  tables  of  subchapters  are  also  deleted. 

Chapter  3:S,  Import  Taxes 

5:^;*.  IfK'l^-.:^  yli)  (Kp€*3is  ieci.  +5AZ  Through  4^^  of  the  Cod-^^ — 
ifr^po":  r  jjvjf  on  oUomun^tarine 
This  provision  strikes  out  provisions  relating  to  taxes  on  imported 
oleoma rg?irine>  Requirements  as  to  ^holesomeness  and  purity  are  en- 
forced by  the  Food  and  r>nig  Administration  outside  the  requirements 
of  the  Int<?mal  Revenue  Code.  Xo  taxes  are  collected  under  these  pro- 
visic«is  and  at  pres»?nt  they  sserve  no  internal  revenue  purpose.  Since 
the  other  suK'hapter^  of  this  chapter  wiere  repealed  in  196:2,  the  entire 
chapter  is  now  repealed. 

Chapter  "^-.  RecuL^iory  Taxes 

Set.l90iim){t6)  (n?;  ,S06  of  f^^  Cod^^—i4a 
om  ttkife  p]^pkc 

Tliis  juroTKaoQ  repe&^s  prov^  .il  :o  taxes  on  white  y ;..>?- 

phoitHis  ixntehes.  Any  act  tax  fnese  provisions  is  .     .r^ 

under  other  provisions  of  Fei  i  thesie  pro                         : 

needed  for  elective  enforoeiv:    .     N        .x   is  collect t.  >e 
jwtovisions. 

5ft-,  I90i{a)  {17)  yrtpeali  s^t^  iSlI  tknmgh  4S3S  of  the  Code)—taat 
om  «iAittm[ted  hwtter 

This  amendment  strikes  out  the  tax  cai  adulterated  btitrer  and  re- 
late! provisions.  Requirements  as  to  wholescuneness  and  purity  of 
butter  are  enfoivecl  by  the  Food  and  Thnig  Administration  outside  the 
provisic^s  of  the  Code.  Xo  taxes  are  colle^M^evi  as  to  adulterated  battra*. 
This  tax  dates  from  the  lS^>*s,  when  it  s»erred  the  dual  fuiKticm  of 
lestrictiniT  trade  in  this  item  anvi  insuring  purity  » e.r..  netStricting  the 
use  of  rancid  butter) .  At  pivs^nt.  the  tax  and  related  provisioris  sserre 
no  internal  rv^venue  purpose.  Appropriate  r?giilati<Mi  of  commerce  can 
be  accomplished  in  other  provisioits  of  law. 

-Sft",  1904{o)  (IS)  [r^peti*  ««•.  1S8/  fhrowrh  ^88$  of  the  Code)—i4ix 
<m  cimtJmtion  other  tham  of  maiioiud  h^mi^ 
This  par»cTaph  rerieals  provisions  relatinsr  to  ciimlation  of  other 
than  national  bante.  The  CoT«ptTv>ller  of  the  Currency  has  stated  that 
anv  act  taxable  under  thest  ^  ons  is  also  ille^l  nnder  other  pro- 

Tisicms  of  Federal  law  a:  hese  pnovisions  are  not  needed  for 

effective  enfortieiDeiit.  Xo  iax  ;s  voUected  under  these  proviaonsL 


505 

Chapter  40.  General  Provisions  Relating  to  Occupational  Taxes 

Sec.  J904{a)  (19)  {amends  sec.  ^901  of  the  Code) — payment  of  occupa- 
tional taxes 
This  amendment  strikes  out  an  obsolete  provision  relating  to  pay- 
ment of  certain  occupational  taxes  by  stamp,  since  all  taxes  ix)  which 
this  provision  applies  are  paid  by  return. 

Sec.  1904 (a)  {^^)  (amends  sec.  4^05  of  the  Code) — liahiUty  for  occu- 
pational taxes  in  case  of  death  or  change  in  location 
Section  4905  of  the  Code  allows  the  wife  (but  not  husband)  of  a 
decedent  who  paid  a  certain  occupational  tax  before  his  death  to  carry 
on  the  same  trade  or  business  for  the  residue  of  the  term  for  which  the 
tax  was  paid  without  liability  for  additional  tax.  This  amendment 
substitutes  "spouse"  for  "wife"  in  this  provision  so  that  a  widower 
will  have  the  same  privilege  as  a  widow. 

Chapter  41.  Interest  Equalization  Tax 

Sec.  1904{(i)  (21)  (repeals  sees.  4911  through  1^931  of  the  Code) — inter- 
est equalization  tax 
This  paragraph  repeals  provisions  relating  to  the  interest  equaliza- 
tion tax,  since  this  tax  does  not  apply  to  acquisitions  of  stock  and  debt 
obligations  made  after  June  30,  1974.  A  special  effective  date  is  pro- 
vided so  that  the  repeal  of  chapter  41  (Code  sections  4911  through 
4931)  is  to  apply  only  with  respect  to  acquisitions  of  stock  and  debt 
obligations  made  after  June  30,  1974  (or  to  loans  and  commitments 
made  after  that  date).  Thus  the  rights  and  obligations  of  persons  with 
respect  to  acquisitions  of  stock  and  debt  obligations  prior  to  July  1, 
1974,  are  preserved. 

Chapter  42.  Private  Foundations 

Chapter  43.  Qualified  Pension,  Etc.,  Plans 

Sec.  1904(a)  (23)  (amends  sec.  4973  of  the  Code) — tax  on  excess  con- 
tributio-ns  to  certain  retirement  plans 
Subparagraph  (A)  corrects  an  error  in  margination.  Subparagraph 
(B)  corrects  an  erroneous  reference.  Both  these  eri'ors  were  clerical 
errors  in  ERISA. 

Sec.  1904(h) — conforming  amendments 

This  subsection  of  the  bill  makes  various  conforming  amendments 
to  the  amendments  and  repeals  made  by  subsection  (a).  These  amend- 
ments include  repeal  of  several  Code  sections  that  relate  to  violations 
of  laws  and  other  offenses  concerning  oleomargarine  or  adulterated 
butter  (Code  sections  7234  and  7265),  white  phosphorus  matches 
(Code  sections  7239,  7267,  7274,  and  7328),  and  adulterated  butter 
and  process  or  renovated  butter  (Code  sections  7235  and  7264). 
Amendments  conforming  to  the  repeal  of  chapter  41  of  the  Code 
(relating  to  interest  equalization  taxes)  include  the  repeal  of  Code 
sections  263(a)(3)   and   (d)    (relating  to  the  deduction  of  interest 


506 

equalization  taxes),  6011(d),  6076,  6651(e),  6680  (which  relate  to  the 
filing  requirements  for  interest  equalization  tax  returns) ,  6611  (h)  (re- 
lating to  interest  on  overpayments  of  interest  equalization  tax),  6681, 
7241  (relating  to  false  or  fraudulent  equalization  tax  certificates),  and 
6689  (relating  to  failure  by  certain  foreign  issuers  and  obligors  to 
comply  with  United  States  investment  equalization  tax  requirements). 
The  amendments  conforming  to  the  repeal  of  chapter  41  have  vari- 
ous effective  date  provisions  to  assure  that  rights  and  liabilities  (both 
civil  and  criminal)  of  taxpayers  or  other  persons  with  respect  to  acqui- 
sitions of  stock  or  indebtedness  before  July  1,  1974  (or  certain  actions 
with  respect  to  such  acquisitions) ,  are  not  affected.  Thus,  for  example, 
if  a  taxpayer  is  required  to  file  an  interest  equalization  tax  return  with 
respect  to  an  acquisition  of  stock  prior  to  July  1, 1974,  and  has  failed  to 
file  such  return,  the  repeal  of  section  6011(d)  of  the  Code  by  this  bill 
will  not  affect  the  requirement  that  such  a  return  be  filed. 

Sec.  1904 (c) — amendments  to  provisions  referring  to  Territories 

Subsection  (c)  amends  Code  section  4482(c)(1)  by  striking  out 
a  reference  to  Territories  because  the  United  States  no  longer  has 
Territories. 

Sec.  J904-{d) — effective  date 

Subsection  (d)  provides  that  the  amendments  made  by  section  1904 
(except  as  otherwise  provided)  shall  take  effect  on  the  first  day  of  the 
first  month  which  begins  more  than  90  days  after  the  date  of  enact- 
ment of  the  bill. 

SEC.  1905.  AMENDMENTS  OF  SUBTITLE  E;  ALCOHOL,  TO- 
BACCO, AND  CERTAIN  OTHER  EXCISE  TAXES 

Chapter  51.  Distilled  Spirits,  Wines,  and  Beer 

Subchapter  A.  Gallonage  taxes 

Sec.  1905(a)  (1)   [mnends  sec.  5005  of  the  Code) — persons  liahle  for 
tojx  on  distilled  spirits 
This  amendment  strikes  out  provisions  relating  to  an  internal  effec- 
tive date  (July  1, 1959)  which  are  no  longer  needed. 

Sec.  1905 {a)  {2)   {amends  sec.  5008  of  the  Code) — abatement.,  etc.,  of 
tax  on  distilled  spirits  in  instances  of  loss  or  destruction 

Present  law  provides  relief  (under  sec.  5008)  from  the  distilled 
spirits  tax  of  section  5001  for  voluntary  destruction  of  the  spirits  on 
bonded  premises  or  before  the  spirits  are  removed  from  the  bottling 
premises.  In  instances  of  spirits  already  removed  from  bonded  prem- 
ises, tax  relief  is  provided,  under  certain  defined  circumstances,  for 
accidental  destruction  within  the  distilled  spirits  plant.  Finally,  tax 
relief  is  provided  if  spirits  that  have  been  withdrawn  from  bond  (with 
tax  determination  or  payment)  are  thereafter  returned  to  the  bonded 
premises  for  certain  purposes  specified  in  section  5215. 

Because  of  a  technical  error,  this  relief  is  now  provided  only  for  the 
tax  imposed  on  domestic  distilled  spirits  under  section  5001  or  other 
provisions  of  Chapter  51  of  the  Code.  Puerto  Rico  and  Virgin  Island 


507 

spirits  are  taxed  separately  (under  sec.  7652).  A  technical  correction 
is  included  in  the  bill  to  give  the  same  type  of  tax  relief  to  Puerto 
Rican  or  Virgin  Island  spirits  as  is  now  given  for  domestic  spirits. 
This  amendment  also  strikes  out  an  obsolete  internal  effective  date 
(July  1,1959). 

Sec.  1905{a)  (3)    (am,ends  sec.  5009  of  the  Code) — drawback  of  tax 
This  amendment  deletes  a  redundant  citation. 

8ec.  1905 {a)  (^)  {aTnends  sec.  5025  of  the  Code) — exemption  from 
rectification  tax 
This  amendment  permits  stabilization  (without  payment  of  rectifi- 
cation tax)  preparatory  to  export,  thereby  giving  distilled  spirits  to 
be  exported  the  same  treatment,  in  this  instance,  as  is  given  to  distilled 
spirits  preparatory  to  bottling. 

Sec.  1905 {a)  (5)   (amends  sec.  5054  of  t^  Code) — stamps  and  other 
devices  as  evidence  of  payment  of  tax  on  heer 
This  amendment  strikes  out  a  beer  stamp  provision  that  has  never 
been     implemented     and     for    which    there    is    no    intention    of 
implementation. 

Sec.  1905 {a)  (6)  (amends  sec.  5061  of  the  Code) — method  of  collect- 
ing tax 

Subparagraph  (A)  strikes  out  a  stamp  tax  requirement  that  is  now 
obsolete  in  that  the  taxes  to  which  it  applies  are  now  all  paid  by  return. 

Subparagraph  (B)  strikes  out  authority  to  use  stamps,  coupons, 
tickets,  or  tax-stamp  machines  as  alternative  methods  of  collecting 
alcohol  taxes  since  those  methods  neither  have  been  implemented  nor 
are  to  be  implemented.  The  amendment  also  provides  that  taxes  on 
illegal  items  are  to  be  due  and  payable  immediately  at  the  time  given 
in  the  provisions  imposing  the  taxes,  or  (if  no  specific  time  is  pro- 
vided) when  the  event  referred  to  in  the  provision  occurs,  and  that 
these  taxes  are  to  be  assessed  and  collected  in  accordance  with  the  rules 
regarding  taxes  payable  by  return  but  for  which  no  return  has  been 
filed. 

Subparagraph  (C)  strikes  out  a  provision  no  longer  needed  because 
it  applies  only  to  the  unusual  methods  of  collection  stricken  from  the 
statute  by  subparagraph  (B).  In  its  place  is  substituted  a  provision 
making  it  clear  that  the  gallonage  taxes  on  distilled  spirits,  rectifica- 
tion, wines,  and  beer  are  generally  imposed  in  addition  to  import 
duties.  This  conforms  to  the  Tariff  Schedules. 

Sec.  1905(a)(7)    (amends  sec.  51  IS  of  the  Code) — sales  to  limited 
retail  dealers 
This   amendment  conforms  to  section   1905(a)  (10)    of  this  title 
(amending  section  5122(c)  of  the  Code),  which  permits  a  limited  re- 
tail dealer  to  deal  in  distilled  spirits,  u^  m t  11  a?  in  wine  and  beer. 

Sec.  1905(a)(8)  (amends  sec.  5117  of  the  Code) — prohibited  pur- 
chases by  dealers 
This  amendment  provides  that  a  limited  retail  dealer  may  now  pur- 
chase distilled  spirits  from  a  retail  dealer  in  liquors.  This  is  another 
change  in  the  nature  of  an  amendment  conforming  to  section  1905(a) 
(10)  of  the  Act. 


508 

Sec.  1905 {a)  (9)  (amends  sec.  5121  of  the  Code) — imi  osltion  and  rate 
of  tax  on  retail  dealers 
This  paragraph  provides  that  a  limited  retail  dealer  in  distilled 
spirits  is  to  pay  a  special  (occupational)  tax  of  $4.50  per  calendar 
month.  This  amendment  is  necessitated  by  the  broadening  of  the  defi- 
nition of  "limited  retail  dealer"  in  section  1905(a)  (10)  of  this  title 
to  include  limited  retail  dealers  in  distilled  spirits. 

Sec.  1905(d)  {10)    {amends  sec.  5122  of  the   Code) — definition  of 
limited  retail  dealer 
This  provision  expands  the  definition  of  a  limited  retail  dealer  to 
include  a  limited  retail  dealer  in  distilled  spirits,  as  well  as  in  wine 
and  beer. 

Sec.  1905(a)  (11)  (amends  sec.  5131  of  the  Code) — drawback  of  tax 
in  event  of  nonheverage  uses 
Section  5131  of  the  code  permits  drawback  of  distilled  spirits  tax  if 
the  spirits  are  put  to  cited  nonbeverage  uses.  Section  5131  requires  the 
spirits  thus  used,  to  be  eligible  for  the  drawback,  to  have  been  produced 
in  a  domestic  registered  distilleiy  or  industrial  alcohol  plant  and  with- 
drawn from  bond,  or  to  be  spirits  withdrawn  from  the  bonded  prem- 
ises of  a  distilled  spirits  plant.  Domestic  distilled  spirits  used  for  the 
cited  nonbeverage  purposes  must  necessarily  have  been  produced  in  a 
domestic  registered  distillery  or  industrial  alcohol  plant.  Spirits  so 
used  may  also  have  been  imported  or  brought  into  the  United  States, 
but,  if  so,  they  need  first  have  been  transferred  to  the  bonded  premises 
of  a  distilled  spirits  plant  before  withdrawal  for  the  nonbeverage  uses. 
This  amendment  deletes  the  unnecessary  requirement  that  spirits 
"imported"  or  "brought  into"  the  United  States  must  first  be  trans- 
ferred to  the  bonded  premises  of  a  distilled  spirits  plant. 

Sec.  1905(a)  (12)  (amends  sec.  511^.2  of  the  Code) — po.yment  of  taxes 
This  amendment  replaces  existing  provisions  that  occupational  taxes 
be  paid  by  stamp  with  a  requirement  that  they  be  paid  by  return.  These 
taxes  are  now,  in  fact,  being  paid  by  return,  as  is  required  by  Treasury 
regulations.  This  amendment  also  makes  it  clear  that  the  tax  on  stills 
and  condensers  imposed  by  section  5101  is  to  be  paid  by  return. 

Subchapter  B.  Qualification  requirements  for  distilled  spirits 

plants 

Sec.  1905(a)  (13)  (amends  sec.  5171  of  the  Code) — permits  for  dis- 
tilled spirits  plants 
This  amendment  eliminates  a  transitional  rule  relating  to  the  time 
in  which  qualified  distillers,  bonded  warehousemen,  rectifiers,  and  bot- 
tlers of  distilled  spirits  doing  business  as  such  on  June  30,  1959,  could 
obtain  the  required  permit  to  continue  in  business.  In  addition,  a  re- 
dundant citation  is  deleted. 

Sec.  1905(a)  (IJf.)  (amends  sec.  517 If,  of  the  Code) — withdrawal  bonds 

This  paragraph  allows  a  proprietor  of  bottling  premij  es  to  withdraw 

distilled  spirits  which  have  been  botOed  in  bond  to  his  bottling  prem- 


509 

ises  under  his  withdrawal  bond.  The  change  would  permit  greater 
convenience  in  handling  of  bottled  in  bond  cased  goods  and  allow  the 
same  tax  payment  procedures  applicable  to  spirits  bottled  and  cased 
on  bottling  premises  to  be  applied  to  bottled  in  bond  cased  goods. 

Subchapter  C.  Operation  of  distilled  spirits  plants 

Sec.  1905 {a)  (15)  (amends  sec.  5232  of  the  Code) — transfer  of  dis- 
tilled spirits  from  outside  the  United  States 

Under  section  5314  of  the  Code,  distilled  spirits  brought  into  the 
United  States  from  Puerto  Rico  or  the  Virgin  Islands  are  not  treated 
as  "imported,"  but  rather  as  "brought  into"  the  United  States. 

The  first  sentence  of  section  5232  of  the  Code  permits  spirits  im- 
ported or  brought  into  the  United  States  in  bulk  containers  to  be  with- 
drawn from  customs  custody  and  transferred  to  the  bonded  premises 
of  a  distilled  spirits  plant  without  payment  of  the  internal  revenue  tax. 
The  second  sentence  then  transfers  the  liability  for  eventual  payment 
of  the  tax  from  the  "importer"  to  the  operator  of  the  distilled  spirits 
plant.  In  order  to  coordinate  the  two  sentences,  this  amendment  am- 
plifies the  second  sentence  to  extend  relief  from  tax  liability  to  persons 
who  have  brought  such  spirits  into  the  United  States. 

Sec.  1905(d)  (16)  (amends  sec.  5233  of  the  Code) — relating  to  bottling 
requirements 
This  amendment  eliminates  a  redundant  citation. 

Sec.  1905(a)  (17)  (amends  sec.  5234  of  the  Code) — consolidation  for 
further  storage  in  bond 
This  amendment  conforms  the  time  limit  within  which  distilled 
spirits  in  bond  storage  may  be  mingled  with  the  time  limit  in  section 
5006(a)  (2)  for  storing  distilled  spirits  in  bond.  The  latter  limit  was 
raised  from  eight  years  to  twenty  years  in  1958. 

Subchapter  E.  General  provisions  relating  to  distilled  spirits 

Sec.  1905(d)  (18)  (amend^s  sec.  531 4  of  the  Code) — application  of  cer- 
tain provisions  to  Puerto  Rico 
This  provision  corrects  an  erroneous  cross  reference. 

Sec.  1905(a)  (19)   (repeals  sec.  5315  of  the  Code) — status  of  certain 
distilled  spirits  on  July  7, 1959 
This  paragraph  repeals  a  July  1, 1959,  transitional  provision. 

Subchapter  F.  Bonded  and  taxpaid  wine  premises 

Sec.  1905(a)  (20)  (amends  sec.  5368  of  the  Code) — gauging  and  mark- 
ing loine 

Subparagraph  (A)  eliminates  a  reference  to  stamps  in  the  heading 
of  section  5368  since  stamps  are  not  used  to  identify  wines  and  the  use 
of  stamps  is  not  contemplated. 

Subparagraph  (B)  removes  a  reference  to  stamps  in  section  5368 
(b)  and  in  the  heading  of  that  subsection. 


510 

Sec.  1905(a)  (23)  (amends  sec.  5685  of  the  Code) — penalties  for  pos- 
to  taxation  of  wine 

This  amendment  strikes  out  a  citation  that  is  redundant  and  un- 
necessary. 

Subchapter  J.  Penalties,  seizures,  and  forfeitures  relating  to 

liquors 

Sec.  1905(a)  (22)  (amends  sec.  5601  of  the  Code) — presumptions  re- 
lating to  criminal  penalties 

This  amendment  strikes  out  paragraphs  (1),  (3),  and  (4)  of  present 
section  5601  (b) — presumptions  which  either  have  been  specifically  de- 
clared unconstitutional  or  which  the  Internal  Revenue  Service  believes 
to  be  unconstitutional. 

Sec.  1905(a)  (23)   (amends  sec.  5685  of  the  Code) — penalties  for  pos- 
session of  certain  devices 
This  paragraph  conforms  cross  references  and  a  definition  to  changes 
in  chapter  53  made  by  the  Gun  Control  Act  of  1968. 

Chapter  52.  Cigars,  Cigarettes,  and  Cigarette  Papers  and  Tubes 

Sec.  1905(a)  (24)  (amends  sec.  5701  of  the  Code) — rate  of  tax  on  im- 
ported tobacco  prodnicts 
This  amendment  conforms  the  tax  on  imported  tobacco  products  and 
cigarette  tubes  and  papers  to  Tariff  Schedule  item  804, 19  U.S.C.  1202, 
which  provides,  for  articles  previously  exported  from  the  United 
States,  a  customs  duty  "in  lieu  of  any  other  duty  or  tax". 

Sec.  1905(a)  (25)  (amends  sec.  5703  of  the  Code)— liability  for  tobacco 
tax  and  method  of  payment 

Subparagraph  (A)  conforms  provisions  relating  to  tobacco  tax  to 
administrative  practice  and  to  related  provisions  regarding  wines  and 
distilled  spirits. 

Subparagraph  (B)  strikes  out  a  traditional  rule  allowing  tobacco 
taxes  to  continue  to  be  paid  by  stamp  until  regulations  provide  for  pay- 
ment on  the  basis  of  return.  Those  regulations  have  been  issued,  and  so 
the  transitional  rule  no  longer  applies. 

Subparagraph  (C)  eliminates  section  5703(c),  relating  to  the  use  of 
stamps  to  evidence  payment  of  the  tobacco  tax.  These  stamp  provisions 
have  never  been  implemented,  and  there  is  no  intention  to  implement 
them. 

Sec.  1905(a)  (26)  (amends  sec.  5704  of  the  Code) — tobacco  products., 
etc.,  brought  into  or  returned  to  the  United  States 
This  amendment  relaxes  an  unneeded  restriction  by  permitting  pro- 
prietors of  export  warehouses  to  import,  under  bond,  tobacco  products 
and  cigarette  papers  and  tubes  directlv,  rather  than  through  a  tobacco 
products  manufacturer,  as  is  required  by  present  law. 

Sec.  1905(a)  (27)   (amends  sec.  5712  of  the  Code) — tobacco  business 
permits 
This  paragraph  deletes  an  obsolete  transitional  rule  allowing  per- 
sons lawfully  in  business  as  a  tobacco  products  manufacturer  or  as  a 
tobacco  export  warehouse  proprietor  to  remain  in  business  after  en- 


511 

actment  of  the  Excise  Tax  Technical  Changes  Act  of  1958  until  he 
has  had  a  reasonable  opportunity  to  obtain  the  tobacco  permit  required 
by  that  Act. 

Sec.  1905{a)  {28)  (ameTids  sec.  5723  of  th£  Code)— packaging  tohacco 
prior  to  removal 
This  amendment  strikes  out  a  requirement  that  a  tobacco  products 
manufacturer  or  a  tobacco  export  warehouse  proprietor  must  affix  to 
his  package  of  tobacco  products,  etc.,  prior  to  removal,  such  stamps 
as  regulations  may  prescribe.  The  use  of  stamps  to  evidence  payment 
of  the  tobacco  tax  is  being  eliminated  by  the  repeal  of  section  5703(c) 
of  the  Code  by  section  1905(a)  (25)  (C)  of  this  title.  Conforming 
changes  are  made  to  the  headings  of  section  5723  and  5723(b). 

Sec.  1905 {h) — conforming  and  clerical  amendments 

This  subsection  provides  various  conforming  amendments  to  reflect 
the  amendments  and  repeals  made  in  the  alcohol,  tobacco,  etc.,  excise 
tax  provisions  (subtitle  E). 

Sec.  1905 {c) — amendments  to  provisions  referring  to  Territories 

This  subsection  strikes  out  a  number  of  references  to  "Territories" 
in  the  alcohol,  tobacco,  etc.,  tax  provisions  for  the  reason  that  there 
are  no  longer  any  "Territories"  of  the  United  States.  Hawaii,  which 
ceased  to  be  a  Territory  in  1958,  was  the  last.  The  United  States  does 
have  a  number  of  "territories"  (spelled  with  a  beginning  small  letter 
"t"),  but  they  have  never  been  affected  by  these  provisions.  Deletion 
of  these  references  does  not  terminate  the  rights,  duties,  powers,  and 
liabilities  that  arose  before  the  effective  date  of  this  title. 

Sec.  1905 {d) — effective  date 

This  subsection  provides  that  the  effective  date  of  the  amendments 
and  repeals  made  to  subtitle  E  is  to  be  the  first  day  of  the  first  month 
beginning  more  than  90  days  after  enactment  of  this  Act. 

SEC.  1906.  AMENDMENTS  OF  SUBTITLE  F;  PROCEDURE 
AND  ADMINISTRATION 

Chapter  61.  Information  and  Returns 

Sec.  1906(a)  (/)  {amends  sec.  6013  of  the  Code) —joint  returns 

These  amendments  are  clerical,  such  as  the  one  which  uses  the  new 
name  of  the  United  States  Tax  Court. 

Sec.  1906 {a)  {2)  {amends  sec.  6015  of  tlie  Code) — estimated  tax 

This  amendment  strikes  out  an  obsolete  effective  date  provision 
(December  31,  1954)  for  this  section. 

Sec.  1906{a)  {3)    {amends  sec.  6037  of  the  Code) — return.^  of  sub- 
chapter S  corporations 
This  amendment  corrects  an  error  in  a  cross  reference. 

Sec.  1906 {a)  {It)   {amends  sec.  60Jfi  of  the  Code) — information  as  to 
organization  of  foreign  corporations 
This  amendment  eliminates  special  rules  (relating  to  information 
returns  with  respect  to  foreign  corporations)  applicable  to  the  first 
six  months  of  1963. 


512 

Sec.   1906(a)  (S)     (amends   sec.    6051    of   the    Code) — receipts    for 
employees 

This  is  a  clerical  amendment  striking  out  a  misplaced  word. 

Sec.  1906(a)  (6)    (amends  sec.  6066  of  the   Code) — verification  of 
returns 

This  amendment  eliminates  the  authority  to  require  certain  returns, 
statements,  and  other  documents  to  be  verified  by  oaths,  rather  than 
under  the  penaltj-^  of  perjury.  This  authority  is  not  now  used  and  is 
not  expected  to  be  used. 

Sec.  1906(a)  (7)  (repeals  sec.  6105  of  the  Code) — compilation  of  data 
for  certain  excess  profits  cases 
This  amendment  strikes  out  a  provision  for  the  compilation  and 
publication  of  data  with  respect  to  excess  profits  tax  cases  under  sec- 
tion 722  of  the  1939  Code. 

Sec.  1906(a)(8)  (amends  sec.  6111  of  the  Code) — cross  reference 

This  amendment  strikes  out  cross  references  to  a  provision  relating 
to  cotton  futures  (see  section  1952  of  this  title)  and  to  provisions  relat- 
ing to  narcotics  which  were  repealed  by  the  Comprehensive  Drug 
Abuse  Prevention  and  Control  Act  of  1970. 

Chapter  62.  Time  and  Place  for  Paying  Tax 

Sec.  1906(a)(9)   (amends  sec.  6162  of  the  Code) — installment  pay- 
ments by  Goiyorations 
This  amendment  strikes  out  a  rule  for  taxable  years  ending  before 
December  31,  1954,  which  allowed  a  corporation  to  pay  taxes  imposed 
by  chapter  1  in  four  installments. 

Sec.  1906(a)  (10)   (amends  sec.  6164-  of  the  Code) — installment  pay- 
ments of  estimated  ineome  tax  by  corporations 
These  amendments  strike  out  various  transitional  rules  applicable 
to  installments  of  estimated  tax  for  taxable  years  beginning  in  1968, 
1969, 1970, 1971, 1972, 1973,  and  1974. 

Sec.  1906(a)  (11)  (amends  sec.  6167  of  the  Code) — payment  of  Fed- 
eral unemploynrient  tax  quarterly  or  on  other  basis 
These  amendments  strike  out  special  rules  relating  to  the  computa- 
tion of  Federal  unemployment  tax  for  calendar  quarters  or  other 
periods  in  1970  and  1971. 

Sec.  1906(a)  (12)  (repeal  of  sec.  6162  of  the  Code) — extension  of  time 
for  payment  of  tax  on  the  liquidation  of  certain  personcd  holding 
companies 
This  amendment  repeals  a  section  dealing  with  an  extension  of  time 
for  the  payment  of  tax  on  gain  on  the  liquidation  before  1957  of  cer- 
tain personal  holding  companies. 

Chapter  63.  Assessment 

Sec.  1906(a)  (13)  (amends  sec.  6205  of  the  Code) — relating  to  the  Dis- 
trict of  Columbia  as  an  employer 
This  is  a  clerical  amendment  changing  "Commissioner  of  the  Dis- 
trict of  Columbia"  to  "Mayor  of  the  District  of  Columbia"  in  order  to 


513 

reflect  the  enactment  of  the  District  of  Columbia  Self  Government  and 
Governmental  Keorganization  Act. 

Sec.  1906{a)  {H)    {amends  sec.  6207  of  the  Code) — cross  references 
The  amendment  strikes  out  a  cross  reference  to  provisions  rej^ealed 
in  1962. 

Sec.  1906 {a)  {15)  {amends  sec.  6213  of  the  Code) — restrictions  appli- 
cdble  to  deficiencies ;  fetitions  to  the  Tax  Court 
This  amendment  conforms  the  provision  to  the  definition  of  "United 
States",  used  in  a  geographical  sense,  that  appears  in  section  7701 
(a)(9)  of  the  Code. 

Sec.  1906 {a)  {16)  {amends  sec.  6215  of  the  Code) — assessment  of  defi- 
ciency found  hy  Tax  Court 
This  amendment  strikes  out  an  unnecessary  citation. 

Chapter  64.  Collection 

Sec.  1906{a)  {17)  {amends  sec.  6302  of  the  Code) — collection  of  certain 
excise  taxes 
This  is  a  clerical  amendment  to  strike  out  references  to  certain  obso- 
lete provisions  relating  to  taxes  on  coconut  and  palm  oil  (repealed 
in  1962)  and  on  narcotias  (repealed  in  1970). 

Sec.  1906 {a)  {18)  {repeals  sec.  630 J^.  of  the  Code) — collection  under  the 
Tariff  Act  of  1930 
This  amendment  repeals  a  cross  reference  to  provisions  repealed  in 
1962. 

Sec.  1906{a)  {19)  {amends  sec.  6313  of  the  Code) — fractional  parts  of 
a  cent 
This  amendment  deletes  a  reference  to  taxes  payable  by  stamp  from 
the  rules  pertaining  to  rounding  off  fractional  parts  of  a  cent  in  the 
payment  of  taxes,  since  no  tax  now  collected  by  stamp  will  be  due  in 
fractions  of  a  cent. 

Sec.  1906 {a)  {20)  {amends  sec.  6326  of  the  Code) — cross  references  for 
sections  relating  to  lien  for  taxes 
This  provision  conforms  to  current  drafting  style  in  striking  out 
unnecessary  Statutes  at  Large  citations  in  paragraphs  2,  3,  4,  and  5. 

Sec.  1906 {a)  {21)  {amends  sec.  6365  of  the  Code) — deftnitiotis  a7id 
special  rules 
This  amendment  changes  the  term  "Commissioner  of  the  District  of 
Columbia"  to  "Mayor  of  the  District  of  Columbia"  to  reflect  the  pro- 
visions of  the  District  of  Columbia  Self  Government  and  Govern- 
mental Reorganization  Act. 

Chapter  65.  Abatements,  Credits,  and  Refunds 

Sec.  1906 {a)  {22)  {amends  sec.  64J2  of  the  Code)— floor  stocks  refunds 
This  is  a  clerical  amendment  which  renumbers  two  paragraphs. 

Sec.  1906 {a)  {22)  {amends  sec.  6P3  of  the  Code) — special  rules  appli- 
cable to  employment  taxes 
Subparagraphs  (A)  and  (C)  are  clerical  amendments  substituting 
"Mayor"  for  "Commissioners"  of  the  District  of  Columbia  to  reflect 


514 

enactment  of  the  District  of  Columbia  Self  Government  and  Govern- 
mental Reorganization  Act. 

Subparagraph  (B)  is  a  clerical  amendment  to  reflect  an  increase  in 
the  social  security  wage  base  ceiling  and  to  strike  out  certain  rules 
applicable  to  special  refunds  or  credits  of  certain  employment  taxes 
deducted  from  wages  received  in  calendar  years  prior  to  1975.  A  spe- 
cial effective  date  is  provided  so  that  refunds  or  credits  with  respect 
to  wages  paid  in  calendar  years  before  1977  will  not  be  affected. 

Subparagraph  (D)  strikes  out  an  obsolete  internal  effective  date 
(1967). 

Sec.  1906 {a)  (24-)  (amends  sec.  6^16  of  the  Code) — refund  or  credit  of 
taxes  on  special  fuels 

Subparagraph  (A)  is  a  clerical  correction  redesignating  two  sub- 
paragraphs in  section  6416(a)  (3). 

Subparagraph  (B)  deletes  provisions  relating  to  credits  or  refunds 
of  overpayments  of  taxes  imposed  on  taxable  sales  or  uses  under  se-c- 
tion  4041  of  the  Code,  but  ultimately  used  or  resold  for  exempt  pur- 
poses (such  as  a  use  on  a  farm  for  farming  purposes).  These  deleted 
provisions  relate  only  to  uses  or  resales  prior  to  July  1, 1970.  Exempt 
uses  or  resales  after  June  30,  1970,  are  covered  by  section  6427  of  the 
Code.  '  '  J 

Section  6416  of  the  Code  allows  a  credit  to  be  taken  "on  any  subse- 
quent return"  for  a  number  of  overpayments,  including  those  described 
in  the  deleted  provisions  of  section  6416.  It  is  possible,  therefore, 
that  claims  for  overpayments  on  account  of  sales  and  uses  prior  to 
July  1,  1970,  may  still  be  open,  and,  accordingly,  the  bill  provides  a 
special  effective  date  for  the  deletions  made  in  paragraph  (B)  to  pre- 
serve any  such  claims  that  may  still  be  open. 

Sec.  1906(a)  (26)  (repeal  of  sec.  6417  of  the  Code) — coconut  and  palm 
oil 

This  amendment  strikes  out  a  section  of  the  Code  relating  to  the 
former  tax  on  coconut  and  palm  oil  that  was  repealed  in  1962. 

Sec.  1906(a)  (26)  (amends  sec.  6420  of  the  Code) — gasoline  used  on 
farms 

Subparagraph  (A)  deletes  obsolete  provisions  concerning  claims 
for  refund  with  respect  to  gasoline  used  before  July  1,  1965. 

Subparagraph  (B)  corrects  a  typographical  error. 

Subparagraphs  (C)  and  (D)  strike  out  obsolete  effective  date  pro- 
visions (December  31,  1955,  and  June  30,  1965). 

Sec.  1906(a)  (27)  (araends  sec.  6421  of  the  Code) — gasoline  used  for 
nonhighway  purposes  or  hy  local  transit  systems 

Subparagraph  (A)  strikes  out  an  obsolete  internal  effective  date 
(June  30, 1970). 

Subparagraph  (B)  deletes  obsolete  provisions  relating  to  claims  for 
refund  with  respect  to  gasoline  used  before  July  1,  1965. 

Subparagraphs  (C)  and  (D)  strike  out  obsolete  internal  effective 
dates  (June  30, 1956,  and  June  30, 1965) . 

Sec.  1906(a)  (28)   (atnends  sec.  6422  of  the  Code) — ci'oss  references 
relating  to  credits  and  refunds 
This  amendment  deletes  unnecessary  citations  to  the  Statutes  at 
Large. 


515 

Sec.  1906 {a)  (29)  (amends  sec.  64^3  of  the  Code) — credit  or  refund  of 
alcohol  and  tobacco  taxes 
These  amendments  delete  obsolete  internal  effective  dates  (April  30, 
1958,  April  30, 1959,  May  1, 1958,  and  June  15, 1957)  relating  to  claims 
for  credit  or  refund  and  suits  filed  with  respect  to  alcohol  and  tobacco 
taxes. 

Sec.  1906(a)  (30)  (amends  sec.  6424  of  the  Code) — lubricating  oil  not 
used  in  highway  motor  vehicles 
These  amendments  strike  out  a  transitional  rule  for  taxable  years 
beginning  in  1966  and  an  obsolete  internal  effective  date  (December  31, 
1965)  relating  to  the  use  of  certain  lubricating  oil. 

Sec.  1906(a)  (31)  (amends  sec.  61^27  or  the  Code) — fuels  not  used  for 

taxable  purposes 

These  amendments  strike  out  an  obsolete  effective  date  (June  30, 

1970)  relating  to  repayment  or  credit  of  the  tax  on  use  of  certain  fuels. 

A  special  effective  date  for  this  provision  ("fuel  used  or  resold  after 

June  30, 1970")  is  provided  because  credits  and  refunds  for  fuels  used 

or  resold  prior  to  July  1, 1970,  are  governed  by  section  6416(b)  of  the 

Code. 

Chapter  66.  Limitations 

Sec.  1906(a)  (32)  (amends  sec.  660 ^  of  the  Code) — cross  references 

Subparagraph  (A)  is  a  clerical  amendment  to  combine  several  cross 
references  mto  one  paragraph.  Subparagraph  (B)  renumbers  the 
paragraphs  of  section  6504  of  the  Code  in  conformance  with  the 
amendment  made  by  subparagraph  (A)  and  the  deletion  of  para- 
graphs (1),  (6),  and  (7)  by  paragraphs  (36)  (C),  (37)  (D),  and  (39) 
(B)  of  section  1901(b)  of  this  title. 

Sec.  1906(a)  (33)  (amends  sec.  6511  of  the  Code) — limitations  on  credit 
or  refund 
These  amendments  strike  out  obsolete  internal  effective  date  pro- 
visions (September  1,  1959,  and  December  31,  1965)  relating  to  cer- 
tain claims  for  credit  or  refund. 

Chapter  67.  Interest 

Sec.  1906(a)  (34)  (amends  sec.  6601  of  the  Code) — interest  on  under- 
payments 
This  amendment  strikes  out  an  obsolete  reference  to  a  provision  of 
the  1939  Code  relating  to  intei'ost  on  estimated  tax  payments. 

Chapter  68.  Additions  to  the  Tax,  Additional  Amounts,  and 
Assessable  Penalties 

Sec.  1906(a)  (35)   (amends  sec.  6654  of  the  Code)— payment  of  esti- 
mated inccyine  tax 
This  amendment  strikes  out  an  internal  effective  date  (December  31, 
1954)   that  is  no  longer  needed. 

Chapter  69.  General  Provisions  Relating  to  Stamps 

Sec.  1906(a)  (36)    (amends  sec.  6802  of  the  Code) — supply  and  dis- 
tribution of  stamps 
This  paragraph  is  a  clerical  amendment  substituting  a  period  for 
a  semicolon. 


516 

Sec.  1906(a)  (37)    [amends  sec.  6803  of  the  Code) — accounting  aTid 
safeguarding  of  stamps 
These  amendments  redesignate  subsections  (b)  (1)  and  (2)  as  sub- 
sections (a)  and  (b)    (the  previous  subsection  (a)  having  been  re- 
pealed in  1972)  and  strike  out  an  obsolete  cross  reference. 

Chapter  70.  Jeopardy,  Bankruptcy,  and  Receiverships 

Sec.  1906 {a)  {38)   {amends  sec.  6863  of  the  Code) — stay  of  collection 
of  jeopardy  assessments 
This  amendment  strikes  out  an  obsolete  internal  effective  date  (Jan- 
uary 1,  1955)  relating  to  a  stay  of  sale  of  seized  property  pending  a 
Tax  Court  decision. 

Chapter  72.  Licensing  and  Registration 

Sec.  1906 {a)  {39)  {amends  sec.  7012  of  the  Code) — cross  referenxies 
This  amendment  strikes  out  a  cross  reference  to  the  tax  on  white 
phosphorous  matches  (which  is  repealed  by  section  1904(a)  (16)  of 
this  title),  corrects  an  erroneous  cross  reference,  and  renumbers  the 
remaining  subsections. 

Chapter  73.  Bonds 

Sec.  1906 {a)  {40)  {amends  sec.  7103  of  the  Code) — cross  referervces 

This  amendment  strikes  out  cross  references  to  taxes  on  oleomar- 
garine, adulterated  butter,  filled  cheese,  opium  for  smoking,  and  white 
phosphorus  matches  repealed  by  sections  1904(a)  (15),  (16),  and  (17) 
of  the  Act  and  by  legislation  enacted  in  1962,  1970,  and  1974. 

Chapter  75.  Crimes,  Other  Offenses,  and  Forfeitures 

Sec.  1906{a){41)   {amends  sec.  7271  of  the  Code) — penalties  for  of- 
fense relating  to  stamps 
This  amendment  strikes  out  an  obsolete  provision  relating  to  pay- 
ment of  certain  taxes  by  stamp. 

Sec.  1906{a)  {4^)  {amends  sec.  7272  of  the  Code) — penalty  for  failure 
to  register 
This  amendment  strikes  out  cross  references  to  narcotics  provisions 
which  were  repealed  by  the  Comprehensive  Drug  Abuse  Prevention 
and  Control  Act  of  1970. 

Sec.  1906  {a)  {43)  {amends  sec.  7326  of  the  Code)  — disposal  of  forfeited 
or  abandoned  property 
These  amendments  correct  an  erroneous  reference  and  redesignate 
subsection  (c)  as  subsection  (b),  the  previous  subsection  (b)  having 
been  repealed  by  the  Comprehensive  Drug  Abuse  Prevention  and 
Control  Act  of  1970. 

Chapter  76.  Judicial  Proceedings 

Sec.  1906 {a)  {44)   {amends  sec.  7^22  of  the  Code) — civil  actions  for 
refund 
These  amendments  strike  out  an  o^bsolete  internal  effective  date 
(June  15,  1942),  relating  to  the  effect  of  certain  suits  and  Tax  Court 
petitions  filed  after  that  date. 


517 

Sec.  1906{a)  {^S)  {amends  sec.  7^8  of  the  Code) — cross  references  re- 
lating to  proceedings  hy  taxpayers 
Unnecessary  Statutes  at  Large  citations  are  struck  out  in  this 
amendment. 

Sec.  1906(a)  {4S)  (amends  sec.  744^  of  the  Code) — annuities  to  widoios 
and  dependent  children  of  Tax  Court  judges 

These  amendments  eliminate  a  distinction  in  present  law  between 
male  and  female  judges  of  the  Tax  Court  in  respect  to  annuities  to 
surviving  family  members  of  Tax  Court  judges.  As  now  worded,  sec- 
tion 7448  refers  only  to  a  widow  (defined  as  a  surviving  wife)  of  a 
Tax  Court  judge,  and  similarly  to  a  mother  of  issue  of  a  judge's  mar- 
riage. However,  it  appears  that  there  is  no  continuing  intent  to  deny 
equal  protection  to  the  surviving  spouses  of  all  Tax  Court  judges 
regardless  of  sex. 

The  bill  eliminates  any  distinction  based  on  sex  and  replaces  the 
terms  "widow",  "widower",  "surviving  wife",  "mother",  "her",  and 
"she"  with  the  terms  "surviving  spouse  ',  "parent",  and  "such  spouse" 
as  appropriate. 

Sec.  1906(a)  (J^7)  (amends  sec.  71^71  of  the  Code) — employees  of  Tax 
Court 

These  amendments  delete  unnecessary  Statutes  at  Large  citations 
from  subsections  (a)  and  (b)  of  section  7471. 

Sec.  1906(a)  (JfS)  (amends  sec.  71^76  of  the  Code) — declaratory 
judgments 
This  amendment  makes  a  clerical  correction  in  placing  the  material 
in  subsection  (a)  that  follows  paragraph  (2)  (B)  at  the  flush  left 
margin.  This  is  done  to  make  it  clear  that  that  material  refers  to  all 
of  subsection  (a),  and  not  merely  to  subsection  (a)  (2). 

Chapter  77.  Miscellaneous  Provisions 

Sec.  1906(a)  (It9)  (amends  sec.  7502  of  the  Code) — timely  mailing 
treated  as  timely  filing 
This  paragraph  is  a  clerical  amendment  changing  a  reference  (relat- 
ing to  postmarks)  from  the  "United  States  Post  Office"  to  the  "United 
States  Postal  Service"  to  reflect  the  enactment  of  the  Postal  Reor- 
ganization Act. 

Sec.  1906(a)  (50)  (amends  sec.  7507  of  the  Code) — exemption  for  in- 
solvent hanks 
These  amendments  strike  out  an  obsolete  date  (May  28,  1938)  relat- 
ing to  assessment  of  certain  taxes  owed  by  insolvent  banks. 

Sec.  1906(a)  (51)  (amends  sec.  7508  of  the  Code) — time  for  perform- 
ing certain  acts  postponed  hy  reason  of  loar 
These  are  clerical  amendments  changing  the  heading  of  section  7508 
to  refer  to  "service  in  a  combat  zone"  and  using  the  defined  term 
"United  States"  (sec.  7701(a)  (9)  of  the  Code)  to  replace  "States  of 
the  Union  and  the  District  of  Columbia". 

Sec.  1906(a)  (52)   (amends  sec.  7509  of  the  Code) — expenditures  hy 
the  Post  Office  JDepartnwnt 
Subparagraphs  (A),  (B),  and  (C)  are  clerical  amendments  to  use 
the  term  "United  States  Postal  Service"  in  lieu  of  "United  States  Post 
Office"  to  reflect  the  enactment  of  the  Postal  Reorganization  Act. 

234-120  O  -  77  -  34 


518 

Subparagraph  (D)  eliminates  a  cross  reference  to  a  previously 
repealed  subsection. 

Chapter  78.  Discovery  of  Liability  and  Enforcement  of  Title 

Sec.  1906(a)  {63)   {amends  sec.  7621  of  the  Code) — internal  revenue 
districts 

This  amendment  eliminates  the  term  "Territory*'  since  there  are  no 
longer  any  Territories. 

Sec.  1906 {a)  {5Jf.)  {repeals  sec.  76^1  of  the  Code) — supervision  of  oper- 
ations of  certain  Tnanufacturers 
This  provision  repeals  subchapter  C  of  chapter  78,  which  contains 
administrative  provisions  relating  to  the  taxes  on  filled  cheese,  oleo- 
margarine, process  or  renovated  butter,  and  white  phosphorus  matches. 
The  tax  on  these  items  are  repealed  by  other  provisions  of  tlie  Act 
or  have  been  repealed  by  prior  law. 

Sec.  1906{a)  {65)  {amends  sec.  7652  of  the  Code)— shipments  to  the 
United  States 

These  subparagi-aphs  strike  out  obsolete  provisions  relating  to  pay- 
ments to  the  Virgin  Islands  of  taxes  collected  in  1955  and  1956. 

Sec.  1906  {a)  {56)   {anvend^  sec.  7653  of  the  Code)— shipments  from 
the  United  States 

This  amendment  deletes  a  citation  to  the  Statutes  at  Large. 
Chapter  79.  Definitions 

Sec.  1906 {a)  {67)  {amende  sec.  7701  of  the  Code)— definitions 

Subparagraph  (A)  defines  the  term  "Secretary"'  to  mean  the  Secre- 
tary of  the  Treasury  or  his  delegate.  (The  term  "Secretary"  is  cur- 
rently defined  as  the  "Secretary  of  the  Treasury*'.)  Subparagraph 
(A)  also  provides  that  the  term  "Secretary  of  the  Treasury**  means  the 
Secretary  of  the  Treasury,  personally,  not  including  any  delegate. 

Subparagraph  (B)  redefines  the  term  "or  his  delegate**  for  purposes 
of  the  Internal  Revenue  Code.  This  term  may  i^.clude.  for  example, 
the  Commissioner  of  Internal  Revenue. 

To  make  use  of  these  new  terms,  subparagraph  (A)  of  subsection 
(b)  (13)  of  section  1906  of  this  title  amends  the  Internal  Revenue  Code 
by  striking  out  "Secretary  or  his  delegate"'  each  place  it  appears  and 
inserting  in  lieu  thereof  "Secretary*'.  Paragraphs  (B),  (C).  and  (M) 
of  subsection  (b)  (13)  strike  out  "Secretary*'  and  insert  in  lieu  thereof 
"Secretary  of  the  Treasury**  in  19  provisions  of  the  Code  whicli  cur- 
rently use  the  term  "Secretary*"  without  reference  to  any  of  his 
delegates. 

Subparagraphs  (D),  (I).  (J),  (K).and  (L)  of  subsection  (b)  (13) 
change  certain  derivations  of  the  term  "Secretary  or  his  delegate" 
(such  as  "Secretary  nor  his  delegate"")  to  "Secretary". 

Subparagraphs  (E).  (F),  and  (H)  of  subsection  (b)  (13)  change 
the  term  "Secretarv'"  to  "Secretarv  of  Labor"'  in  the  following  sec- 
tions of  the  Code:  3304(c),  3310(d)  (2).  and  3310(e). 


519 

Subparagraph  (G)  of  subsection  (b)  (13)  amends  sections  3221(a) 
and  3221(c)  of  the  Code  by  striking  out  the  words  "of  the  Treasury" 
following  the  word  "Secretary"  so  that  the  notification  of  certain  ac- 
tions by  employers  or  by  the  Railroad  Retirement  Board  required  by 
such  sections  does  not  have  to  be  made  to  the  Secretary  of  the  Treasury 
personally. 

Chapter  80.  General  Rules 

Sec.  1906(a)  (58)    {amends  sec.  7803  of  the  Code) — other  personnel 
This  paragraph  is  a  clerical  amendment  redesignating  subsection 
(d)  as  subsection  (c),  the  previous  subsection  (c)  having  been  re- 
pealed. 

Sec.  1906 {a)  {59)  {amends  sec.  7809  of  the  Code) — deposit  of  collec- 
tions 
This  amendment  deletes  cross  references  to  provisions  repealed  by 
the  Comprehensive  Drug  Abuse  Prevention  and  Control  Act  of  1970. 

Sec.  1906 {h)  — conforming  and  clerical  amendments 

This  subsection  of  the  bill  makes  clerical  and  conforming  amend- 
ments to  several  sections  and  tables  of  sections  of  the  Code  to  reflect 
the  repeal  of  Code  sections  6105,  6162,  6304,  6417,  and  7641  and  the 
amendment  of  Code  sections  6111,  6154,  6416,  6420,  6424,  7448,  7508, 
7509,  and  7701  by  section  1906(a)  of  this  title. 

Sec.  1906{c) — am^endments  to  sections  referring  to  Territories 

This  subsection  amends  sections  6871(a),  7622(b),  and  7701(a)  (4) 
of  the  Code  by  striking  out  references  to  Territories  since  there  are  no 
longer  any  United  States  Territories. 

Sec.  1906 {d) — effective  date 

Section  1906(d)  provides  that,  except  as  otherwise  expressly  pro- 
vided, the  amendments  made  by  section  1906  are  to  take  effect  on  the 
first  day  of  the  first  month  which  begins  more  than  90  days  after  the 
date  of  enactment  of  the  bill  (October  4, 1976) ,  except  that  any  amend- 
ment, when  relating  to  a  tax  imposed  by  chapter  1  or  chapter  2  of  the 
Code,  is  to  apply  with  respect  to  taxable  years  beginning  after  Decem- 
ber 31, 1976. 

SEC.  1907.  AMENDMENTS  OF  SUBTITLE  G;  THE  JOINT 
COMMITTEE  ON  INTERNAL  REVENUE  TAXATION 

Paragraph  (1)  of  subsection  (a)  substitutes  the  name  "Joint  Com- 
mittee on  Taxation"  for  "Joint  Committee  on  Internal  Revenue  Taxa- 
tion" in  section  8001.  This  change  is  made  in  the  interest  of  brevity  and 
does  not  change  the  functions  of  the  Joint  Committee.  The  duties  of 
the  Joint  Committee  are  set  forth  in  section  8022  of  the  Internal  Reve- 
nue Code  and  relate  only  to  internal  revenue  taxes  and  to  the  Internal 
Revenue  Service  (or  any  other  agency  to  the  extent  it  is  charged  with 
administration  of  those  taxes) . 

Paragraph  (2)  amends  section  8004  to  refer  to  the  compensation  of 
"the  Chief  of  Staff"  instead  of  "a  clerk,"  thus  conforming  this  provi- 
sion to  the  present  language  of  section  8023  (b) . 


520 

Paragraph  (3)  of  subsection  (a)  strikes  out  an  outdated  limitation 
on  the  cost  of  stenographic  ser^^ces  incurred  by  the  Joint  Committee. 

Paragraph  (4)  is  a  clerical  amendment  to  make  more  readable  sec- 
tion 8023(c),  dealing  with  the  inapplicability  of  reorganization  plans 
to  the  Joint  Committee. 

Paragraph  ( 5 )  is  a  general  provision  that  all  references  in  any  other 
statute,  or  in  any  rule,  regulation,  or  order,  to  the  Joint  Committee  on 
Internal  Revenue  Taxation  are  to  be  considered  to  be  made  to  the  Joint 
Committee  on  Taxation. 

Subsection  (b)  also  makes  conforming  amendments  to  the  heading 
of  subtitle  G  and  to  the  table  of  subtitles.  Subsection  (c)  provides  that 
the  amendments  made  by  this  section  of  the  bill  are  to  take  effect  on 
the  first  day  of  the  first  month  which  begins  more  than  90  days  after 
enactment. 

SEC.  1908.  EFFECTIVE  DATE  OF  CERTAIN  DEFINITIONS 
AND  DESIGNATIONS 

This  section  resolves  possible  conflicts  between  amendments  made 
by  other  titles  of  the  Act  and  amendments  made  by  these  Deadwood 
provisions.  The  section  states  that  if  another  title  of  the  Act  contains 
a  term  which  is  defined  or  modified  bj^  the  Deadwood  provisions,  and 
if  that  other  amendment  has  an  effective  date  earlier  than  the  effective 
date  of  the  Deadwood  amendment,  then  the  effective  date  of  the  Dead- 
wood  amendment  is  converted  into  the  earlier  effective  date  of  the 
amendment  made  by  the  other  title.  This  section  assures  that  any  term 
given  a  particular  meaning  by  the  Deadwood  provisions  has  that  par- 
ticular meaning  as  soon  as  the  Code  amendment  embodying  it  becomes 
effective. 

SUBTITLE  B— AMENDMENTS  OF  CODE  PROVISIONS  WITH 
LIMITED  CURRENT  APPLICATION;  REPEALS  AND 
SAVINGS  PROVISIONS 

Sec.  1951.  Provisions  of  subtitle  B 

Sec.  1951  (a)  {explartation  of  references  to  sections) 

This  subsection  eliminates  the  need  of  repeated  references  to  the 
Internal  Revenue  Code  of  1954  in  this  section  by  providing  that  when 
this  section  of  the  bill  refers  to  an  amendment  or  repeal  of  a  section 
or  other  provision,  it  is  to  be  considered  an  amendment  or  repeal  of 
a  section  or  other  provision  of  the  Internal  Revenue  Code. 

Sec.  1951(b)  (1)  {amends  sec.  72  of  the  Code) — certain  joint  and  sur- 
vivor annuities 
Subparagraph  (A)  of  this  paragraph  removes  from  the  Code  a 
special  provision  for  joint  and  survivor  annuities  where  the  first  an- 
nuitant died  in  1951,  1952,  or  1953.  Subparagraph  (B),  however,  pro- 
vides that  the  deleted  provision  is  to  continue  to  apply  in  cases  of 
annuity  contracts  under  wliich  distributions  were  made  in  taxable 
years  beginning  before  January  1,  1977,  and  to  which  the  deleted 
provision  was  applicable. 


521 

Sec.  1951(h)(2)  (amends  sec.  108  of  the  Code) — railroad  corpora- 
tions'' discharge  of  indebtedness 
This  provision  strikes  out  a  special  rule  of  very  limited  current  ap- 
plicability relating  to  an  exclusion  from  the  income  of  railroad  corpo- 
rations for  income  arising  from  the  discharge,  cancellation,  or  modifi- 
cation of  indebtedness  pursuant  to  a  receivership  proceeding  or  re- 
organization proceeding  under  section  77  of  the  Bankruptcy  Act  which 
was  commenced  before  January  1,  1960.  The  special  rule  continues  to 
apply,  however,  to  any  existing  railroad  corporation  receivership  or 
reorganization  proceeding  commenced  before  1960. 

Sec.  1951(h)(3)  (amends  sec.  16 If,  of  the  Code) — payments  for  mu- 
nicipal-type services  in  Atomic  Energy  Communities 
This  paragraph  strikes  out  a  provision  that  authorizes  deduction  of 
certain  amounts  paid  to  the  Atomic  Energy  Commission  (or  its  succes- 
sors, currently  the  Nuclear  Regulatory  Commission)  for  municipal- 
type  services  in  atomic  energy  communities.  However,  the  committee 
understands  that  payments  are  still  being  made  for  such  services  in 
Los  Alamos,  New  JVlexico.  For  this  reason,  the  provision  is  to  have 
continued  application  to  amounts  paid  or  accrued  in  a  communitj^  in 
which  the  Commission's  successor  provided  municipal-type  services 
on  December  31, 1976. 

Sec.  1951(h)  (Ji)  (repeals  sec.  168  of  the  Code) — 60-nwnth  amortiza- 
tion of  emergency  facilities 

This  paragraph  repeals  the  provision  allowing  five-year  amortiza- 
tion of  emergency  facilities.  The  provision  is  largely  obsolete  since 
certification  of  an  emergency  facility  is  required  if  the  rapid  amortiza- 
tion is  to  be  allowed,  but  the  existing  provision  does  not  permit  certifi- 
cation after  1959. 

Some  additional  language  in  the  bill's  provision  is  necessitated  by 
a  conforming  amendment  to  section  642(f)  of  the  Code. 

Sec.  1951(h)(5)  (amends  sec.  171  of  the  Code) — amortizahle  hond 
premium  for  certain  honds  acquired  after  January  22,  1954,  ^^ 
before  January  1, 1958 

This  provision  strikes  from  the  Code  a  special  rule  relating  to  the 
amortizable  bond  premium  of  taxable  bonds  (for  which  an  election  is 
made  under  section  171  (c)  of  the  Code)  issued  after  January  22, 1951, 
with  a  call  date  not  more  than  three  years  after  the  issue  date,  if 
acquired  by  the  taxpayer  after  January  22,  1954,  and  before  January 
1,1958. 

Although  stricken  from  the  Code,  this  special  rule  is  retained  in 
the  public  laws  for  all  such  bonds. 

Sec.  1951(h)  (6)  (ameiids  sec.  333  of  the  Code) — liquidations  of  cer- 
tain corporations  affected  by  the  Revenue  Act  of  1964 
This  paragraph  deletes  a  provision  allowing  stockholders  to  elect 
the  application  of  certain  nonrecognition  of  gain  rules  in  cases  of 
liquidation  distributions  of  corporations  that  were  not  personal  hold- 
ing companies  in  one  of  the  two  taxable  years  ending  before  Febru- 
ary 26,  1964  (the  date  of  enactment  of  the  Revenue  Act  of  1964)  but 
which  would  in  that  year  have  been  personal  holding  companies  under 
the  new,  stricter  provisions  of  this  Act. 


522 

Shareholders  of  such  corporations  may  still  claim  the  benefit  of 
nonrecognition  of  gain  rules  applicable  to  liquidations  after  1966  if 
their  corporations  meet  certain  tests  and  requirements  set  out  in  the 
existing  section  333(g)  (2).  Therefore,  the  bill  retains  those  particular 
provisions  in  the  public  laws,  although  they  are  deleted  from  the 
Code. 

Sec.  J 951(h)  (7)  (amends  sec.  45S  of  the  Code) — certain  installment 
sales  prior  to  1954- 
This  paragraph  strikes  from  the  Code  references  to  the  tax  treat- 
ment of  payments  on  installment  sales  of  realty  and  casual  installment 
sales  of  personality  concluded  before  1954.  The  special  rule  applicable 
to  those  sales  made  before  1954  is  retained  in  the  public  laws,  how- 
ever, for  the  continued  use  of  taxpayers  now  eligible  to  use  this  rule 
because  their  sales  were  covered  by  section  44(b)  of  the  Internal 
Revenue  Code  of  1939.  (Before  1954,  installment  sales  tax  treatment 
for  sales  of  this  class  could  be  obtained  only  if  there  was  a  payment 
or  payments  of  a  total  not  exceeding  30  percent  of  the  selling  price 
in  the  taxable  year  of  the  sale.  After  1953,  it  was  not  required  that 
there  be  any  payment  in  the  year  of  sale.) 

Sec.  1951  (h)  (8)  (amends  sec.  512  of  the  Code) — exclusions  from  unre- 
lated business  taxable  income 

This  paragraph  deletes  a  provision  of  the  Code  (sec.  512(b)  (13)) 
excluding  from  the  definition  of  unrelated  business  taxable  income  cer- 
tain income  received  by  exempt  trusts  created  by  the  wills  of  individ- 
uals who  died  between  August  16,  1954,  and  January  1,  1957,  if  that 
income  is  received  by  those  trusts  as  limited  partners  (as  defined) .  Also 
deleted  is  an  exclusion  of  income  used  by  a  labor,  agricultural,  or  hor- 
ticultural organization  to  establish,  maintain,  or  operate  a  retirement 
home,  hospital,  or  similar  facility,  if  the  income  is  derived  from  agri- 
cultural pursuits  on  grounds  contiguous  to  the  facility  and  if  the 
income  does  not  provide  more  than  75  percent  of  the  cost  of  operating 
or  maintaining  the  facility. 

For  both  cases,  a  savings  provision  is  retained  in  the  public  laws  to 
continue  to  allow  these  exclusions. 

Sec.  1951(b)  (9)  (amends  sec.  5Jf5  of  the  Code) — deductions  allowable 
in  computing  personal  holding  company  income 

This  provision  strikes  from  the  Code  a  paragraph  (sec.  545(b)  (9)) 
which  permits  the  deduction  from  personal  holding  company  income 
(upon  which  a  special  70-percent  tax  rate  is  imposed)  of  the  amount 
of  any  properly  filed  lien  in  favor  of  the  United  States  to  which  the 
taxpayer  is  subject  at  the  end  of  the  taxable  year.  This  provision 
appears  to  have  rare,  if  any,  usage  now.  It  was  enacted  in  1951  for  the 
benefit  of  a  personal  holding  company  which  is  no  longer  in  existence. 

The  paragraph  to  be  deleted  also  requires  the  sum  of  the  amounts 
deducted  to  be  recaptured  by  their  inclusion  in  the  taxable  income  of 
the  taxpayer  for  the  year  the  lien  is  satisfied  or  released,  and  it  permits 
the  taxpayer's  shareholders  to  compute  the  income  tax  on  dividends 
attributable  to  amounts  so  included  in  income  as  though  the}^  were 
received  ratably  over  the  period  the  lien  was  in  effect.  These  latter 
provisions  are  retained  in  the  public  laws  for  application  to  recaptures, 


523 

on  account  of  liens  satisfied  or  released  in  taxable  years  beginning  on 
or  after  January  1,  1977,  of  deductions  taken  in  taxable  years  begin- 
ning before  that  date. 

Sec.  1951  {I)  {10)  {amends  sec.  691  of  the  Code)—i'nstallment  ohliga- 
tions  received  from  a  decedent 

This  paragraph  deletes  the  provision  allowing  taxpayers  to  elect  to 
report,  on  a  pro  rata  basis,  installment  payments  on  certain  obliga- 
tions transferred  from  a  decedent  (in  taxable  years  to  which  the  1939 
Code  applied)  without  the  necessity  of  maintaining  a  bond  with  the 
Internal  Revenue  Service  to  guarantee  the  proper  reporting  of  the 
installment  payments,  as  had  been  necessary  with  respect  to  returns 
required  to  be  filed  before  September  3, 1964. 

It  is  believed  either  that  none  of  these  obligations  are  still  outstand- 
ing, or,  if  any  are,  that  the  taxpayei-s  have  already  exercised  the 
election.  This  amendment  preserves  the  rights  of  any  taxpayers  still 
reporting  such  installment  payments  who  will  have  made  the  election 
with  respect  to  taxable  years  beginning  before  January  1,  1977. 

Sec.  1951  {h)  {11)  {amends  sec.  817  of  the  Code) — life  insurance  com- 
pany gains  on  transactions  occurt'ing  prior  to  January  7,  1959 

This  paragraph  deletes  from  the  Code  section  817(d),  which  ex- 
cludes from  taxation  gains  realized  by  life  insurance  companies  in 
cases  of  gains  from,  or  considered  under  the  life  insurance  company 
tax  provisions  as  from,  the  sale  or  other  disposition  of  a  capital  asset 
(or  of  property  which,  except  for  section  817(d),  would  constitute 
section  1231  assets)  before  1959.  Before  1959,  such  gains  were  usually 
not  subject  to  tax  in  the  case  of  life  insurance  companies. 

It  is  unlikely  that  this  provision  has  any  current  applicability  since 
taxpayers  are  not  likely  to  be  currently  receiving  gains  from  pre-1959 
dispositions,  except  in  the  limited  area  of  installment  sales.  In  those 
cases,  the  number  of  transactions  to  which  the  provision  might  apply 
may  be  expected  to  decrease  each  year.  For  these  reasons,  the  provision 
is  removed  from  the  Code,  but  retained  in  the  public  laws. 

Sec.  1951  {h)  {12)  {repeals  sec.  13^7  of  the  Code) — claims  filed  against 
the  United  States  before  January  i,  1958 

This  paragraph  deletes  from  the  Code  a  provision  limiting  to  33 
percent  of  the  amount  paid  (without  taking  into  account  the  interest 
paid) ,  the  tax  payable  on  payments  by  the  United  States  on  claims  un- 
paid for  15  years  and  involving  the  acquisition  of  property.  The  pro- 
vision applied  only  if  the  claim  was  filed  before  January  1,  1958. 

It  is  believed  that  no  claim  of  the  type  described  in  section  1347  is 
still  outstanding.  If  any  does  exist,  however,  it  will  remain  subject  to 
the  same  tax  treatment  by  virtue  of  the  inclusion  in  the  public  laws 
of  the  provision  deleted  from  the  Code. 

Several  conforming  changes  necessitated  by  the  deletion  of  section 
1347  are  also  made. 

Sec.  1951  {h)  {13)  {repeals  sec.  11^71  of  the  Code) — recovery  of  exces- 
sive profits  on  Government  contracts  subject  to  the  Vinso7i- 
Tra7nmell  Act 

This  paragraph  deletes  from  the  Code  a  provision  relating  to  a  few 
possible  situations  of  excessive  profits  on  Government  contracts  not 


524 

covered  by  the  Renegotiation  Act.  In  addition,  the  provision  would  be 
fully  operative  if  the  Renegotiation  Act  should  ever  be  allowed  to 
expire.  Since  this  provision  does  not  involve  taxation  as  such,  but 
instead  provides  for  collection  of  certain  excessive  profits  as  taxes  are 
collected,  it  is  removed  from  the  Code  but  retained  in  tlie  public  laws. 

Sec.  1951  (h)  (14)  {amends  sec.  1481  of  the  Code) — renegotiated  ex- 
cessive defense  contract  profits  of  taxable  years  governed  hy  the 
Internal  Revenue  Code  of  1939 

This  paragraph  deletes  from  the  Code  a  provision  (section  1481(d) ) 
regarding  the  readjustment  of  taxes  for  taxable  years  governed  by  the 
Internal  Revenue  Code  of  1939  if  excessive  defense  contract  profits 
taxed  in  those  years  are  recaptured  by  the  Government  pursuant  to 
the  Renegotiation  Act  of  1951,  as  amended. 

It  is  believed  that  no  years  governed  by  the  Internal  Revenue  Code 
of  1939  (in  general,  taxable  years  beginning  before  January  1,  1954) 
are  now  in  court  or  in  the  renegotiation  process.  However,  it  appears 
that  some  excessive  profits  renegotiated  for  years  subject  to  the  1939 
Code  are  still  being  collected.  In  addition,  defense  contractors  and  sub- 
contractors who  failed  to  file  reports  of  renegotiable  profits  for  those 
years  could  be  required  to  file  such  reports  (although  this  is  con- 
sidered an  unlikely  possibility).  For  these  reasons,  the  provision 
deleted  from  the  Code  is  retained  in  the  public  laws. 

Sec.  1951  (c) — conforming  and  clerical  aTnendments 

This  subsection  provides  conforming  and  clerical  amendments 
necessitated  by  the  repeals  made  by  section  1951(b)  of  this  title. 

Sec.  1951  {d) — effective  date 

Subsection  (d)  provides  that  the  amendments  made  by  section  1951 
(b)  and  (c)  of  this  title,  except  as  otherwise  expressly  provided,  are  to 
apply  to  taxable  years  beginning  after  December  31,  1976. 

SEC,  1952.  PROVISIONS  OF  SUBCHAPTER  D  OF  CHAPTER 
39;  COTTON  FUTURES 

This  section  repeals  provisions  (sections  4851  through  4877  of  the 
Code)  taxing  cotton  futures  contracts.  These  provisions  impose  pro- 
hibitory taxes  upon  cotton  futures  contracts  which  do  not  meet  the  i-e- 
quirements  set  forth  in  these  provisions  and  in  related  Department  of 
Agriculture  regulations.  No  tax  is  collected  under  these  provisions, 
which  provide  the  necessary  authority  to  regulate  the  cotton  futures 
market.  (See  legislative  findings  in  title  7  of  the  United  States  Code  at 
section  5,  6a  (first  sentence),  and  2101  (second  and  third  sentences).) 
The  bill  reenacts  these  provisions  (providing  appropriate  penalties), 
which  results  in  transferring  the  law  on  tliis  subject  out  of  the  Inter- 
nal Revenue  Code.  The  material  in  this  section  has  been  reviewed  by 
the  Department  of  Agriculture,  the  New  York  Cotton  Exchange,  and 
the  staff  of  the  Committee  on  Agriculture  of  the  House  of  Repre- 
sentatives. 

A  number  of  conforming  and  clerical  amendments  to  the  Code  are 
necessitated  by  the  repeal  of  sections  4851  through  4877  and  are  made 
by  subsection  (n) .  The  provisions  of  this  section  of  the  title  are  to  take 
effect  on  the  90th  day  after  the  date  of  enactment. 


S.  ESTATE  AND  GIFT  TAXES 

1.  Unified  Rate  Schedule  for  Estate  and  Gift  Taxes;  Unified 
Credit  in  Lieu  of  Specific  Exemptions  (sec.  2001  of  the  Act 
and  sees.  2001,  2010,  2011,  2012,  2013,  2014,  2035,  2038,  2052, 
2101,  2102,  2104,  2106,  2206,  2207,  2502,  2504,  2505,  2521,  and 
6018  of  the  Code) 

a.  Unified  Rate  Schedule 

Prior  law 

An  estate  tax  is  imposed  on  transfers  at  death  and  a  gift  tax  is  im- 
posed on  transfers  during  life.  Under  prior  law,  each  tax  had  a  separate 
rate  schedule  and  exemption. 

The  rates  under  the  prior  gift  tax  rate  schedule  were  progre^ve 
and  ranged  from  2^4  percent  on  the  first  $5,000  in  taxable  gifts  by  a 
donor  to  57%  percent  on  taxable  gifts  by  a  donor  (computed  on  a 
cumulative  basis)  in  excess  of  $10  million.  The  gift  tax  rates  were 
three-fourths  of  the  estate  tax  rates  for  the  corresponding  brackets. 
The  tax  was  based  on  the  fair  market  value  of  the  gifts  made  by  a  donor 
reduced  by  amounts  allowable  under  the  $3,000  per  donee  annual  ex- 
clusion, allowable  charitable  and  marital  deductions,  and,  under  prior 
law,  any  portion  of  the  gift  tax  specific  exemption  of  $30,000  which  had 
not  been  used  for  previous  gifts  by  the  donor.  The  gift  tax  base  was 
the  value  of  the  property  transferred  to  a  donee,  and  did  not  take  into 
account  the  gift  taxes  paid  by  the  donor  with  respect  to  the  transfer. 

The  estate  tax  rates  also  are  progressive  and,  under  prior  law, 
ranged  from  3  percent  of  the  first  $5,000  of  the  taxable  estate  to  77 
percent  of  the  taxable  estate  in  excess  of  $10  million.^ 

The  tax  base,  or  taxable  estate,  is  determined  by  deducting  from  the 
value  of  the  gross  estate  the  allowable  deductions  for  estate  administra- 
tion and  funeral  expenses,  claims  against  the  estate,  casualty  and 
theft  losses  sustained  during  administration  of  the  estate,  the  chari- 
table and  marital  deductions,  and,  under  prior  law,  the  estate  tax 
specific  exemption  of  $60,000.  Generally,  the  estate  tax  base  was  deter- 
mined solely  by  reference  to  transfers  at  death  without  regard  to  the 
amount  of  lifetime  transfers  or  the  gift  taxes  paid  on  those  transfers. 
The  estate  tax  was  based  on  the  value  of  the  estate  without  diminution 
for  the  amount  which  was  used  to  pay  the  Federal  estate  tax  (unlike 
the  gift  tax  provisions  under  which  the  tax  base  is  the  value  of  the 
property  transferred  to  a  donee). 

In  certain  eases,  lifetime  transfers  wliich  were  made  by  a  decedent 
are  also  included  in  the  g-ross  estate.  A  lifetime  transfer  is  included  in 


1  In  the  case  of  nonresident  aliens,  the  estate  tax  imposed  on  the  portion  of  the  estate 
situated  in  the  United  States  ranged  from  5  percent  of  the  first  $100,000  of  the  taxable 
estate  to  25  percent  of  the  taxable  estate  in  excess  of  $2  million. 

(525) 


526 

a  decedent's  gross  estate  if  he  had  retained  certain  interests,  rights,  or 
powers  in  the  property  transferred.  In  addition,  transfers  made  "in 
contemplation  of  death"  Avere  included  in  the  decedent's  gross  estate 
(to  minimize  the  incentive  to  transfer  property  in  anticipation  of 
death  because  of  the  favorable  gift  tax  treatment).  Transfers  made 
within  3  years  of  death  were  presumed  to  be  made  "in  c-ontemplation 
of  death"  and  included  in  the  decedent's  gross  estate  unless  the  execu- 
tor could  prove  to  the  contrary.  If  a  lifetime  transfer  was  included 
in  the  decedent's  gross  estate,  credit  against  the  estate  tax  was  allowed 
for  the  gift  tax  paid  on  the  transfer  (although  the  amount  of  gift  tax 
paid  itself  was  excluded  from  the  gross  estate) . 

Reasons  for  change 

Under  prior  law,  there  was  a  substantial  disparity  of  treatment  be- 
tween the  taxation  of  transfers  during  life  and  transfers  at  death.  In 
general,  there  were  three  factors  which  provided  a  decided  preference 
for  lifetime  transfers.  First,  the  gift  tax  rates  were  set  at  three- fourths 
of  the  estate  tax  rates  at  each  corresponding  rate  bracket.  Second,  life- 
time transfers  were  not  taken  into  account  for  estate  tax  purposes  and 
the  estate  remaining  at  death  was  subject  to  tax  under  a  separate  rate 
schedule  starting  at  the  lowest  rates.  Thus,  even  if  the  rates  were 
identical,  separate  rate  schedule-s  provided  a  preference  for  mak- 
ing both  lifetime  and  deathtime  transfers  rather  than  having  the  total 
transfer  subject  to  one  tax.  Third,  the  gift  taxes  paid  were  not  gen- 
erally taken  into  account  for  either  transfer  tax  base.  In  the  case  of  a 
gift,  the  tax  base  did  not  include  the  gift  tax  but  the  payment  of  the 
tax  resulted  in  a  decrease  in  the  value  of  the  estate  retained  by  the 
donor.  However,  if  the  property  were  retained  until  death,  the  tax 
base  included  the  full  value  of  the  property,  even  though  a  portion 
might  be  required  to  satisfy  estate  taxes.  Thus,  even  if  the  applicable 
transfer  tax  rates  were  the  sa^me,  the  net  amount  transferred  to  a 
beneficiary  from  a  given  pre-tax  amount  of  propei-ty  was  greater  for  a 
lifetime  transfer  solely  because  of  the  difference  in  the  tax  bases. 

As  a  matter  of  equity,  the  Congress  believed  the  tax  burden  im- 
posed on  transfers  of  the  same  amount  of  wealth  sliould  be  substan- 
tially the  same  whether  the  transfers  are  made  both  during  life  and  at 
death  or  made  only  upon  death.  As  a  practical  matter,  the  preferences 
for  lifetime  transfers  are  available  only  for  wealthier  individuals  who 
are  able  to  afford  lifetime  transfers.  The  preference  for  lifetime  trans- 
fers are  not  generally  available  for  those  of  small  and  moderate  wealth 
since  they  generally  Avant  to  retain  their  pi"operty  until  death  to  assure 
financial  security  during  lifetime.  Therefore,  the  Congress  believed 
that  the  preferences  for  lifetime  transfers  principally  benefit  the 
wealthy  and  resulted  in  eroding  the  transfer  tax  base. 

The  Congress  believed  that  it  was  desirable  to  reduce  the  disparity 
of  treatment  between  lifetime  and  deathtime  transfere  through  the 
adoption  of  a  single  unified  estate  and  gift  tax  rate  schedule  providing 
progressive  rates  based  on  cumulative  lifetime  and  deathtime  transfers. 
However,  the  Congress  retained  part  of  the  incentives  for  life- 
time transfers.  Thus,  the  provisions  of  prior  law  under  which  the 
amount  of  gift  tax  was  not  included  or  "grossed  up"  in  the  transfer  tax 
ba^e  are  continued,  excei)t  in  the  case  of  gifts  made  within  three  years 


527 

of  the  date  of  death.  In  addition,  the  annual  gift  tax  exclusion  of  $3,000 
per  donee  is  continued.  The  advantiage  of  avoiding  a  transfer  tax  on 
the  appreciation  which  might  a/ccrue  between  the  time  of  a  gift  and 
the  donor's  death  represents  a  further  incentive  for  lifetime  transfer. 

The  estate  tax  provisions  relating  to  transfers  in  contemplation  of 
death  have  caused  substantial  problems  for  executors,  beneficiaries, 
and  the  Internal  Revenue  Service.  The  presumption  under  prior  law 
that  gifts  made  within  3  years  of  death  were  in  contemplation  of  death 
has  caused  considerable  litigation  concerning  the  motives  of  decedents 
in  making  gifts.  The  Congress  believed  that  this  problem  should  be 
eliminated  by  requiring  the  inclusion  of  all  such  gifts  in  the  gross  estate 
without  having  to  attempt  to  ascertain  the  motives  of  the  decedent. 
Under  a  unified  transfer  tax  system,  this  requirement  does  not  affect 
the  tax  imposed  upon  most  estates  in  a  major  way  because  the  gift 
taxes  paid  are  allowed  as  a  credit  in  determining  the  net  estate  tax  due. 

Since  the  gift  tax  paid  on  a  lifetime  transfer  which  was  included 
in  a  decedent's  gross  estate  was  taken  into  account  both  as  a  credit 
against  the  estate  tax  and  also  as  a  reduction  in  the  estate  tax  base, 
substantial  tax  savings  could  be  derived  under  prior  law  by  making 
so-called  "deathbed  gifts''  even  though  the  transfer  was  subject  to 
both  taxes.  To  eliminate  this  tax  avoidance  technique,  the  Congress 
believed  that  the  gift  tax  paid  on  transfers  made  within  3  years  of 
death  should  in  all  cases  be  included  in  the  decedent's  gross  estate.  This 
"gross-  up"'  rule  will  eliminate  any  incentive  to  make  deathbed  transfers 
to  remove  an  amount  equal  to  the  gift  taxes  from  the  transfer  tax  base. 

Explanation  of  provisions 

The  Act  provides  a  single  unified  rate  schedule  for  estate  and  ^ft 
taxes.  The  rates  are  progressive  on  the  basis  of  cumulative  lifetime 
and  deathtime  transfers.  The  unified  rate  schedule  eliminates  the 
preferential  rates  for  lifetime  transfers  (which  were  three-fourths  of 
the  estate  tax  rates  at  each  corresponding  bracket).  In  general,  the 
rules  established  under  prior  law  are  retained  as  to  when  a  gift  is 
considered  to  be  completed  for  gift  tax  purposes  and  as  to  when 
propertj'  is  included  in  a  decedent's  gross  estate  for  estate  tax  purposes. 
However,  the  estate  tax  rules  concerning  transfers  in  contemplation 
of  death  are  modified  as  described  below. 

Under  the  unified  rate  schedule,  the  rates  are  to  range  from  18  per- 
cent for  the  first  $10,000  in  taxable  transfers  to  70  percent  of  taxable 
transfers  in  excess  of  $5  million.  However,  after  taking  into  account 
the  unified  credit  in  lieu  of  an  exemption,  the  lowest  rate  at  which 
\tax  liability  is  actually  incurred  under  the  schedule  would  be  in  a 
fligher  marginal  tax  bracket.  For  1977, 1978,  and  1979,  the  lower  mar- 
ginal rate  at  which  liability  is  first  incurred  is  to  be  30  percent,  after 
taking  into  account  the  unified  credit  after  1979,  the  lowest  marginal 
rate  at  which  liability  is  first  incurred  is  to  be  32  percent,  after  taking 
into  account  the  unified  credit. 

The  amount  of  gift  tax  payable  (for  any  calendar  quarter  or  year, 
as  the  case  may  be)  is  to  be  determined  by  applying  the  unified  rate 
schedule  to  the  cumulative  lifetime  taxable  transfers  and  then  sub- 
tracting the  taxes  payable  on  the  lifetime  transfers  made  for  past 
taxable  periods.  In  computing  cumulative  taxable  gifts  for  preceding 
taxable  periods,  the  donor's  taxable  gifts  for  periods  preceding  Jan- 


528 

uary  1,  1977,  are  to  be  taken  into  account.  At  the  same  time,  in  com- 
puting the  tax  payable,  the  reduction  for  taxes  previously  paid  is  to  be 
based  upon  the  new  unified  rate  schedule  even  though  the  gift  tax 
actually  imposed  upon  prior  transfers  may  have  been  less  than  this 
amount.  Thus,  a  donor's  previous  taxable  gifts  only  affect  the  starting 
point  in  determining  the  applicable  rate  and  net  tax  on  gifts  made 
after  December  31, 1976. 

The  amount  of  estate  tax  is  to  be  determined  by  applying  the  uni- 
fied rate  schedule  to  the  aggregate  of  cumulative  lifetime  and  death- 
time  transfers  and  then  subtracting  (or  "offsetting")  the  gift  taxes 
payable  on  the  lifetime  transfers  (i.e..  the  gift  tax  payable  after 
application  of  the  unified  credit  allowable  with  respect  to  the  life- 
time transfers) .  As  a  transitional  rule,  the  completed  lifetime  transfers 
taken  into  account  in  determining  cumulative  transfers  at  death  for 
purposes  of  imposing  the  estate  tax  arc  only  to  include  taxable  gifts 
made  after  December  31,  1976.  CorresiX)ndingly,  the  gift  tax  paid 
with  respect  to  gifts  made  before  January  1,  1977.  is  not  to  be  in- 
cluded as  part  of  the  subtraction  or  offset  in  computing  the  estate  tax. 
The  subtraction,  or  offset,  is  to  include  the  aggregate  amount  of  gift 
tax  payable  on  .qrifts  made  after  December  31. 1976. 

Transfers  included  in  the  tax  base  as  lifetime  transfers  (described 
as  "adjusted  taxable  gifts"  by  the  Act)  are  not  to  include  transfers 
which  are  also  included  in  the  decedent's  gross  estate  (i.e.,  transfers 
made  within  three  years  of  the  date  of  death  and  lifetime  transfers 
where  the  dece^'pn*-  had  retained  certain  interests.  ri.<rhts.  or  powers  in 
the  property).  This  is  to  preclude  having  the  same  lifetime  transfers 
taken  into  account  more  than  once  for  transfer  tax  purposes.  However, 
the  gift  tax  payable  on  these  transfers  is  to  be  subtracted  in  determin- 
ing the  estate  tax  imposed. 

In  addition,  the  gift  tax  paid  by  a  spouse  is  to  be  a  subtraction,  or 
offset,  in  computing  the  estate  tax  imposed  where  the  transfer  subject 
to  the  tax  is  included  in  the  decedent's  gross  estate  and  was  considered 
to  have  been  a  transfer  made  in  part  bv  the  surviving  spouse  under 
the  gift-splitting  provisions  of  the  tax  law.  The  effect  of  this  treat- 
ment is  to  reverse  the  consenuences  of  havinq:  treated  the  sur^-iving 
spouse  as  the  donor  of  one-half  of  a  .qrift  mnde  to  a  third  party  for  gift 
tax  purposes  where  the  property  transferred  is  subsequentlv  included 
in  the  decedent's  irross  pstate.  However,  there  is  to  be  no  restoration  of 
any  portion  of  the  unified  credit  used  asrainst  gift  taxes  paid  by  the 
surviving  spouse.  (Tliis  treatment  is  similar  to  court  decisions  reached 
under  prior  law  which  did  not  permit  restoration  of  anv  portion  of 
the  jrift  tax  exemption  used  with  respect  to  a  transfer  which  was  later 
included  in  t^^e  other  spouse's  estate  because  it  was  made  in  contem- 
plation of  death.) 

The  Act  provides  for  the  inclusion  in  the  decedent's  gross  estate 
of  all  gifts  made  during  the  3-year  period  ending  on  the  date  of 
the  decedont's  death.  Thus,  the  presumption  of  prior  law  that  a  sfift 
made  within  that  period  is  mnde  in  contemplation  of  death  is  elimi- 
nated. The  presumption  of  prior  law  was  intended  to  prevent  the 
avoidance  of  estnte  taxes  by  making  lifetime  transfers  in  anticipa- 
tion of  death.  The  presumntion  was  provided  because  the  Su- 
preme  Court,  in  Heiner  v.  Dormant  held  that   a  conclusive  pre- 

*  285  U.S.  312  (1932). 


529 

sumption  created  an  unreasonable  classification  in  violation  of  the 
due  process  clause  of  the  Fifth  Amendment  because  it  resulted 
in  taxino;  some  inter  viros  transfers  under  the  estate  tax  because 
of  the  fortuitous  event  of  death  while  other  similar  transfers 
were  exempt.  Even  assuming  that  the  1932  case  would  be  fol- 
lowed today,  the  Congress  believed  that  the  approach  taken  under 
the  Act  is  distinguishable  from  the  statute  which  was  held  to 
be  unconstitutional.  First  the  Act  does  not  provide  a  presumption  as 
to  whether  a  transfer  is  in  contemplation  of  death.  The  theory  under- 
lying the  provision  does  not  depend  on  whether  the  transfer  was  in 
contemplation  of  death  as  a  substitute  for  a  testamentary  disposition. 
The  donor's  motive  is  immaterial.  Second,  the  1932  decision  dealt  with 
the  impact  of  the  contemplation  of  death  rules  under  a  taxing  statute 
where  substantial  differences  in  tax  liability  would  liave  risen,  depend- 
ing upon  whether  or  not  a  lifetime  transfer  was  included  in  a  deced- 
ent's gross  estate  because  no  gift  tax  was  imposed  at  that  time. 

With  the  adoption  of  a  single  unified  rate  schedule,  the  tax  impact  of 
a  rule  requiring  the  inclusion  of  all  transfers  made  within  3  years  of 
death  is  not  as  significant  as  would  be  the  case  where  either  no  sepa- 
rate gift  tax  is  imposed  or  a  dual  tax  system  providing  rate  differen- 
tials between  lifetime  and  deathtime  transfers  is  imposed.  The  most 
significant  adverse  consequence  would  result  where  the  property  trans- 
ferred substantially  appreciates  in  value  between  the  date  of  the 
transfer  and  the  date  of  the  decedent's  death.  On  the  other  hand,  the 
inclusion  of  these  transfers  may  enlarge  the  amount  deductible  as  a 
marital  deduction,  since  it  would  be  taken  into  account  as  part  of  the 
adjusted  gross  estate  to  which  the  50-percent  limitation  applies. 

Under  the  rule  for  transfers  made  within  3  years  of  death,  an  excep- 
tion is  provided  for  transfers  for  an  adequate  and  full  consideration  in 
money  or  money's  worth.  Generally  the  inclusion  rule  will  only  apply 
to  transfers  treated  as  gifts  for  gift  tax  ])urposes.  In  addition,  another 
exception  is  provided  on  the  basis  of  administrative  convenience  so  that 
the  amount  of  gifts  included  is  limited  to  the  excess  of  the  estate  tax 
value  over  the  amount  excludible  with  respect  to  the  gifts  under  the 
$3,000  annual  gift  tax  exclusion. 

In  detennining  the  amount  of  the  gross  estate,  the  amount  of  gift 
tax  paid  within  3  years  of  death  is  to  be  includable  in  a  decedent's  gross 
estate.  This  "gross-up"  rule  for  gift  taxes  eliminates  any  incentive  to 
make  deathbed  transfers  to  remove  an  amount  equal  to  the  gift  taxes 
from  the  transfer  tax  base.  The  amount  of  gift  tax  subject  to  this  rule 
would  include  tax  paid  by  the  decedent  or  his  estate  on  any  gift  made 
by  the  decedent  or  his  spouse  after  December  31,  1976.  It  would  not, 
however,  include  any  gift  tax  paid  by  the  spouse  on  a  gift  made  by  the 
decedent  within  3  years  of  death  which  is  treated  as  made  one-half  by 
the  spouse,  since  the  spouse's  payment  of  such  tax  would  not  reduce  the 
decedent's  estate  at  the  time  of  death. 

The  Act  also  provides  for  the  unification  of  estate  and  gift  taxes  in 
the  case  of  estates  of  nonresident  aliens  who  owned  or  transferred 
property  situated  in  the  United  States.  As  under  pnor  law,  the  gift 
tax  provisions  applicable  to  citizens  and  residents  are  also  to  apply 
to  gifts  of  property  situated  in  the  United  States  by  a  nonresident 
alien.  Also,  a  special  estate  tax  rate  schedule  is  to  apply  to  the  estate  of 
nonresident  aliens,  as  under  j)rior  law.  The  rate  schedule  is  revised 


530 

to  provide  rates  ranging  from  6  percent  on  the  first  $100,000  in  taxable 
transfers  to  30  percent  on  taxable  transfers  over  $2  million.  As  in 
the  case  of  the  regular  estate  tax,  the  amount  of  estate  tax  would  be 
determined  by  applying  the  unified  rate  schedule  to  the  cumulative 
lifetime  and  deathtime  transfers  subject  to  United  States  transfer 
taxes  and  then  subtracting  the  gift  taxes  payable  on  the  lifetime  trans- 
fers. The  lifetime  transfers  to  be  taken  into  account  in  computing  the 
estate  tax  would  include  gifts  made  by  the  decedent  after  December  31, 
1976. 

The  special  credit  against  estate  tax  for  gift  tax  payable  with  respect 
to  lifetime  transfers  which  are  included  in  a  decedent's  gross  estate 
(sec.  2012)  is  not  to  apply  to  gifts  made  after  December  31,  1976.  For 
these  gifts,  the  computation  of  the  gross  estate  tax  payable  will  reflect 
the  credit  for  gift  tax  paid  on  lifetime  transfers  included  in  the  gross 
estate.  Thus,  the  special  gift  tax  credit  provision  is  not  necessary 
under  a  unified  transfer  tax  approach. 

Effective  date 
In  general,  the  amendments  apply  to  the  estates  of  decedents  dying 
after  December  31,  1976,  and  to  gifts  made  after  December  31,  1976. 
However,  the  amendments  relating  to  the  estate  tax  treatment  of 
transfers  made  within  three  years  of  a  decedent's  death  do  not  apply 
to  transfers  made  before  January  1, 1977.  The  contemplation  of  death 
rules  under  prior  law  will  apply  to  gifts  made  before  January  1,  1977, 
where  the  decedent  dies  after  December  31,  1976,  and  the  transfer  is 
made  within  3  years  of  death. 

h.  Unified  Credit  in  Lieu  of  Specific  Exemptions 

Prior  law 

Under  prior  law,  separate  exemptions  were  provided  for  estate  and 
gift  taxes.  The  gift,  tax  specific  exemption  was  $30,000  for  each  donor. 
In  the  case  of  a  married  couple,  the  exemption  available  was,  in  effect 
$60,000  if  the  spouse  consented  to  treat  one-half  of  the  gifts  made  by 
the  donor  spouse  as  being  made  by  him  or  her.  The  specific  exemption 
was  in  addition  to  the  annual  $3,000  per  donee  exclusion. 

Under  prior  law,  the  estate  tax  specific  exemptio7i  was  $60,000.  In  the 
case  of  a  nonresident  alien,  the  exemption  was  $30,000.  The  estate  tax 
exemption  was  not  increased  for  any  portion  of  the  gift  tax  specific 
exemption  which  was  not  used  against  lifetime  transfers. 

Reasons  for  change 

The  amoimt  of  the  estate  tax  exemption  was  established  in  1942. 
Since  that  date,  the  purchasing  power  of  the  dollar  has  decreased 
to  less  than  one-tliird  of  its  value  in  1942.  To  some  extent  this  effect 
has  been  mitigated  by  the  addition  of  a  provision  for  a  marital  deduc- 
tion in  1948.  Despite  this  change  in  1948,  the  inflation  which  has  oc- 
curred means  that  the  estate  tax  now  has  a  much  broader  impact  than 
it  did  oriarinally. 

In  addition,  since  the  estate  tax  exemption  under  prior  law  was  a 
deduction  in  rletermining  the  taxable  estate,  it  reduced  each  estate's 
tax  at  iho,  highest  estate  tax  brackets.  However,  a  credit  in  lieu  of  an 
exemption  has  the  effect  of  reducing  the  estate  tax  at  the  lower  estate 
tax  brackets  since  a  tax  credit  is  applied  as  a  dollar-for-dollar  reduc- 


531 

tion  of  the  amount  othenvise  due.  Thus,  at  a  given  level  of  revenue 
cost,  a  tax  credit  tends  to  confer  more  tax  savings  on  small-  and 
medium-sized  estates,  whereas  a  deduction  or  exemption  tends  to  con- 
fer more  tax  savings  on  larger  estates.  The  Congress  believed  it  would 
be  more  equitable  if  the  exemption  were  replaced  with  a  credit. 

As  a  practical  matter,  the  gift  tax  exemption  was  not  available  to 
individuals  who  could  not  afford  to  make  lifetime  transfers.  Thus,  the 
overall  transfer  tax  exemption  was  effectively  greater  for  individuals 
who  were  financially  able  to  utilize  the  gift  tax  exemption  through 
lifetime  transfei-s.  The  Congress  believed  that  it  would  be  more  equi- 
table if  a  unified  credit  in  lieu  of  an  exemption  were  available  on  an 
equal  basis  without  regard  to  whether  the  transfers  were  made  only  at 
death  or  were  made  both  during  lifetime  and  at  death. 

Explanation  of  provisions 

The  Act  provides  a  unified  credit  against  estate  and  gift  taxes,  in 
lieu  of  the  specific  exemptions  provided  under  prior  law.  The  credit 
is  to  be  phased-in  over  a  5-year  period.  Subject  to  a  transitional  rule 
for  certain  gifts,  the  amount  of  the  credit  is  $30,000  for  gifts  made  in, 
and  decedents  dving  in,  1977,  $34,000  in  1978,  $38,000  in  1979,  $42,500 
in  1980.  and  $47,000  in  1981. 

The  unified  credit  allowable  is  to  be  reduced  by  an  amount  equal 
to  20  percent  of  the  amount  allowed  as  a  specific  exemption  under 
prior  law  for  gifts  made  after  September  8,  1976,  and  before  Janu- 
ary 1,  1977.  However,  the  unified  credit  is  not  to  be  reduced  for  any 
amount  allowed  as  a  specific  exemption  for  gifts  made  prior  to  Sep- 
tember 9,  1976.  As  a  transitional  rule  for  gift  tax  purposes,  only  $6,000 
of  the  unified  credit  can  be  applied  with  respect  to  gifts  made  after 
December  31, 1976,  and  prior  to  July  1, 1977. 

In  general,  any  portion  of  the  unified  credit  used  against  gift  taxes 
will  reduce  the  credit  available  to  be  used  against  the  e-state  tax.  The 
unified  credit  rules  are  set  forth  separately  under  the  estate  and  gift 
tax  provisions  of  the  Act.  Since  the  credit  used  against  gift  taxes  is 
reflected  as  a  reduction  in  gift  taxes  payable,  for  purposes  of  determin- 
ing the  estate  tax  payable,  a  corresponding  estate  tax  provision  is  set 
forth  separately  to  preserv'o  the  effect  of  the  credit.  However,  because 
of  the  interrelationship  of  the  separate  credit  and  the  computation  of 
the  estate  tax  payable,  the  separate  estate  tax  credit  provision  does  not 
operate  to  pemiit  the  allowance  of  the  credit  both  as  to  lifetime  trans- 
fers and  also  as  to  deathtime  transfers.  Thus,  the  credit  is  in  effect  a 
single  unified  credit  for  estate  and  gift  tax  purposes.  In  addition,  the 
application  of  the  unified  credit  is  mandatory  with  respect  to  transfers 
in  the  order  of  time  in  which  they  are  made. 

The  amount  of  the  unified  credit  to  be  allowed  is  not  to  exceed  the 
amount  of  transfer  tax  imposed. 

Since  the  limitation  on  the  credit  against  the  estate  tax  for  State 
death  taxes  is  determined  by  reference  to  the  taxable  estate,  a  conform- 
ing change  is  made  to  reflect  the  fact  that  the  credit  does  not  enter 
into  the  computation  of  the  taxable  estate.  The  purpose  of  the  con- 
forming chan<re  is  to  continue  the  allowance  of  the  same  amount  for 
the  State  death  tax  credit  as  under  prior  law. 

The  estate  tax  filing  requirement  is  revised  by  the  Act  to  conform  to 
the  adoption  of  a  higher  credit  in  terms  of  exemption  equivalent.  To 


532 

reflect  the  exemption  equivalent  after  it  is  fully  phased-in,  an  estate 
tax  return  is  to  be  required  if  the  decedent's  ffross  estate  exceeds 
$175,000,  rather  than  $60,000  as  provided  by  prior  law.  During  the 
phase-in  period  for  the  unified  credit,  the  filing  requirements  are  to 
be  $120,000,  $134,000,  $147,000,  and  $161,000  for  estates  of  decedents 
dying  in  1977,  1978,  1979,  and  1980,  respectively.  However,  the  ap- 
plicable amount  w^ould  be  adjusted  for  certain  lifetime  transfers. 
The  applicable  amounts  would  be  reduced  by  the  sum  of  the  adjusted 
taxable  gifts  made  by  the  decedent  after  December  31,  1976,  and  the 
amount  of  the  specific  gift  tax  exemption  under  prior  law  which  may 
have  been  used  by  tho  decedent  with  respect  to  gifts  made  after  Sep- 
tember 8, 1976,  and  before  1977. 

In  the  case  of  the  estate  of  a  nonresident  alien  a  credit  of  $3,600 
is  to  be  allowed  against  the  estate  tax.  No  credit  against  gift  tax  is  to 
be  allowable.  This  is  similar  to  the  provision  under  prior  law  which 
did  not  make  the  specific  gift  tax  exemption  available  to  a  nonresident 
alien  unless  it  was  provided  imder  an  applicable  tax  treaty. 

In  the  case  of  a  resident  of  a  possession  of  the  United  States,  the 
credit  allowable  is  to  be  the  greater  of  $3,600  or  the  proportion  of 
$15,075  which  the  value  of  the  property  situated  in  the  United  States 
bears  to  the  value  of  the  entire  gross  estate  wherever  situated.  For 
estates  of  decedents  dying  during  1977,  1978,  1979,  and  1980,  the 
$15,075  amount  is  to  be  $8,480,  $10,080,  $11,680,  and  $13,388,  respec- 
tively. 

In  the  case  of  the  estate  tax  ])ro visions  relating  to  expatriation  to 
avoid  estate  tax,  the  credit  allowable  is  to  be  $13,000. 

Effective  date 
These  amendments  are  to  apply  to  estates  of  decedents  dying  after 
December  31,  1976,  and  to  gifts  made  after  December  31,  1976. 

2.  Increase  in  Limitations  on  Marital  Deductions;  Fractional  In- 
terest of  Spouse  (Sec.  2002  of  the  Act  and  Sees.  2056,  2523  and 
2040  of  the  Code) 

a.  Increase  in  Marital  Deductions 

Prior  Imv 

Under  estate  tax  law,  an  estate  of  a  decedent  is  allowed  a  deduction 
for  estate  tax  purposes  for  certain  property  passing  from  the  decedent 
to  the  surviving  spouse.  ITnder  prior  law,  the  maximum  allowable  de- 
duction was  50  percent  of  the  adjusted  gross  estate  of  the  decedent. 
In  addition,  a  marital  deduction  is  allowed  for  gift  tax  purposes  in 
the  case  of  lifetime  transfers  to  a  spouse.  In  tho  case  of  gifts,  the  max- 
imum allowable  deduction  was  50  percent  of  the  value  of  the  property 
transferred  to  the  spouse.  The  marital  deduction  generally  equates  the 
tax  results  of  transfers  between  the  spouses  in  common  law  states  and 
those  in  community  property  states.^  The  decedent's  share  of  com- 
munity property  passing  to  a  spouse  is  not  eligible  for  the  marital  de- 
duction, because  only  the  decedent's  share  of  the  community  property 
is  included  in  the  e;ross  estate. 


1  The  Uinitation  of  50  perrent  was  an  attempt  to  provide  substantial  parity  between 
common  law  States  and  community  property  law  States.  In  community  property  States, 
generally  only  50  percent  of  the  community  property  is  treated  as  owned  by  the  deceased 
spouse  and  included  in  the  gross  estate. 


533 

Reasons  for  change 
The  Congress  believed  that  a  decedent  with  a  small-  or  medium- 
sized  estate  should  be  able  to  leave  a  minimum  amount  of  property 
to  the  surviving'  spouse  without  the  imposition  of  an  estate  tax.  The 
Congress  further  believed  that  the  prior  limitation  on  transfers  to  a 
spouse  free  of  gift  tax  was  too  restrictive  and  tended  to  interfere  with 
normal  interspousal  lifetime  transfers. 

Explanation  of  provisions 

The  Act  increases  the  maximum  estate  tax  marital  deduction  for 
property  passing  from  the  decedent  to  the  surviving  spouse  to  the 
greater  of  $250,000  or  one-half  of  the  decedent's  adjusted  gross  estate. 
The  $250,000  amount  is  adjusted  where  the  decedent  owns  community 
property  at  death,  so  that  the  parit}^  provided  under  jDrior  law  be- 
tween common  law  property  and  community  property  law  states  is 
continued. 

The  Act  also  amends  the  gift  tax  marital  deduction  to  provide  an 
unlimited  deduction  for  transfers  between  spouses  for  the  first  $100,- 
000  in  gifts.  Allowance  of  the  marital  deduction  is  determined  on  the 
basis  of  the  donor's  and  donee's  marital  status  at  the  time  of  the  gift 
and,  in  the  case  of  the  remarriage  of  the  donor,  the  unlimited  marital 
deduction  would  be  determined  on  the  basis  of  the  aggregate  amount 
of  gifts  made  to  all  spouses.  Thereafter,  the  deduction  allowed  will  be 
50  percent  of  the  interspousal  lifetime  transfers  in  excess  of  $200,000. 
Under  this  provision,  the  limitation  on  the  estate  tax  marital  deduc- 
tion is  to  be  reduced  by  the  amount  of  the  marital  deduction  allowed 
for  lifetime  transfers  in  excess  of  50  ):)ercent  of  the  value  of  the  trans- 
fers (i.e.,  where  lifetime  gifts  eligible  for  the  marital  deduction  are 
less  than  $200,000). 

Effective  date 

In  general,  these  provisions  are  effective  with  respect  to  the  estates 
of  decedents  dying  after  December  81,  1976,  and  to  gifts  transferred 
after  December  31, 1976. 

Because  the  maximum  estate  tax  marital  deduction  under  prior  law 
was  limited  to  one-half  the  adjusted  gross  estate,  many  existing  wills 
and  trusts  provide  a  maximum  marital  deduction  formula  clause.  The 
Congress  was  concerned  that  many  testators,  although  using  the  for- 
mula clause,  may  not  have  wanted  to  pass  more  than  one-half  the 
estatae  (recognizing  the  prior  law  limitation)  to  the  spouse.  For  this 
reason  a  two-year  transition  rule  provides  that  the  increased  estate 
tax  marital  cleduction,  as  provided  by  the  Act,  will  not  apply  to 
transfers  resulting  from  a  will  executed  or  trust  created  before  Jan- 
uary 1, 1977,  which  contains  a  maximum  marital  deduction  clause  pro- 
vided that:  (1)  the  formula  clause  is  not  amended  before  the  death  of 
the  decedent,  and  (2)  there  is  not  enacted  a  State  law,  applicable  to  the 
estate,  which  would  construe  the  formula  clause  as  referring  to  the 
increased  marital  deduction  as  amended  by  the  Act.  This  transitional 
rule  will  be  eifective  for  decedents  dying  after  December  31,  1976  and 
before  January  1, 1979. 

h.  Fractional  Interests  of  Spouse 

Prior  Jaw 
Under  gift  and  estate  tax  law,  the  creation  and  termination  of  joint 
property  interests  have  differing  gift  and  estate  tax  consequences  de- 

234-120  O  -  77  -  35 


534 

pending  on  the  nature  of  the  joint  property,  the  type  of  joint  owner- 
ship, the  consideration  paid  by  each  co-owner  for  the  property,  and 
the  ownership  rights  in  the  property  under  local  law. 

For  gift  tax  purposes,  a  completed  transfer  is  a  prerequisite  to  the 
imposition  of  the  tax.  If  a  joint  tenant,  who  has  furnished  all  the 
consideration  for  the  creation  of  the  joint  tenancy,  is  pemiitted  to 
draw  back  to  himself  the  entire  joint  property  (as  in  a  typical  joint 
bank  account),  the  transfer  is  not  complete  and  there  is  no  gift  at  that 
time.  If  the  creation  of  a  joint  tenancy  has  resulted  in  a  completed 
transfer,  the  value  of  the  gift  will  depend  upon  whether,  under  ap- 
plicable local  law,  the  right  of  survivorship  may  be  defeated  by  either 
owner  unilaterally.  If  either  joint  tenant,  acting  alone,  can  bring  about 
a  severance  of  his  interest,  the  value  of  the  gift  will  be  one-half  the 
value  of  the  jointly  held  property.  If  the  right  of  surA^vorship  is  not 
destructible  except  by  mutual  consent,  then  the  value  of  the  gift  re- 
quires a  calculation  which  takes  into  account  the  ages  of  the  donor  and 
the  other  concurrent  owner.  This  calculation  is  necessary  because  the 
younger  of  the  tenants,  who  has  a  greater  probability  of  surviving  and 
taking  all  the  property,  has  a  more  valuable  interest.' 

Although  the  creation  or  termination  of  completed  transfers  of  joint 
interests  in  property  (whether  real  or  personal)  is  automatically  sub- 
ject to  the  gift  tax,  the  gift  tax  law  provides  for  an  election  in  the 
case  of  the  creation  of  a  tenancy  by  the  entirety  in  real  property.  The 
creation  of  such  a  tenancy  by  the  entirety  (or  joint  tenancy  between 
husband  and  wife  with  rights  of  survivorship)  will  not  be  considered  a 
gift  unless  the  donor  eleots  to  have  the  transfer  treated  as  a  gift  at 
that  time.  If  the  donor  does  not  make  the  election,  a  taxable  gift  is 
not  considered  to  have  been  made  until  the  termination  of  the  tenancy 
(provided  the  termination  occurs  otherwise  than  by  death  of  a  spouse). 

For  estate  tax  purposes,  the  tax  law  provides  that  on  the  death  of  a 
joint  tenant  the  entire  value  of  the  property  owned  in  joint  tenancy  is 
included  in  a  decedent's  gross  estate  except  for  the  jwrtion  of  the  prop- 
erty which  is  attributable  to  the  consideration  furnished  by  the  sur- 
vivor. Thus,  if  the  decedent  furnished  the  entire  purchase  price  of  the 
jointly  owned  property,  the  value  of  the  entire  property  is  included  in 
his  gross  estate.  If  it  can  be  demonstrated  that  the  survivor  furnished 
part  of  the  purchase  price,  only  a  portion  of  the  value  of  the  property 
is  included  in  the  decedent's  gross  estate. 

In  the  cape  of  certain  trade  or  business  activities  conducted  jointly 
in  the  form  of  a  family  partnei-ship,  the  partnersliip  interest  held  by 
the  surviving  spouse  will  not  be  included  in  the  deceased  spouse's  gross 
estate.  The  effect  of  this  is  that  the  services  ]')erformed  by  the  surviving 
spouse  in  connection  with  tlie  familv  owned  business  are  taken  into 
account,  by  reason  of  the  profit  sharing  ratio,  as  consideration  fur- 
nished for  the  purchase  of  joint h-  owned  property  used  in  the  trade  or 
business  if  a  partnershin  is  used  to  conduct  business.^  This  rule  applies 
even  though  the  applicalile  local  law  would  treat  the  income  and, 
therefore,  the  "consideration  furnished,"  with  respect  to  a  jointly 
operated  family  business  which  is  not  conducted  under  the  partner- 
shi])  form  of  business,  as  belonging  to  the  husband  during  the 
marriasfe. 


«  See  also.  Estate  of  Otte,  31  CCH  Tax  Ct.  Mem.  301  (1972). 


5a5 

Reasons  for  change 
The  Congress  belieA^ed  that  the  prior  application  of  the  provisions 
relating  to  jointly  owned  property  was  unnecessarily  complex  and  may 
result  in  the  same  properties  being  subject  to  botli  the  gift  and  estate 
taxes.  This  double  taxation  (although  mitigated  by  the  allowance  of 
a  credit  for  gift  taxes  paid)  occurs  because  the  gift  tax  consequences 
of  joint  ownership  flow  from  legal  interests  created  under  local  law 
while  the  estate  tax  consequences  are  determined  by  the  decedent's 
relative  contribution  to  the  purchase  price.  Further,  the  Congress 
recognized  that  it  is  often  difficult,  as  between  spouses,  to  determine  the 
degree  to  which  eacli  spouse  is  responsible  for  the  acquisition  and  im- 
provement of  their  jointly  owed  property. 

Explmiation  of  pi^ovision 

ITnder  the  Act,  one-half  of  the  value  of  a  qualified  joint  interest  is 
included  in  the  gross  estate  of  the  decedent  at  the  date  of  the  deced- 
ent's death  (or  alternate  valuation  date),  regardless  of  which  joint 
tenant  furnished  the  consideration.  An  interest  is  a  qualified  joint  in- 
terest only  if  the  following  requirements  are  satisfied:  (1)  the  in- 
terest must  have  been  created  by  the  decedent  or  his  spouse,  or  both ; 
(2)  in  the  case  of  personal  property,  the  creation  of  the  joint  interest 
must  have  been  a  completed  gift  for  purposes  of  the  gift  tax  provi- 
sions; (3)  in  tlie  case  of  real  property,  the  donor  must  have  elected 
to  treat  the  creation  of  the  joint  tenancy  as  a  taxable  event  at  that 
time  (even  tliough  no  gift  tax  is  actually  paid  because  of  the  annual 
exclusion,  marital  deduction,  or  use  of  the  unified  credit) ;  and  (4)  the 
joint  tenants  cannot  be  persons  other  than  the  decedent  and  his  spouse. 
Thus,  if  a  donor  creates  a  joint  interest  in  real  property  with  his  spouse 
on  January  1,  1977,  and  makes  the  election  to  have  the  creation  of  the 
joint  tenancy  treated  as  a  taxable  gift  at  that  time,  then,  upon  the 
death  of  one  spou.se,  only  one-half  of  the  value  of  the  property  is  to  be 
included  in  the  gross  estate  of  the  decedent. 

The  provision  is  to  ai^plv  to  ioint  interests  created  after  December 
ol,  1976.  For  this  purpose,  the  chain  of  title  of  the  property  before  the 
creation  of  the  joint  tenancy  is  immaterial.  Thus,  if  a  severance  or 
partition  of  an  existing  joint  tenancy  is  made  after  December  31, 1976, 
and  the  joint  tenancy  between  the  spouses  in  that  property  is  then 
recreated,  the  creation  of  the  new  joint  tenancy  will  be  eligible  for 
the  fractional  interest  rule  so  long  as  the  other  requirements  are  satis- 
fied and  the  ci-eation  of  the  new  joint  tenancy  is  A^alid  undei-  local  law. 
The  tax  consequences,  if  any,  of  the  severance  or  partition  of  the  exist- 
ing joint  interest  will  continue  to  be  determined  in  accordance  with  the 
provisions  in  effect  prior  to  the  Act,  e.g.,  no  gift  will  be  considered  to 
have  been  made  if  the  nroperty  interests  or  proceeds  are  distributed 
or  reinvested  in  pro])ortion  to  the  consideration  furnished  by  each.  Tlie 
amount  of  coiisideration  furnislied  bv  each  spouse  for  the  recreation 
of  the  joint  tenancy  will  also  continue  to  be  determined  imder  the 
principles  in  effect  prior  to  the  Act.  Tlie  election  provided  under  the 
gift  tax  provisions  for  joint  interests  in  real  estate  Avill  then  be 
available  witli  respect  to  the  amount  of  the  <rift  determined. 

The  donor  is  to  make  the  election  by  including  the  transfer  in  the 
gift  tax  return  for  the  calendar  quarter  in  which  the  joint  tenancy  was 
created.  Tlie  effect  of  including  only  one-half  the  value  of  the  property 


536 

in  the  gross  estate  in  these  situations  is  to  implicitly  recognize  the 
services  furnished  by  a  spouse  toward  the  accumulation  of  the  jointly 
owned  property  even  though  a  monetary  value  of  the  services  cannot 
be  accurately  determined. 

If  the  donor  does  not  elect  (in  the  case  of  real  property)  to  treat 
the  transfer  as  a  gift  at  the  time  of  the  creation  of  the  interest  (by  not 
including  the  transfer  on  a  timely  filed  gift  tax  return),  then,  upon 
the  death  of  a  spouse,  the  joint  property  is  to  be  subject  to  inclusion 
in  the  gross  estate  at  the  full  value  of  the  property  less  the  value  attrib- 
utable to  any  contribution  that  can  be  traced  to  the  survivor.  If  the 
creation  of  the  joint  tenancy  is  not  a  completed  transfer  for  gift  tax 
purposes  (as,  for  example,  a  joint  bank  account  in  which  either  tenant 
is  entitled  to  withdraw  the  entire  account) ,  the  new  rules  added  by  the 
Act  will  not  apply,  and  upon  death  of  either  co-tenant  the  property 
will  be  subject  to  inclusion  in  the  gross  estate  at  full  value,  subject  to 
the  contribution-furnished  test. 

Once  the  election  is  made  with  regard  to  the  creation  of  the  joint 
tenancy  in  real  property,  it  applies  to  all  subsequent  additions  in 
value  to  that  property.  Thus,  additional  gift  tax  returns  will  be 
required  to  be  filed  with  respect  to  additions  in  value  for  any  taxable 
period  in  which  gifts  to  the  donee  spouse  exceed  the  $3,000  annual 
exclusion.  For  purposes  of  this  provision,  additions  in  value  would 
include  mortgage  payments  on  debts  against  the  property  as  well  as 
improvements  made  to  the  property.  For  this  purpose,  the  mere  appre- 
ciation in  the  value  of  the  property  is  not  to  constitute  additional  gifts. 
If  this  election  is  made  the  value  of  real  property  to  be  included  in  the 
gross  estate  is  one  half  the  value  of  the  property  at  the  date  of  the 
decedents'  death,  even  though  the  joint  tenancy,  under  local  law,  can 
be  broken  only  with  mutual  consent.  In  addition  the  actuarial  com- 
putations normally  necessary  to  determine  a  gift  upon  creation  of  a 
joint  tenancy  between  spouses  are  not  required  in  the  case  of  real 
property. 

The  Act  does  not  change  the  treatment  of  interests  of  spouses  in 
family  partnerships  for  estate  and  gift  tax  purposes. 

Ejfective  date 
In  general,  this  provision  is  effective  with  respect  to  joint  interests 
created  after  December  31, 1976. 

3.  Valuation  for  Purposes  of  the  Federal  Estate  Tax  of  Certain 
Real  Property  Devoted  to  Farming  or  Closely  Held  Business 
Use  (sec.  2003  of  the  Act  and  sees.  2032A  and  6324B  of  the 
Code) 

Prior  la/w 

Under  the  estate  tax  law,  the  value  of  property  included  in  the 
gross  estate  of  a  decedent  is  the  fair  market  value  of  the  property 
interest  at  the  date  of  the  decedent's  death  (or  at  the  alternate  valua- 
tion date  if  elected).  The  fair  market  value  is  the  price  at  which  the 
property  would  change  hands  between  a  willing  buyer  and  a  willincr 
seller,  neither  being  under  any  compulsion  to  buy  or  to  sell  and  both 
having  reasonable  knowledge  of  relevant  facts.  One  of  the  most  im- 
portant factors  used  in  determining  fair  market  value  is  the  highest 
and  best  use  to  which  the  property  can  be  put. 


537 

Where  the  fair  market  vahie  of  real  property  is  the  subject  of  dis- 
pute, there  are  several  valuation  techniques  which  the  courts  tend  to 
accept.  These  methods  include  the  income-capitalization  technique,  the 
reproduction-cost  minus  depreciation  technique,  and  the  comparative 
sales  technique.  Courts  will  generally  use  one  of  these  methods,  or  a 
combination  of  these  methods,  in  determining  fair  market  value. 

However,  in  all  cases,  it  is  presumed  that  land  would  change  hands 
between  a  willing  buyer  and  a  willing  seller  based  on  the  "highest  and 
best  use"  to  which  that  land  could  ^  put,  rather  than  the  actual  use 
of  the  land  at  the  time  it  is  transferred. 

Reasons  for  change 

The  Congress  believed  tliat,  when  land  is  actually  used  for  farm- 
ing purposes  or  in  other  closely  held  businesses  (both  before  and  after 
the  decedent's  death),  it  is  inappropriate  to  value  the  land  on  the  basis 
of  its  potential  "highest  and  best  use"  especially  since  it  is  desirable  to 
encourage  the  continued  use  of  property  for  farming  and  other  small 
business  purposes.  Valuation  on  the  basis  of  highest  and  best  use, 
rather  than  actual  use,  may  result  in  the  imposition  of  substantially 
liigher  estate  taxes.  In  some  cases,  the  greater  estate  tax  burden  makes 
continuation  of  farming,  or  the  closely  held  business  activities,  not 
feasible  because  the  income  potential  from  these  activities  is  insuffi- 
cient to  service  extended  tax  payments  or  loans  obtained  to  pay  the 
tax.  Thus,  the  heirs  may  be  forced  to  sell  the  land  for  development 
purposes.  Also,  wliere  the  valuation  of  land  reflects  speculation  to  such 
a  degree  that  the  price  of  the  land  does  not  bear  a  reasonable  relation- 
ship to  its  earning  capacity,  the  Congress  believed  it  unreasonable 
to  require  that  this  "speculative  value"  be  included  in  an  estate  with 
respect  to  land  devoted  to  farming  or  closely  held  businesses. 

However,  the  Congress  recognized  that  it  would  be  a  windfall 
to  the  beneficiaries  of  an  estate  to  allow  real  property  used  for  farm- 
ing or  closely  held  business  purposes  to  be  valued  for  estate  tax  pur- 
poses at  its  farm  or  business  value  unless  the  beneficiaries  continue  to 
use  the  property  for  farm  or  business  purposes,  at  least  for  a  reasonable 
period  of  time  after  the  decedent's  death.  Also,  the  Congress  believed 
that  it  would  be  inequitable  to  discount  speculative  values  if  the  heirs 
of  the  decedent  realize  these  speculative  values  by  selling  the  property 
within  a  short  time  after  the  decedent's  death. 

For  these  reasons,  the  Act  provides  for  special  use  valuation  in 
situations  involving  real  property  used  in  farming  or  in  certain  other 
trades  or  businesses,  but  has  further  provided  for  recapture  of  the 
estate  tax  benefit  where  the  land  is  prematurely  sold  or  is  converted 
to  nonqualifying  uses. 

Explanation  of  provisio7is 
Special  valuation  in  general. — The  Act  provides  that,  if  certain 
conditions  are  met,  the  executor  may  elect  to  value  real  propertj'  in- 
cluded in  the  decedent's  estate  which  is  devoted  to  farming  or  closely 
held  business  use  on  the  basis  of  that  property's  value  as  a  farm  or  in 
the  closely  held  business,  rather  than  its  fair  market  value  determined 
on  the  basis  of  its  highest  and  best  use.  However,  this  special  use 
valuation  can  not  reduce  the  decedent's  gross  estate  by  more  than 
$500,000. 


538 

QuaUf,cation  hy  estate. — To  qualify  for  this  special  use  valuation : 
(1)  the  decedent  must  have  been  a  citizen  or  resident  of  the  United 
States  at  his  death ;  (2)  the  value  of  the  farm  or  closely  held  business 
assets  in  the  decedents'  estate,  including  both  real  and  personal  prop- 
erty (but  reduced  by  debts  attributable  to  the  real  and  personal  prop- 
erty), must  be  at  least  50  percent  of  the  decedent's  gross  estate  (re- 
duced by  debts  and  expenses)  ;  (3)  at  least  25  percent  of  the  adjusted 
value  of  the  gross  estate  must  be  qualified  farm  or  closely  held  business 
real  jjroperty;  (4)  the  real  property  qualifying  for  special  use  valua- 
tion must  pass  to  a  qualified  heir;  (5)  such  real  property  must  have 
been  owned  by  the  decedent  or  a  member  of  his  family  and.  used  or  held 
for  use  as  a  farm  or  closely  held  business  for  5  of  the  last  8  years  prior 
to  the  decedent's  death;  and  (6)  there  must  have  been  material  par- 
ticipation ^  in  the  operation  of  the  farm  or  closely  held  business  by 
the  decedent  or  a  member  of  his  family  in  5  years  out  of  the  8  years 
immediately  preceding  the  decedent's  death. 

For  purposes  of  the  50-percent  and  25-percent  tests,  the  value  of 
property  is  determined  without  regard  to  its  special  use  value.  The 
term  "qualified  heir"  means  a  member  of  the  decedent's  family,  in- 
cluding his  spouse,  lineal  descendants,  parents,  and  aunts  or  uncles  of 
the  decedent  and  their  descendants. 

Qualifying  real  property. — Real  property  may  qualify  for  special 
use  valuation  if  it  is  located  in  the  IJnited  States  and  if  it  is  devoted 
to  either  (1)  use  as  a  farm  for  farming  purposes  or  (2)  use  in  a  trade 
or  business  other  than  farming.  In  the  case  of  either  of  these  qualify- 
ing uses,  the  Congress  intended  that  there  must  be  a  trade  or  business 
use.  The  mere  passive  rental  of  property  will  not  qualify.  How^ever, 
where  a  related  party  leases  the  property  and  conducts  farming  or 
other  business  activities  on  the  property,  the  real  property  may  qualify 
for  special  use  valuation.  For  example,  if  A,  the  decedent,  owned  real 
property  which  he  leased  for  use  as  a  farm  to  the  ABC  partnership  in 
which  he  and  his  sons  B  and  C  each  had  a  one-third  interest  in  profits 
and  capital,  the  real  property  could  qualify  for  special  use  valuation. 
However,  if  the  property  is  used  in  a  trade  or  business  in  which 
neither  the  decedent  nor  a  member  of  his  family  materially  partici- 
pates, the  property  would  not  qualify. 

In  general,  a  "farm"  includes  stock,  dairy,  poultry,  fruit,  furbear- 
ing  animal,  and  truck  farms,  plantations,  ranches,  nurseries,  ranges, 
greenhouses  or  other  similar  structures  used  primarily  for  the  rais- 
ing of  agricultural  or  horticultural  commodities.  Farms  also  include 
orchards  and  woodlands.  In  deciding  whether  real  propertv  is  used 
as  a  farm  for  farming  purposes,  the  activities  enffa<red  in  on  the  real 
pronerty  are  determinative.  In  addition  to  cultivation  of  the  soil  and 
raising  or  harvesting  of  aarricultural  or  horticultural  commodities  and 
preparing  such  commodities  for  market,  the  term  "farming  purposes" 
as  used  in  these  provisions  includes  the  plantin.e.  cultivating,  caring 
for  or  cuttin.of  of  trees,  and  the  preparation  (other  than  milling)  of 
trees  for  market. 


'  Whether  there  has  been  "material  participation"  by  an  individual  in  the  operation  of 
n  farm  or  closely  held  business  is  to  be  determined  in  a  manner  similar  to  the  manner  in 
which  material  participation  is  determined  for  purposes  of  the  tax  on  self-employment 
Income  with  respect  to  the  production  of  agricultural  or  horticultural  commodities  under 
present  law.  (Sec.  1402(a)  (1) ). 


539 

As  indicated  above,  real  property  which  is  used  in  a  trade  or  busi- 
ness other  than  the  trade  or  business  of  farming  may  also  qualify  for 
special  use  valuation  so  long  as  the  property  was  used  in  a  trade  or 
business  in  which  the  decedent  or  a  member  of  his  family  materially 
participated  prior  to  tlie  decedenfs  death.  This  is  true  even  though 
the  party  carrying  on  the  business  was  not  the  decedent  or  a  member  of 
his  family  so  long  as  the  decedent  or  a  member  of  his  family  materially 
l^articipated  in  the  business. 

In  the  case  of  qualifying  real  property  where  the  material  participa- 
tion requirement  is  satisfied,  the  real  property  which  qualifies  for  spe- 
cial use  valuation  includes  the  farmhouse,  or  other  residential  build- 
ings, and  related  improvements  located  on  qualifying  real  property 
if  such  buildings  are  occupied  on  a  regular  basis  by  the  owner  or  lessee 
of  the  real  property  (or  by  employees  of  the  owner  or  lessee)  for  the 
purpose  of  operating  or  maintaining  the  real  property  or  the  business 
conducted  on  the  property.^^  Qualified  real  property  also  includes 
roads,  buildings,  and  other  structures  and  improvements  functionally 
related  to  the  qualified  use.  On  the  other  hand,  elements  of  value  which 
are  not  related  to  the  farm  or  business  use  (such  as  mineral  rights)  are 
not  to  be  eligible  for  special  use  valuation.  For  example,  if  there  is  an 
oil  lease  on  a  farm,  the  full  value  of  the  lease  is  to  be  taken  into 
account  for  estate  tax  purposes.  Similarly,  if  there  are  buildings  or 
other  improvements  on  (or  contiguous  with)  the  farm  and  the  build- 
ings or  other  improvements  are  neither  functionally  related  to 
the  farm  nor  qualify  as  a  farmhouse  and  related  improvements,  these 
buildings  and  other  improvements  are  not  treated  as  qualified  farm 
real  property. 

The  Act  directs  the  Treasury  Department  to  prescriJDe  regulations 
setting  forth  the  application  of  these  special  use  valuation  rules  (and 
the  security  requirement,  discussed  below)  to  situations  involving 
otherwise  qualifying  real  property  held  in  a  partnership,  corporation, 
or  trust  which,  with  respect  to  the  decedent,  is  an  interest  in  a  closely 
held  business.  Trust  property  shall  be  deemed  to  have  passed  from  the 
decedent  to  a  qualified  heir  to  the  extent  that  the  qualified  heir  has  a 
present  interest  in  that  trust  property.  The  Congress  intended  that  a 
decedent's  estate  generally  should  be  able  to  utilize  the  benefits  of  spe- 
cial use  valuation  where  he  held  the  qualifying  real  property  in- 
directly, that  is,  through  his  interest  in  a  partnership,  corporation,  or 
trust,  but  onlv  if  the  business  in  which  such  property  is  used  constitutes 
a  closely  held  business  (as  defined  in  section  6166,  as  added  by  the  Act) 
and  the  real  property  would  qualify  for  special  use  valuation  if  it  had 
been  held  directly  by  the  decedent. 

'\  Vahtation  methods:  (a)  Farm  method. — If  a  farm  qualifies  for 
special  use  valuation  under  this  new  provision,  its  value  is  generally  to 
bip  determined  by  dividing : 

(i)  The  excess  of  the  average  annual  gross  cash  rental  for 
comparable  land  used  for  farming  purposes  and  located  in  the 
locality  of  such  farm  over  the  average  annual  State  and  local  real 
estate  taxes  for  such  comparable  land  by 


=  Rpsidential  buildings  or  related  Improvements  shall  be  treated  as  belnc  on  the  qualified 
real  property  If  thev  are  on  real  property  which  is  contiguous  with  oualified  real  nroperty 
or  would  be  contlRuous  with  such  property  except  for  the  interposition  of  a  road,  street, 
railroad,  stream,  or  similar  property. 


540 

(ii)    The  averag:e  annual  effective  interest  rate  for  all  new 
Federal  Land  Bank  loans. 
For  purposes  of  this  rule,  each  average  annual  computation  is  to 
be  made  on  the  basis  of  the  5  most  recent  calendar  years  ending  before 
the  date  of  the  decedent's  death. 

The  special  farm  valuation  method  is  provided  to  permit  the  execu- 
tor, in  many  situations,  to  achieve  a  substantial  amount  of  certainty  in 
arriving  at  use  valuatioii  for  farmland  as  well  as  to  eliminate  nonfarm 
factors  in  valuing  farmland.  Since  this  method  involves  a  mathemat- 
ical computation  in  which  the  amount  of  the  annual  rental  may  in 
many  cases  be  determinable  with  reasonable  certainty  and  the  capital- 
ization rate  is  determinable,  this  method  should  offer  three  advantages. 
First,  it  should  reduce  subjectivity,  and  thus  controversy,  in  farm  valu- 
ation. Second,  it  should  eliminate  from  valuation  any  values  attributa- 
ble to  the  potential  for  conversion  to  nonagricultural  use.  Third,  it 
should  also  eliminate  as  a  valuation  factor  any  amount  by  Avhich  land 
is  bid  up  by  speculators  in  situations  where  nonagricultural  use  is  not  a 
factor  in  inflated  farmland  values. 

However,  this  special  farm  valuation  method  is  not  applicable 
where — 

(i)   It  is  established  that  there  is  no  comparable  land  from 
which  the  average  annual  gross  cash  rental  may  be  determined,  or 
(ii)  The  executor  elects  to  have  the  value  of  the  farm  deter- 
mined bv  apnlying  the  multinle  factor  method  (described  below), 
(b)  Multiple  factor  method. — The  Act  sets  forth  the  following  list 
of  factors  that  are  to  be  taken  into  account  in  determining  special  use 
valuation  for  qualifying  real  property  not  used  in  farming  and  for 
qualifying  farm  real  property  if  the  special  farm  method  is  not  used : 

(1)  The  capitalization  of  income  that  the  property  can  be  expected 
to  yield  for  farming  or  closely  held  business  purposes  over  a  reason- 
able period  of  time  under  prudent  management  using  traditional 
cropping  patterns  for  the  area,  taking  into  account  soil  capacity,  ter- 
rain configuration  and  similar  factors, 

(2)  The  capitali7ation  of  the  fair  rental  value  of  the  land  for  farm- 
land or  closely  held  business  purposes, 

(3)  Assessed  land  values  where  the  State  provides  a  differential 
or  use  value  assessment  law  for  farmland  or  land  used  in  closely  held 
businesses. 

(4)  Comparable  sales  of  other  farm  or  closely  held  business  land  in 
the  same  geographical  area  far  enough  removed  from  a  metropolitan 
or  resort  area  so  that  nonagricultural  use  is  not  a  significant  factor 
in  the  sales  price,  and 

(5)  Any  other  factor  which  fairly  values  the  farm  or  closely  held 
business  value  of  the  property. 

Recapture. — The  Act  provides  that  if.  within  15  years  after  the 
death  of  the  decedent  (but  before  the  death  of  the  qualified  heir),  the 
property  is  disposed  of  to  nonfamily  members  or  ceases  to  be  used  for 
farming  or  other  closely  held  business  purposes,  all  or  a  portion  of  the 
Federal  estate  tax  bene^ts  obtained  by  virtue  of  the  reduced  valuation 
are  to  be  recaptured.  This  recapture  provision  is  to  apply  not  only 
where  the  qualified  real  property  is  sold  (or  exchanged  in  a  taxable 


541 

transaction )  to  nonf  amily  members,  but  also  where  the  property  is  dis- 
]50sed  of  to  nonf  amily  members  in  a  tax-free  exchange  (e.g.,  under 
section  1031)  or  where  the  property  is  disposed  of  under  an  involuntary 
conversion,  rollover,  or  similar  transaction  (which  is  nontaxable  by 
reason  of  section  1033  or  1034)  .^  The  preceding  sentence  does  not  apply 
to  an  involuntary  conversion  or  condemnation  if  the  proceeds  are 
reinvested  in  the  real  property  which  originally  qualified  for  special 
use  valuation. 

The  amount  of  the  tax  benefit  potentially  subject  to  recapture  is  the 
excess  of  the  estate  tax  liability  which  would  have  been  incurred  had 
the  special  use  valuation  provision  not  been  utilized  over  the  actual 
estate  tax  liability  based  on  the  special  use  valuation  provisions.  This 
amount  is  called  the  "adjusted  tax  difference".  Where  more  than  one 
qualified  heir  receives  qualified  real  property  with  respect  to  which 
special  use  valuation  has  been  elected  or  receives  an  interest  in  such 
property,  the  adjusted  tax  difference  is  to  be  allocated  among  the 
property  interests  in  proportion  to  their  respective  reductions  in  value. 

In  general,  if  a  recapture  event  occurs  within  10  years  of  the  de- 
cedent's death,  the  amount  of  the  additional  or  "recapture"  tax  im- 
posed with  respect  to  the  interest  shall  be  an  amount  equal  to  the  lesser 
of  the  adjusted  tax  difference  attributable  to  this  interest  or  the  excess 
of  the  amount  realized  with  respect  to  the  interest  over  the  value  of  the 
interest  determined  with  the  special  use  valuation.  In  cases  where 
there  is  a  cessation  of  qualifying  use  or  a  sale  or  exchange  at  other 
than  arm's  length,  the  amount  of  the  additional  tax  imposed  will  be 
the  lesser  of  the  adjusted  tax  difference  attributable  to  the  interest  or 
the  excess  of  the  fair  market  value  of  the  interest  over  the  special  use 
valuation.  If  the  recapture  event  occurs  more  than  10,  but  less  than  15, 
years  .tfter  the  decedent's  death  (but  prior  to  the  death  of  the  qualified 
iieir),  the  amount  subject  to  recapture  (as  described  in  the  preceding 
two  sentences)  is  phased  out  on  a  ratable  monthly  basis. 

Disposition,  or  cessation  of  qualified  use.  of  a  portion  of  an  interest 
may  result  in  a  full  or  partial  recapture.  Also,  if  there  are  two  recap- 
ture events  with  respect  to  one  i")roi)erty  interest  (which  may  occur 
where,  for  instance,  the  c{ualified  heir  changes  the  use  of  the  property 
and  later  sells  it) ,  a  recapture  tax  will  be  imposed  on  the  first  "recap- 
ture event,"  but  no  recapture  tax  will  be  imposed  upon  .he  second 
"recapture  event." 

A  qualified  heir  is  expressly  made  personally  liable  for  the  recapture 
tax  imposed  with  respect  to  his  interest  in  qualified  property. 

In  p-eneral.  if  the  qualified  heir  dies  without  havinjr  disposed  of  the 
property  or  converted  it  to  a  nonqualified  use  or  a  period  of  1.5  years 
from  the  decedent's  death  lapses,  the  potential  liability  for  recapture 
will  cease.  Thus,  if  the  decedent  leaves  qualified  property  to  two  of  his 
children  as  tenants  in  common  and  the  special  use  valuation  is  elected, 

'It  was  intpndpd.  howpvpr.  that  tho  TrPasTiry  pppnrtnipnt  will  provide  bv  regulations 
that  the  disposition  of  qualified  property  by  tax-free  transfer  to  a  corporation  pursuant 
to  section  351  or  to  a  partnership  pursuant  to  section  721  is  not  to  result  in  application 
of  the  recanture  tax:  if  (1)  the  qualified  heir  retains  the  same  equitible  interest  in  the 
property  :  (2)  if  the  cornoration  or  partnership  woulri.  with  respect  to  the  qualified  heir, 
he  considered  a  closely  held  1)iislne<-s  within  the  nieaninff  of  section  Rlfifi;  and  (31_if  the 
corporation  or  pavtnership  consents  to  personal  liab'lity  for  the  recapture  if  it  disposes 
of  the  real  property  or  ceases  to  use  the  property  for  qualified  purposes  during  the 
perld  in  whicli  recapture  may  occur. 


542 

the  death  of  one  of  the  children  would  free  his  interest  in  the 
property  from  any  further  potential  liability  for  the  recapture  tax. 
However,  if  the  decedent  leaves  qualified  real  property  to  two  or 
more  qualified  heirs  with  successive  interests  in  the  property  and  the 
special  use  valuation  is  elected,  potential  liability  for  the  recapture 
t-ax  is  not  diminished,  and  none  of  the  property  is  to  be  released  from 
potential  liability  for  the  recapture  tax.  until  the  death  of  the  last  of 
the  qualified  heirs  (or.  if  earlier,  upon  the  expiration  of  15  years  from 
the  date  of  the  death  of  the  decedent) . 

Since  a  sale,  exchanire.  or  other  disposition  (such  as  a  gift)  by  one 
qualified  heir  to  another  qualified  heir  is  not  treated  as  a  recapture 
event,  the  Act  provides  that  the  second  nualified  heir  is  to  be  treated  as 
if  he  had  received  the  property  from  the  decedent.  Thus,  the  second 
qualified  heir  steps  into  the  shoes  of  the  first  heir  and  becomes  liable 
for  the  recapture  tax.  and  the  special  estate  tax  lien  for  this  potential 
recapture  tax  remains  on  the  property,  even  though  the  second  quali- 
fied heir  may  have  paid  the  first  qualified  heir  full  fair  market  value 
for  the  qualified  property. 

^"liile  the  recapture  tax  is  generally  treated  as  a  separate  estate  tax, 
it  is  treated  as  a  tax  on  the  estate  of  the  decedent  for  purposes  of  the 
previously  taxed  property  credit.  If  the  qualified  heir  dies  within  10 
years  of  the  time  of  the  death  of  the  decedent  but  after  a  recapture 
event  has  occurred,  this  recapture  tax  would  be  utilized  in  computing 
the  previously  taxed  property  credit.  However,  it  would  be  treated  as 
ha%'ing  been  imposed  as  of  the  date  of  the  decedent's  death,  rather  than 
at  the  time  the  actual  recapture  event  occurred. 

The  "cessation  of  Qualified  use"  which  constitutes  a  disposition  oc- 
curs if  (1)  the  qualified  property  ceases  to  be  used  for  the  qualified 
use  under  which  the  property  qualified  for  special  use  valuation  or  (2) 
during  any  period  of  8  years  endins:  after  the  date  of  the  decedent's 
death  and  before  the  date  of  the  death  of  the  qualified  heir,  there  have 
been  periods  aggregating  3  years  or  more  during  which  there  was  no 
material  participation  by  the  qualified  heir  or  a  member  of  his  familj- 
in  the  operation  of  the  farm  or  other  business. 

Specwl  lieu  on  qanTi-fied  real  proprrfy. — The  Act  provides  a  special 
lien  on  all  qualified  farm  or  closely  held  business  real  property  with 
respect  to  which  an  election  to  use  the  special  use  valuation  provision 
has  been  made.  This  lien  is  to  continue  until  the  tax  benefit  is  recap- 
tured or  until  the  potential  liability  for  recapture  ceases  (i.e.,  the 
nualified  heir  dies  or  a  period  of  I.t  yeai-s  from  the  decedent's  death 
lanses).  T'nder  this  provision,  the  Treasury  Denartment  is  authorized 
to  set  forth  remdations  under  which  other  security  could  be  substituted 
for  *^he  real  property. 

Election  an/1  acrreem^nt. — Under  the  Act.  the  election  to  use  this 
special  use  valuation  mav  be  made  not  later  than  the  time  for  filing  the 
estate  tax  return,  including  extensions. 

One  of  the  requirements  for  making  a  valid  election  is  the  filing  with 
the  estate  tax  return  a  written  agreement  signed  by  each  person  in 
h^mcr  who  has  an  interest  (whether  or  not  in  possession)  in  any  quali- 
fied real  propertv  with  respect  to  which  the  use  valuation  is  elected. 
This  agreement  must  evidence  the  consent  of  each  of  these  parties  to 
the  application  of  the  recapture  tax  provisions  to  the  property.  As 


543 

noted  above,  such  a  consent  also  amounts  to  a  consent  to  be  personally 
liable  for  any  recapture  tax  imposed  with  respect  to  the  qualified  heir's 
interest  in  the  qualified  property.  The  Congress  believed  that  each 
person  receiving  an  interest  subject  to  potential  recapture  should  agree 
to  this  potential  liability,  especially  since  that  person  may  not  have 
received  the  tax  benefits  from  the  special  use  valuation  (because,  for 
example,  the  estate  tax  burden  is  borne  by  a  residuary  legatee  who  did 
not  receive  farm  property). 

Sfafufc.  of  Ihnifafwns.—TYie  Act  provides  for  an  extension  of  the 
statutory  period  for  assessment  and  collection  of  the  recapture  tax 
until  3  years  after  the  Internal  Revenue  Service  is  notified  that  an 
event  has  occurred  which  results  in  the  imposition  of  this  tax.* 

Effective  date 
These  provisions  are  to  apply  to  the  estates  of  decedents  dying 
after  December  31,  1976. 

4.  Extension  of  Time  for  Payment  of  Estate  Tax  (sec.  2004  of  the 
Act  and  sees.  303,  6161,  6163,  6166,  6503,  6601,  and  6324A  of 
the  Code) 

Prior  law 

Generally,  an  estate  tax  return  is  due  nine  months  after  the  dece- 
dent's death.  Except  in  certain  specified  situations,  payment  of  the 
estate  tax  is  required  to  be  made  with  the  return. 

However,  prior  law  contained  two  provisions  which  permit  the 
estate  tax  to  be  paid  over  a  period  of  up  to  ten  years  after  the  due 
date  of  the  return.  First,  the  Internal  Revenue  Service  may  extend 
the  time  for  payment  of  tax  up  to  ten  years  if  it  found  that  a  current 
payment  of  the  tax  would  result  in  "undue  hardship"  to  the  estate  (sec. 
6161(a)  (2)).  Second,  an  executor  may  elect  to  pay  the  estate  tax  in 
installments  over  two  to  ten  years  where  the  estate  consists  largely  of 
interests  in  a  closely  held  business  or  businesses  (sec.  6166).^ 

Discretionary  extensions. — In  order  to  qualify  under  the  fii*st  provi- 
sion, the  executor  must  have  been  able  to  show  that  the  payment  of  the 
estate  tax  on  tlie  due  date  would  cause  undue  hardship.  The  term  "un- 
due hardship"  required  more  than  a  showing  of  reasonable  cause  or 
inconvenience  to  the  estate.  In  general,  undue  hai-dship  could  be  es- 
tablished in  a  case  where  the  assets  in  the  gross  estate  which  must  be 

*ThP  Act  provirlfK  that  the  lien  Imposed  by  new  section  6r!'24B  must  bo  filed  to 
have  priority  ag:ainst  any  purchaser,  holder  of  a  security  interest,  mechanic's  lienor,  or 
a  creditor.  It  also  provides  (hat  the  same  jreneral  priority  and  super  priorities  rules  apply 
ns  annly  with  respect  to  the  lien  under  section  fi324A.  If  the  lien  provided  for  by  section 
6,^24B  applies,  the  property  is  not  to  be  subject  to  the  general  estate  tax  Hen  provided 
under  section   6.^24. 

1  There  are  also  other  provisions  under  which  an  executor  may  obtain  a  lesser  extension 
of  time  for  the  payment  of  estate  tax.  Under  section  6161(a)(1),  the  Service  may  extend 
the  time  for  payment  of  all  or  a  nortion  of  the  estate  tnx  for  up  to  one  year,  if  there  is 
reasonable  cause  for  sucli  extension.  "Reasonable  cause"  is  a  much  easier  tost  to  meet 
than  "undue  hardship"  ;  it  could  be  satisfied  by  showing  that  the  executor  needs  time  to 
collect  receivables  or  to  convert  assets  into  cash. 

Under  section  6101  (b).  nn  executor  could  obtain  an  extension  of  up  to  four  years  to  pay 
a  deficiency  if  he  could  show  that  the  payment  on  the  date  the  payment  was  due  would 
cause  undue  hardsliin  to  the  estnte. 

If  the  value  of  a  reversionary  or  remainder  interest  in  property  is  Included  in  the  gross 
estate,  the  executor  may  elect  to  have  the  nayment  of  the  nortion  of  the  tax  attributable 
to  the  interest  deferred  until  six  months  after  the  termination  of  the  preceding  interest  or 
interests  in  the  property  (sec.  616.S(a)).  If  the  executor  could  show  thnt  payment  at  the 
end  of  this  period  would  result  in  undue  hardship  to  the  estate,  an  additional  extension 
or  extensions  of  up  to  three  years  could  be  obtained  (see.  6163(b) ). 


544 

liquidated  to  pay  the  estate  tax  can  only  be  sold  at  a  sacrifice  price. 
Also,  undue  hardship  could  be  estaiblished  where  a  farm  or  closely  held 
business  could  be  sold  to  unrelated  persons  at  a  price  equal  to  its  fair 
market  value,  but  the  executor  seeks  an  extension  of  time  to  raise  other 
funds  for  the  payment  of  the  estate  tax. 

Automatic  extensions  for  closely  held  businesses. — Under  the  second 
provision,  an  executor  may  elect  to  pay  the  estate  tax  attributable  to 
an  interest  in  a  farm  or  other  closely  held  business  in  installments  over 
a  period  not  to  exceed  10  years.  In  order  to  qualify  under  this  pix>vision, 
the  value  of  the  interest  in  the  closely  held  business  must  exceed  35 
percent  of  the  value  of  the  gix)ss  estate  or  50  percent  of  the  taxable  es- 
tate of  the  decedent.  For  this  purpose,  the  term  "interest  in  a  closely 
held  business""  means  an  interest  as  sole  proprietor  in  a  trade  or  busi- 
ness; an  interest  as  a  partner  in  a  paptnei"ship  having  not  more  than  10 
partners,  or  in  which  the  decedent  owned  20  percent  or  more  of  the 
capital ;  or  ownei-ship  of  stock  in  a  corporation  having  not  more  than  10 
shareholders,  or  in  which  the  decedent  owned  20  percent  or  more  of  the 
voting  stock. 

If  a  decedent's  gross  estate  includes  more  than  50  percent  of  the 
value  of  each  of  two  or  more  closely  held  businesses,  the  businesses 
can  be  treated  as  a  single  closely  held  business  in  determining  whether 
either  the  35  percent  or  50  percent  test  is  satisfied. 

Under  prior  law  (sec.  6166(h)),  an  acceleration  of  payment  of  the 
unpaid  installments  occurred  on  the  happening  o*^  any  of  the  follow- 
ing events: 

(1)  The  estate  has  undistributed  net  income  in  any  taxable  year 
after  its  fourth  taxable  year ; 

(2)  There  is  failure  to  pay  an  installment ; 

(3)  There  is  a  withdrawal  of  funds  from  the  business  that 
equals  or  exceeds  50  percent  of  the  value  of  the  trade  or  business 
(and  such  withdrawal  is  attributable  to  the  decedent's  interest)  ; 
or 

(4)  There  is  a  disposition  of  50  percent  or  more  of  the  value 
of  the  decedent's  interest  in  the  business.^ 

Under  either  of  these  provisions,  the  Internal  Revenue  Service  may, 
if  it  deems  it  nex^'essary,  require  the  executor  to  furnish  a  bond  for  the 
payment  of  the  tax  in  an  amount  not  more  than  double  the  amount 
of  the  tax  for  which  an  extension  is  granted.  In  addition,  the  executor 
is  personallv  liable  for  the  payment  of  the  tax  unless  he  is  discharged 
upon  payment  of  the  tax  due  and  upon  furnishing  any  bond  or  security 
which  may  be  reouired  for  the  tax  which  is  not  presently  due  because 
of  an  extension  of  time  for  payment. 

2  RedPmptions  of  stock  under  section  303  (relating  to  certain  redemptions  for  the  pay- 
ment of  estate  taxes)  do  not  count  as  withdrawals  for  this  ruirpose.  If  there  were  such 
a  redemption,  the  value  of  the  trade  or  business  in  coniputlnc  the  extent  of  the  with- 
drawal would  be  the  value  reduced  by  the  proportionate  share  of  the  redemption.  The 
exception  Is  inapplicable  unless  on  or  before  the  date  of  the  first  Installment  of  the 
estate  tax  which  becomes  due  after  redemption,  there  la  paid  on  account  of  the  estate 
tax  an  amount  not  less  than  the' value  of  the  property  and  money  distributed  (sec. 
eififirh) (1)(B)). 

When  the  executor  has  knowledge  of  any  transaction  that  results  in  a  withdrawal  of 
funds  from  the  business,  or  a  disposition  of  a  qualifylnc  closely  held  business,  sufficient 
to  cause  acceleration  of  payment,  he  must  notify  the  District  Director  in  writing  within 
thirt.v  days. 


545 

Redemptions  to  pay  death  taxes. — Under  the  income  tax  law  (sec. 
303),  a  qiialitied  redemption  of  stock  to  pay  estate  taxes  will  be  taxed 
as  capital  gain  rather  than  as  a  dividend  distribution  taxed  as  ordinary 
income,  even  though  a  similar  redemption  would  have  been  treated  as 
a  dividend  if  the  stock  had  been  redeemed  from  the  decedent  during 
his  lifetime.  To  qualify  for  this  treatment  under  prior  law,  the  value 
of  the  stock  redeemed,  plus  the  value  of  the  other  stock  of  the  redeem- 
ing corporation  includible  in  the  estate,  must  have  been  more  than 
either  35  percent  of  the  gross  astate  or  50  percent  of  the  taxable  estate. 
The  value  of  the  stock  redeemed  could  be  no  greater  than  the  sum  of 
all  death  taxes  (and  interest)  plus  funeral  and  administration  ex- 
penses allowable  as  an  estate  tax  deduction.  The  time  generally  al- 
lowed for  the  redemption  was  three  years  and  ninety  days  after  the 
estate  tax  return  was  filed.^ 

Interest  on  amounts  not  paid  on  due  date  of  retmyi. — In  general, 
interest  is  payable  by  a  taxpayer  to  the  government  if  the  tax  is  not 
paid  on  the  due  date  of  the  return  (disregarding  extensions).  Prior  to 
July  1,  1975,  the  interest  rate  on  extended  (or  late)  tax  payments 
was*  generally  G  percent  per  year.  HoAvever,  there  were  a  number  of 
special  situations  Avhere  a  4  percent  annual  rate  was  specified.  These 
included:  (1)  where  the  estate  tax  attributable  to  a  closely  held  busi- 
ness included  in  a  decedent's  estate  could  be  paid  in  up  to  10  annual 
installments;  (2)  where  an  executor  elected  deferred  payment  of  the 
estate  tax  imposed  with  respect  to  the  value  of  a  reversionary  or  re- 
mainder interest  included  in  the  gross  estate;  p.nd  (3)  where  the  In- 
ternal Revenue  Service,  after  determining  that  the  payment  of  any 
part  of  the  estate  tax  on  any  due  date  would  impose  undue  hardship 
upon  the  estate,  granted  an  extension  of  time  for  payment. 

In  1975,  Congress  changed  the  law  relating  to  interest  on  tax  pay- 
ments owed  to  the  government  (or  on  overpayments  owed  taxpayers 
by  the  government).  In  general,  the  changes  increased  the  6  percent 
rate  to  9  percent  and  provided  that  the  interest  rate  was  to  be  ad- 
justed periodicallv  by  the  Treasury  Department  to  keep  it  approxi- 
mately equal  to  90  percent  of  the  prime  rate  quoted  by  commercial 
banks  to  large  businesses  (as  regularly  published  by  the  Board  of 
Governors  of  the  Federal. Reserve  System).  Effective  on  February  1, 
1976,  the  interest  rate  was  decreased  from  9  percent  to  7  percent.* 

The  amendments  made  in  1975  also  eliminated  the  special  4  percent 
rate.  At  that  time,  it  was  noted  that 

"although  an  extension  of  time  to  pay  a  tax  may  be  appropri- 
ate in  certain  cases  in  order  to  avoid  unnecessary  hardships, 
the  committee  sees  no  sound  reason  to  permit  some  taxpayers 
to  pav  interest  at  a  lower  rate  than  other  taxpayers  are  re- 
quired to  pav  on  underpavments  of  tax.  Relief  from  the  hard- 
shi]:)  of  paying  taxes  in  a  lump  sum  should  not  also  mean  that 
the  interest  rate  should  be  reduced  if  payments  are  made  in 
installments.  This  is  particularly  so  if  a  closely  held  business 
owned  by  an  estate  ...  is  or  can  be  earning  a  significantly 
higher  return  on  the  tax  money  which  it  presently  can,  in 


^  Under  eprtain  circumstances,  stock  could  be  redeemed  for  a  period  whicli  does  not  end 
prior  to  90  davs  after  a  decision  of  the  Tax  Court  becomes  final. 
*  See  Technical  Information  Release  No.  1407,  October  14,  1975. 


546 

effect,  borrow  from  the  Government  at  4  percent."  (S.  Rep. 
No.  93-1857,  93rd  Cong.,  2d  Sess.,  19-20). 

Reasons  for  change 

These  provisions  have  proved  inadec[uate  to  deal  with  the  liquidity 
problems  experienced  by  estates  in  which  a  substantial  portion  of  tlie 
assets  consist  of  a  closely  held  business  or  other  illiquid  assets.  In  many 
cases,  the  executor  was  forced  to  sell  a  decedent's  interest  in  a  fami 
or  other  closely  held  business  in  order  to  pay  the  estate  tax.  This  may 
have  occurred  even  when  the  estate  qualified  for  the  10-year  extension 
provided  for  closely  held  businesses.  In  these  cases,  it  may  have  taken 
several  years  before  a  business  could  regain  sufficient  jfinancial  strength 
to  generate  enough  cash  to  pay  estate  taxes  after  the  loss  of  one  of  its 
principal  owners.  Moreover,  some  businesses  were  not  so  profitable 
that  they  yielded  enough  to  pay  both  the  estate  tax  and  interest  espe- 
cially if  the  interest  rate  was  high. 

On  the  other  hand,  where  a  substantial  portion  of  an  estate  consisted 
of  illiquid  assets  other  than  a  farm  or  closely  held  business,  it  had  been 
extremely  difficult  to  obtain  an  extension  on  the  grounds  of  "undue 
hardship"  because  the  Internal  Revenue  Service  generally  took  a  re- 
strictive approach  toward  granting  such  extensions.  The  Congress 
believed  that  additional  relief  was  needed  by  estates  with  liquidity 
problems. 

In  addition,  many  executors  found  it  both  difficult  and  expensive 
to  obtain  a  bond  to  satisfy  the  extended  payment  requirements.  There- 
fore, many  executoi-s  refused  to  elect  the  extended  payment  provisions 
because  they  remained  personally  liable  for  tax  for  the  entire  length 
of  the  extension. 

The  Con<rress  also  believed  that  it  was  appropriate  to  revise  the  pro- 
visions allowing  capital  gains  treatment  of  a  redemption  of  stock  in  a 
closely  held  business  to  provide  for  the  payment  of  estate  taxes  and 
other  deathtime  debts.  In  general,  it  appeared  desirable  to  lengthen 
the  period  for  redemption  of  stock  in  cases  where  an  automatic  election 
to  pay  the  estate  tax  in  installments  has  been  made,  while  restricting 
the  benefit  of  the  redemption  provisions  to  persons  whose  interest  in 
the  estate  is  chargeable  with  the  debts  and  taxes  of  the  de^^edent's 
estate,  and  restricting  the  availability  to  situations  in  which  a  large 
portion  of  the  estate  consists  of  an  interest  in  a  closely  held  business 
or  businesses. 

Explanation  of  provisions 

In  general. — The  Act  makes  four  changes  in  prior  law. 

First,  the  Act  substitutes  a  "reasonable  cause"  standard  for  the 
"undue  hardship"  standard  under  prior  law  in  the  case  of  the  ten- 
year  discretionary  extension  of  time  for  payment  of  estate  tax  (sec. 
6161(a)  (2) ).  For  this  purpose,  the  term  "reasonable  cause"  is  to  have 
the  same  meaning  as  the  term  is  used  for  granting  discretionary  exten- 
sions of  up  to  twelve  months  (regs.  §  20.6161-1  (a) ) . 

Second,  the  Act  retains  the  present  ten-year  extension  for  payment 
of  estate  tax  (renumbered  as  sec.  6166A)  where  the  value  of  a  closely 
held  business  exceeds  35  percent  of  the  value  of  the  gross  estate  or  50 
percent  of  the  taxable  estate  of  the  decedent. 


547 

Third,  the  Act  adopts  a  new  15-year  extension  as  an  alternative 
for  extending  the  payment  of  estate  tax  attributable  to  a  closely  held 
business  where  the  business  constitutes  more  than  65  percent  of  the 
decedent's  adjusted  gross  estate. 

Fourth,  the  Act  provides  a  special  lien  procedure  for  payment  of  the 
estate  tax  deferred  under  either  of  the  two  extensions  for  closely  held 
businesses.  The  executor  will  be  discharged  from  personal  liability 
where  this  special  lien  procedure  is  followed.  Moreover,  substantial 
revisions  are  made  in  the  provisions  relating  to  redemptions  of  cor- 
porate stock  to  pay  estate  taxes  and  funeral  and  administration 
expenses. 

Automatic  extensions  in  cases,  involving  closely  held  hitsinesses. — 
The  Act  provides  a  15-year  period  for  the  payment  of  the  estate  tax 
attributable  to  the  decedent's  interest  in  a  farm  or  other  closely  held 
business.  Under  the  Act,  the  executor  may  elect  to  defer  the  estate 
tax  (but  not  interest  on  the  tax)  for  a  period  of  up  to  5  years  and 
thereafter  pay  the  tax  in  equal  annual  installments  over  the  next  10 
years. 

To  qualify  for  this  deferral  and  installment  payment  treatment,  the 
value  of  the  closely  held  business  (or  businesses)  in  the  decedent's 
estate  must  exceed  65  percent  of  the  value  of  the  gross  estate 
reduced  by  expenses,  indebtedness,  and  losses.^ 

Under  this  provision,  the  executor  can  elect  to  defer  principal  pay- 
ments for  up  to  5  years  from  the  due  date  of  the  estate  tax  return. 
However,  interest  for  the  first  5  years  is  payable  annually.^  There- 
after, pursuant  to  the  executor's  initial  election,  the  principal  amount 
of  the  estate  tax  liability  may  be  paid  in  from  2  to  10  installments. 
The  Act  provides  that  a  special  4-percent  interest  rate  is  allowed 
on  the  estate  tax  attributable  to  the  first  $1  million  of  farm  or  other 
closely  held  business  property,  and  interest  on  amounts  of  estate  tax 
in  excess  of  this  amount  will  bear  interest  at  the  regular  rate  for 
interest  on  deferred  payments  (currently  7%).^ 

Allowing  the  reduced  interest  rate  at  a  4-percent  level  for  a  limited 
amount  of  tax  was  intended  to  reflect  the  problems  that  smaller  busi- 
nesses have  in  generating  enough  income  and  cash  flow  to  pay  interest 
at  a  normal  rate  and  amortize  the  principal  amount  of  the  estate  tax 
liability.  It  was  felt  that  the  5-year  deferral  period  plus  the  reduced 
interest  rate  on  the  tax  attributable  to  the  first  $1  million  in  value  of 
a  closely  held  business  should,  in  most  cases,  give  the  business  time  to 
generate  sufficient  funds  to  pay  the  estate  tax  and  interest  thereon 
without  the  business  having  to  be  sold  to  satisfy  the  estate  tax  liability 


5  The  expenees,  Indebtedness,  and  losses  which  reduce  the  gross  estate  for  purposes  of 
the  65%  test  shall  be  determined  on  the  basis  of  the  facts  and  circumstances  In  existence 
on  the  date  (Including  extensions)  for  filing  the  estate  tax  return  (or,  If  earlier,  the  date 
on  which  the  return  is  filed). 

•Where  a  deficiency  with  respect  to  amounts  subject  to  a  section  6166  extension  Is 
assessed  during  the  Initial  five-.vear  period,  interest  that  has  already  accrued  on  the 
deficiency  Is  due  upon  notice  and  demand. 

'For  purposes  of  determining  the  amount  of  tax  which  qualifies  for  this  4%  Interest 
rate,  the  statutory  provision  has  the  effect  of  assuming  that  the  closely  held  business 
Is  the  Item  In  the  decedent's  estate  which  Is  taxed  at  the  lowest  rates.  The  reasons  for 
adopting  this  proposal  were  that  It  provides  simplicity  In  computation  and  gives  the  same 
benefit  to  relatively  small  estates  with  a  $1  million  business  as  it  does  to  larger  estates 
with  a  slmilnr  biisines*.  This  is  a  somewh.nt  different  approach  from  that  contained  in  tlie 
determination  of  what  tax  Is  attributable  to  the  business  and  what  tax  is  attributable 
to  other  assets  in  the  estate  for  purposes  of  computing  the  amount  of  tax  which  is  eligible 
for  deferral  under  section  6166(a)(2),  which  provides  for  a  pro  rata  allocation. 


548 

(includinjs^  a  period  for  adjustment  after  the  loss  of  one  of  the  prin- 
cipal owners). 

The  Act  generally  retains  the  definition  of  existing  law  relating  to 
an  interest  in  a  closely  held  business.  However,  it  expands  the  defini- 
tion to  include  situations  where  the  decedent  had  a  20  percent  capital 
interest  in  the  partnership  or  the  partnership  had  15  or  fewer  partners 
(rather  than  10  or  fewer,  as  required  by  prior  law),  and  situations 
in  which  the  decedent  had  at  least  a  20  percent  of  the  voting  stock  of 
the  business  or  the  corporation  had  15  or  fewer  shareholders  (rather 
than  10,  as  required  by  prior  law).  The  Act  also  adds  certain  rules 
which  treat  community  property  and  property  which  is  held  by  a  hus- 
band and  wife  as  joint  tenants,  tenants  by  the  entirety,  or  tenants  in 
common,  as  though  the  property  were  owned  by  one  shareholder  or  one 
partner,  as  the  case  may  be,  for  purposes  of  satisfying  the  numerical 
test  for  shareholdei"s  or  partners.  Also,  in  order  to  prevent  avoidance 
of  the  shareholder  or  partner  limitations  by  the  use  of  partnerships, 
trusts,  or  tiei-s  of  corporations,  the  Act  provides  that  property  (includ- 
ing stock  or  a  partnei-ship  interest)  owned  directly  or  indirectly  by  or 
for  a  corporation,  partnership,  estate,  or  trust  are  to  be  considered  as 
being  owned  proportionately  by  or  for  its  shareholders,  partners,  or 
beneficiaries.  However,  beneficiaries  are  counted  for  apportionment 
only  if  they  have  j^resent  interests  in  the  trust. 

In  the  case  of  a  closely  held  business  which  is  engaged  in  farming, 
the  Act  provides  that  the  interest  in  the  business  includes  an  interest 
in  residential  buildings  and  related  improvements  on  the  farm  if  they 
are  occupied  on  a  regular  basis  by  the  owner  or  lessee  of  the  farm  or 
by  persons  employed  by  the  owner  or  lessee  for  purposes  of  operating 
or  maintaining  the  farm.  Also,  the  Act  provides  that  the  value  in- 
cluded in  these  computations  is  to  be  the  value  determined  for  pur- 
poses of  the  estate  tax.  Thus,  in  the  case  of  a  farm  where  the  executor 
has  elected  special  use  valuation  (under  section  2032A),  the  special 
use  valuation  is  to  be  treated  as  the  "value"  for  purposes  of  this  ex- 
tended payment  provision  (sec.  6166)  .* 

The  Act  also  liberalizes  the  rules  relating  to  when  2  or  more  busi- 
nesses may  be  aggregated  for  purposes  of  determining  (1)  whether 
the  estate  qualifies  under  the  65  percent  test  and  (2)  the  amount  of 
tax  to  be  deferred.  Prior  law  required  that  moi-e  than  50  percent  of 
the  total  value  of  each  business  must  be  included  in  the  decedent's 
estate  before  the  businesses  are  aggregated  for  purposes  of  this  ex- 
tended payment  provision  (sec.  6166) .  The  Act  reduces  this  50  percent 
requirement  to  a  requirement  that  more  than  20  percent  of  the  total 
value  of  each  such  business  is  included  in  the  decedent's  estate.  This 
liberalization  is  intended  to  recognize  that  even  minority  interests  in 
multiple  businesses  can  cause  the  decedent's  estate  to  be  illiquid.® 

The  Act  essentially  retains  provisions  of  orior  law  wh-ch  provide 
for  acceleration  of  the  deferred  tax  when  all  or  a  significant  portion 
of  the  closely  held  business  is  disposed  of  or  liquidated  or  upon 

»  A  farmhouse  or  related  Improvements  shall  be  treated  as  being  on  the  farm  if  It  Is 
contlcrnons  with  land  used  In  farmlnp  or  would  be  contipuons  with  such  property  except 
for  the  Interposition  of  a  road,  street,  railroad,  stream,  or  similar  property. 

*  The  Act  allows  the  spouse's  communit.v  property  Interest  (or  intere<!t  as  a  .joint 
tenant,  tenant  by  the  entirety,  or  tenant  in  common)  to  be  apsrregn ted  with  the  de- 
cedent's interest  In  determining  whether  this  20  or  50  percent  aggregation  limit  is  met. 


549 

failure  to  pay  an  installment  when  due.  However,  liquidation  or  dis- 
position of  one-third  (rather  than  one-half  as  under  prior  law)  of 
the  business  is  to  be  sufficient  to  cause  acceleration." 

The  Act  also  allows  the  executor  to  pay  any  estate  tax  deficiencies 
in  installments  if  the  estate  qualifies  for  the  election,  but  the  executor 
has  not  made  the  election.  In  general,  this  is  to  apply  both  to  situa- 
tions where  on  the  basis  of  the  estate  tax  return,  as  filed,  the  estate  was 
eligible  to  make  the  election  but  did  not  do  so  (for  instance,  because 
there  was  enough  cash  in  the  estate  to  pay  the  tax  liability  shown  on  the 
return) ,  and  to  situations  where  the  adjustments  on  the  return  on  audit 
increase  the  valuation  of  the  closely  held  business  or  businesses  to  the 
point  where  the  estate  is  now  eligible  for  the  automatic  election.  If 
an  executor  elects  to  pay  a  deficiency  in  installments  under  this  pro- 
vision, but  has  not  so  elected  with  respect  to  any  portion  of  the  estate 
tax  liability  shown  on  the  return,  interest  is  to  be  paid  in  the  manner 
prescribed  by  the  Secretary,  consistent  with  the  provisions  of  section 
6166(f). 

The  Act  retains  the  present  ten-year  extension  for  payment  of  es- 
tate tax  (renumbered  as  sec.  6166A)  where  the  value  of  a  closely  held 
business  exceeds  35  percent  of  the  value  of  the  gross  estate  or  50  per- 
cent of  the  taxable  estate  of  the  decedent. 

Lien  in  lieu  of  executor's  personal  liability  or  bond. — The  Act  also 
provides  a  special  lien  for  payment  of  the  deferred  taxes  attributable 
to  the  closely  held  business  in  situations  where  the  executor  has  made 
an  election  under  the  extended  payment  provision  rules  (section  6166 
or  6166A).  This  new  lien  provision  (section  6324A)  is  elective,  and  an 
executor  and  all  parties  who  have  an  interest  in  the  property  which  is 
to  be  subject  to  the  lien  must  file  an  agreement  consenting  to  the  cre- 
ation of  the  lien  and  designating  a  responsible  person  to  be  the  agent 
for  the  beneficiaries  of  the  estate  and  the  persons  who  consented  to  the 
creation  of  the  lien  for  purposes  of  dealings  with  the  Internal  Revenue 
Service. 

Tliis  lien  is  to  apply  to  real  property  and  other  assets  which  can  be 
expected  to  survive  the  period  for  payment  of  tax  under  this  provision. 
Where  this  lien  procedure  is  followed  and  a  party  is  designated  to 
make  estate  tax  payments  and  receive  and  trnnsmit  notices  from  the 
Internal  Revenue  Service,  the  executor  is  to  be  discharged  from  per- 
sonal liability.  I^'^nder  this  provision,  the  Internal  Revenue  Service  will 
have  no  authority  to  require  a  bond  except  to  the  extent  that  there  is 
not  adequate  security  for  the  unpaid  principal  amount  of  tax  liability 
plus  interest.  The  value  of  property  which  the  Internal  Revenue  Serv- 
ice may  require  under  this  provision  may  not  exceed  the  sum  of  the 
deferred  principal  amount  of  the  taxes  plus  the  aggregate  amount  of 
interest  to  be  payable  over  the  payout  period.  In  valuing  property  to 
be  subject  to  the  lien,  the  value  is  to  be  determined  as  of  the  due  date 
for  the  estate  tax  return  and  is  to  be  reduced  by  taking  into  account 
other  prior  encumbrances,  such  as  mortgages  find  liens  under  the  pro- 
vision (sec.  6324B)  relating  to  farm  valuation  recapture. 


'Trior  law  (section  6166)  also  requires  acceleration  to  the  extent  that  the  estate  has 
undistributed  net  Income  for  any  taxable  year  after  Its  fourth  taxable  year.  Since,  under 
section  6166  as  amended  by  the  Act,  the  first  payment  may  not  be  due  until  .5  years  after 
the  estate  tax  return  Is  filed,  this  requirement  is  amended  to  require  acceleration  only  where 
the  estate  has  undistributed  net  Income  for  any  taxable  year  ending  on  or  after  the  due 
date  for  the  first  installment. 


234-120  O  -  77  -  36 


550 

If  the  property  covered  by  the  agreement  or  proposed  to  be  covered 
by  the  agreement  is  insufficient,  the  Service  may  accept  a  bond  for  the 
difference.  Also,  additional  lien  property  can  be  required  by  the  Serv- 
ice if  the  value  is  initially  less  or  declines  below  the  sum  of  the  unpaid 
deferred  amount  of  taxes  and  the  aggregate  interest  amount.  If  addi- 
tional property  is  not  furnished  as  security  or  other  security  is  not  fur- 
nished within  90  days  after  notice  and  demand  by  the  Internal 
Revenue  Service,  such  failure  is  an  event  which  is  to  accelerate 
payment. 

This  special  lien  is  in  lieu  of  the  regular  estate  tax  lien  (under 
sec.  6324)  as  to  the  property  subject  to  the  special  lien.  The  Act  re- 
quires that  this  new  lien  must  be  filed  to  be  valid  as  against  any  pur- 
chaser, holder  of  the  security  interest,  mechanic's  lienor,  or  judgment 
lien  creditor.  However,  once  filed,  it  need  not  be  refiled  every  6  years 
as  is  required  of  tax  liens  generally.  This  new  lien  arises  when  the 
executor  is  discharged  from  liability  or,  if  earlier,  when  the  notice 
of  lien  is  filed.  It  continues  until  liability  for  the  deferred  amount  of 
taxes  is  satisfied  or  becomes  unenforceable  by  reason  of  lapse  of  time.^^ 

The  lien  is  inferior  to  certain  so-called  "superpriorities."  These 
superpriorities  are  essentially  the  same  as  those  under  the  provisions 
of  present  law  relating  to  most  other  tax  liens  (see  sec.  6323  (b) ) .  Thus, 
even  though  a  notice  of  lien  has  been  filed,  the  lien  is  not  valid 
against  real  property  tax  and  special  assessment  liens  (even  those 
which  come  into  existence  after  the  date  upon  Avhich  the  notice  of  lien 
is  filed).  Also,  this  lien  is  inferior  to  a  mechanic's  lien  for  repairs  and 
improvements,  or  a  real  property  construction  or  improvement  financ- 
ing agreement,  if,  in  the  latter  case,  the  security  interest  came  into 
existence  before  or  after  notice  of  the  tax  lien  was  filed.  If  the  Internal 
Revenue  Service  files  a  notice  that  payment  of  the  deferred  amount 
has  been  accelerated,  tax  liens  shall  take  priority  over  subsequent  me- 
chanic's liens  or  real  property  construction  or  improvement  financing 
agreements,  but  not  real  property  tax  or  special  assessment  liens. 

Reasonahle  cause  standard  for  discretionary  extensions. — The  Act 
allows  discretionary  extensions  of  up  to  10  years  to  pay  the  estate 
tax  for  reasonable  cause,  rather  than  for  "imdue  hardship",  as  under 
prior  law.  Similarly,  a  discretionary  extension  of  time  to  pay  the 
estate  tax  attributable  to  a  remainder  or  reversionary  interest  in- 
cludible in  the  estate  may  be  obtained  upon  a  showing  of  reasonable 
cause  (sec.  6163(b) ).  Also,  the  standard  for  extensions  of  time  to  pay 
deficiencies  of  estate  taxes  is  changed  to  require  only  reasonable  cause. 

In  these  situations  involving  discretionary  extensions  of  time  to  pay 
the  tax,  or  to  pay  deficiencies,  the  normal  rules  relating  to  interest 
(which  currently  requires  7  percent  interest)  are  to  apply. 

Distributions  and  redemption  of  stock  to  pay  death  taxes. — Under 
prior  law,  to  qualify  for  capital  gains  treatment  (under  section  303), 
the  redemption  must  be  accomplished  by  a  corporation  (or,  in  certain 
cases,  corporations)  whose  stock  comprises  more  than  35  percent  of 
the  value  of  the  decedent's  gross  estate,  or  more  than  50  percent  of 
the  taxable  estate,  and  the  amount  of  the  redemption  so  treated  was 

1*  A  Hen  can  become  unenforceable  by  reason  of  lapse  of  time  when,  for  Instance,  there 
is  an  accelerating  event,  the  Internal  Kevenue  Service  Is  notified,  and  it  fails  to  assess  a 
deficiency  within  3  years  of  sach  notification. 


551 

limited  to  the  sum  of  the  estate  taxes,  State  death  taxes,  adminis- 
tration expenses,  and  funeral  expenses.  The  Act  changes  the  35  per- 
cent and  50  percent  alternative  tests  to  a  test  which  requires  that  the 
value  of  the  corporate  stock  included  must  exceed  50  percent  of  the 
value  of  the  gross  estate  reduced  by  the  sum  of  the  losses,  debts,  and 
administration  expenses  of  the  estate.  The  Act  extends  the  time  for 
such  a  redemption  in  cases  where  an  election  has  been  made  (under  sec. 
6166)  until  the  due  date  of  the  last  installment.  However,  for  any 
redemption  made  more  than  four  years  and  ninety  days  after  the 
decedent's  death,  capital  gains  treatment  is  available  only  for  a  dis- 
tribution in  an  amount  which  is  the  lesser  of:  (1)  the  amount  of  the 
qualifying  death  taxes  and  funeral  and  administration  expenses  which 
are  unpaid  immediately  before  the  distribution  or  (2)  the  aggregate 
of  these  amounts  which  are  paid  within  one  year  after  the  distribution. 

Under  prior  law,  if  the  stock  was  included  in  a  decedent's  gross 
estate,  it  could  be  redeemed  from  the  decedent's  estate,  from  a  benefi- 
ciary, or  from  another  party  (such  as  a  donee  of  a  gift  in  contempla- 
tion of  death),  even  though  the  owner  of  the  stock  was  not  chargeable 
with  any  portion  of  the  liability  of  the  estate  for  debts,  expenses,  or 
taxes.  The  Act  amends  the  Code  to  require  that  capital  gains  treatment 
(under  sec.  303)  will  apply  to  the  distribution  by  a  corporation  only 
to  the  extent  that  the  interest  of  a  shareholder  is  reduced  either  di- 
rectly or  through  a  binding  obligation  to  contribute  toward  the  pay- 
ment of  debts,  expenses,  or  tax^. 

Thus,  in  general,  the  changes  made  by  the  Act  are  designed  to  make 
this  special  capital  gains  treatment  available  only  where  the  closely 
held  business  interest  constitutes  a  substantial  part  of  the  estate  of  the 
decedent  and  where  the  party  w'hose  shares  are  redeemed  actually  bears 
the  burden  of  the  estate  taxes.  State  death  taxes,  or  funeral  and  admin- 
istration expenses  in  an  amount  at  least  equal  to  the  amount  of  the 
redemption.  The  extended  period  for  redemption  is  intended  to  more 
closely  correlate  the  special  capital  gains  and  the  extended  payment 
pro\nsions,  particularly  in  that  it  would  allow  the  corporation  to  build 
up  liquid  assets  and  redeem  stock  so  that  the  payment  of  estate  taxes 
miflfht  be  made  at  anv  time  throughout  the  period  for  making  the  in- 
stallment payments  of  tax. 

5.  Carryover  Basis  (sec.  2005  of  the  Act  and  sees.  691,  1014,  1015, 
1016, 1023, 1040, 1246,  6039A,  and  6694  of  the  Code) 

Prior  law 
Under  prior  law,  the  cost  or  basis  of  property  acquired  from  or 
passing  from  a  decedent  was  its  fair  market  value  at  the  date  of  death 
(or  the  date  of  the  alterniate  v'^hiat'on  date  if  that  date  is  elected  for 
estate  tax  purposes).^  Thus,  if  the  fair  market  value  of  the  prop- 
erty had  appreciated  after  the  decedent  acquired  it,  the  resulting 
gain  would  never  be  subiect  to  income  tax.  On  the  other  hand,  if 
the  property  depreciated  in  value  after  the  decedent  acouired  it,  the 
loss  could  never  be  deducted  for  income  tax  purposes.  The  basis  of 

1  For  purposes  of  this  discussion,  a  reference  to  the  fnlr  market  value  at  the  date  of  the 
decedent's  death  will  Include  reference  to  the  value  of  the  property  on  the  alternate  valu- 
ation date. 


552 

property  acquii'ed  f ix>m  or  passing  from  the  decedent  is  often  referred 
to  as  "stepped-up  basis."  (Although  basis  may  have  been  adjusted 
upward  or  downward  at  death,  upward  adjustments  were  more  com- 
mon, partly  because  property  tends  to  appreciate  over  time,  and 
partly  because  individuals  may  have  disposed  of  their  loss  prop- 
erty prior  to  death,  but  tended  to  hold  property  which  had  appreci- 
ated in  order  that  the  beneficiaries  would  receive  the  "step-up.") 

For  the  purposes  of  determining  what  property  was  given  a  stepped- 
up  basis,  the  test  was  generally  whether  the  property  was  included  in 
the  gross  estate  of  the  decedent.  In  addition,  prior  to  the  Act  the  sur- 
viving spouse's  share  of  community  property  was  treated  as  if  it  were 
acquired  from  the  decedent  (and  received  a  stepped-up  basis)  even 
though  that  poition  of  the  community  property  was  not  includible 
in  the  gross  estate  of  the  decedent. 

Where  property  is  transferred  by  gift,  the  basis  of  the  property  in 
the  hands  of  the  donee  is  generally  the  same  as  the  donor's  basis. 
However,  under  prior  law,  this  "carryover  basis"  was  increased  by  the 
amount  of  any  gift  taxes  paid  on  the  transfer  by  gift,  but  not  to  exceed 
the  property's  fair  market  value  as  of  the  date  of  the  gift.  An  exception 
to  the  carryover  basis  rule  is  provided  in  computing  any  loss  resulting 
frojn  the  sale  or  other  disposition  of  property  acquired  by  gift.  Under 
that  exception,  the  basis  of  the  asset  for  purposes  of  computing  loss  is 
the  lesser  of  the  fair  market  value  of  the  property  on  the  date  of  gift  or 
the  basis  of  the  property  in  the  hands  of  the  donor.  Where  the  asset  is 
sold  at  a  price  greater  than  the  fair  market  value  at  the  date  of  gift, 
but  less  than  the  basis  of  the  donor,  then  neither  gain  nor  loss  is  recog- 
nized on  the  transaction. 

Reasons  for  change 

Prior  law  resulted  in  an  unwarranted  discrimination  against  those 
persons  who  sell  their  property  prior  to  death  as  compared  with  those 
whose  property  Avas  not  sold  until  after  death.  Where  a  person  sells 
appreciated  property  before  death,  the  resulting  gain  is  subject  to  the 
income  tax.  However,  if  the  sale  of  the  property  could  be  postponed 
until  after  the  owner's  death,  all  of  the  appreciation  occurring  before 
death  would  not  be  subject  to  the  income  tax. 

This  discrimination  against  sales  occurring  before  death  created  a 
substantial  "lock-in"  effect.  Persons  in  their  lat^r  years  who  might 
otherwise  sell  property  were  effectively  prevented  from  doing  so  be- 
cause they  realized  that  the  appreciation  in  that  asset  would  be  taxed  as 
income  if  they  sold  before  death,  but  would  not  be  subiect  to  income  tax 
if  they  held  the  asset  until  their  death.  The  effect  of  this  "lock-in"  was 
often  to  distort  tlie  allocation  of  capital  between  competing  sources. 

In  order  to  eliminate  these  problems.  Congress  believed  that  the 
basis  of  property  acquired  from  or  passing  from  a  decedent  should 
have  the  same  basis  in  the  hands  of  the  recipient  as  it  had  in  the  hands 
of  the  decedent,  i.e.,  a  "carryover  basis."  This  will  have  the  effect  of 
eliminating  the  unwarranted  difference  in  treatment  between  lifetime 
and  deathtime  transfers. 

However,  in  order  to  prevent  a  portion  of  the  appreciation  from 
being  taxed  by  both  the  estate  tax  and  the  income  tax.  the  Congress  be- 
lieved that  the  carryover  basis  should  be  increased  by  Federal  and 


553 

State  death  taxes  attributable  to  the  appreciation  in  value.  In  addi- 
tion, in  order  to  prevent  beneficiaries  of  smaller  estates  from  paying 
tax  on  appreciation  accruing  before  the  decedent's  death,  the  Congress 
concluded  that  each  estate  should  have  a  minimum  basis  in  all  of  its 
carryover  basis  assets  of  at  least  $60,000.  Finally,  in  order  to  not  sub- 
ject appreciation  arising  prior  to  the  Act  to  income  taxation,  the  Act 
proWdes  that  the  basis  of  assets  acquired  from  a  decedent  which  were 
held  by  that  decedent  on  December  31,  1976,  shall  be  stepped-up  to 
their  value  on  that  date  for  purposes  of  determining  gain. 

Explanation  of  provision 

Under  the  Act,  the  basis  of  most  property  acquired  from  or  passing 
from  a  decedent  who  dies  after  December  31,  1976,  is  no  longer  to  be 
stepped  up  (or  stepped  down)  to  reflect  the  fair  market  value  of  the 
property  on  the  date  of  death.  Property  which  is  no  longer  entitled 
to  this  adjustment  based  on  fair  market  value  is  refererd  to,^  under 
the  Act,  as  "carryover  basis  property."  Property  which  is  not  carry- 
over basis  property  continues  to  be  governed  by  the  basis  rules  of 
prior  law. 

The  Act  adds  a  new  provision  (sec.  1023)  to  provide  rules  for 
determining  the  basis  of  "carryover  basis  property."  In  general,  the 
basis  of  carryover  basis  property  acquired  from  or  passing  from  a 
decedent  dying  after  December  31,  1976,  is  to  be  the  decedent's  basis 
immediately  before  his  death  with  certain  adjustments  discussed 
below. 

Where  the  carryover  basis  rules  apply,  the  gain  on  the  sale  or  other 
disposition  of  property  received  from  a  decedent  is  to  be  taxed  to  the 
recipient  who  sold,  or  otherwise  disposed  of,  the  property.  This  gain 
will  reflect  any  decrease  in  basis  of  the  property  in  the  hands  of  the 
decedent  from  depreciation,  depletion,  or  amortization  deductions 
taken  by  him.  Therefore,  the  gain  on  the  sale  of  such  property  is 
to  be  characterized  as  ordinary  income  to  the  extent  provided  by  the 
recapture  provisions  (sees.  1245,  etc.)  of  the  Code. 

In  the  case  of  property  passing  by  death,  it  is  not  possible  to  selec- 
tively transfer  only  loss  assets  since  all  of  the  assets  of  the  decedent 
must  pass  at  the  death  of  their  owner.  Consequently,  the  Act  does  not 
generally  limit  the  adjusted  carryover  basis  to  the  fair  market  value 
of  property  acquired  from  or  passing  from  a  decedent.  Thus,  in  the 
case  of  investment  assets  held  by  the  decedent,  losses  as  well  as  gains 
are  to  be  measured  by  reference  to  the  basis  of  the  property  in  the 
hands  of  the  decedent. 

However,  the  Congress  believed  that  it  is  inappropriate  to  permit 
the  losses  that  typically  occur  in  connection  with  personal  and  house- 
hold assets  to  offset  gains  attributable  to  the  investment  assets  of  the 
decedent.  Generally,  these  losses  would  have  been  treated  as  nonde- 
ductible personal  losses  if  they  had  been  realized  by  the  decedent  dur- 
ing his  life.  Thus,  the  Act  provides  that,  for  purposes  of  computing 
loss  on  the  sale  or  other  disposition  of  personal  or  household  effects, 
the  basis  of  these  items  cannot  exceed  their  fair  market  value  on  the 
applicable  valuation  date.  AMiere  the  amount  realized  on  the  sale  of  a 
personal  item  is  greater  than  its  fair  market  value  at  the  date  of  death 
of  the  decedent  but  less  than  the  basis  of  the  asset  in  the  hands  of  the 
decedent,  then  no  gain  or  loss  will  be  recognized  on  the  transaction. 


554 

For  this  purpose,  personal  and  household  effects  generally  include 
clothing,  furniture,  sporting  goods,  jewelry,  stamp  and  coin  collec- 
tions, silverware,  china,  crystal,  cooking  utensils,  books,  cars,  tele- 
visions, radios,  stereo  equipment,  et  cet^ira. 

Definition  of  carryover  basis  property. — Generally,  the  term  "carry- 
over basis  propeity"  includes  all  property  acquired  from  or  passing 
from  the  decedent  (within  the  meaning  of  section  1014(b) ).  Thus,  the 
term  generally  covers  all  property  which  receives  a  stepped-up  basis 
under  existing  law.  However,  there  are  a  number  of  exceptions  to  the 
general  rule. 

First,  the  Act  excepts  life  insurance  on  the  decedent's  life  from  the 
definition  of  carryover  basis  property.  Second,  the  Act  makes  a  num- 
ber of  other  exceptions  for  property  where  the  income  attributable  to 
it  is  already  taxed  to  the  recipient  under  present  law.^  In  this  case,  it  is 
unnecessary  to  include  the  property  within  the  scope  of  the  new  carry- 
over basis  rules. 

There  are  often  numerous  items  such  as  clothing,  etc.,  which  the 
decedent  owned  at  his  death,  for  which  it  would  be  extremely  difficult 
for  the  executor  to  determine  their  carryover  bases.  Moreover,  in  most 
cases,  the  fair  market  value  of  these  items  is  less  than  their  adjusted 
bases.  To  deal  with  this  situation,  the  Act  permits  the  executor  of  the 
estate,  in  effect,  to  exempt  up  to  $10,000  Avorth  of  household  and  per- 
sonal effects  of  the  decedent  from  the  carryover  basis  rules  by  making 
an  election  designating  which  items  are  not  to  receive  can*yover  basis 
treatment.  Where  the  executor  makes  such  an  election,  the  pei*sonal 
and  household  effects  to  which  the  election  applies  will  receive  a 
stepped-up  basis,  as  under  prior  law. 

Adjust'ments  to  caivyover  basis. — In  addition  to  a  transitional 
"fresh  start"  adjustment  described  below,  the  Act  provides  three  ad- 
justments that  are  to  be  made  to  the  adjusted  basis  which  is  carried  over 
from  the  decedent.  Under  the  first  adjustment,  the  basis  is  increased 
by  Fedeial  and  State  estate  taxes  paid  by  the  estate  attributable  to 
the  appreciation  in  the  carryover  basis  propert>'.  Secondly,  after  the 
adjustment  for  Federal  and  State  estate  taxes,  if  $60,000  exceeds  the 
adjusted  bases  of  all  carryover  assets,  the  bases  of  appreciated  carry- 
over basis  property  is  increased  by  the  excess.  Finally,  the  basis  of 
carryover  basis  property  is  increased  by  any  State  death  taxes  which 
are  paid  by  the  distributee  of  carryover  basis  property  and  which  a>re 
attributable  to  any  remaining  appreciation  in  carryover  basis  prop- 
erty received  by  that  distributee.  However,  in  no  event  may  the  basis 
of  any  asset  be  increased  by  the  three  adjustments  in  excess  of  its 
fair  market  value  on  the  date  of  the  decedent's  death. 

For  purposes  of  determining  the  appreciation  of  carryover  basis 
property  and  the  limit  on  the  adjustments  in  the  carryover  basis  of 
the  property,  the  fair  market  value  of  property  is  considered  to  be  its 
value  for  Federal  estate  tax  purposes.  Thus,  if  property  is  valued  under 
the  alternate  valuation  method  or  the  special  farm  or  closely  held  busi- 
ness valuation  method  previously  discussed,  that  alternate  or  special 

2  sections  72.  402,  40.%  423(c).  424(c)(1),  691,  and  1014(b)(5)  (and  sec.  1014(b)(9) 
with  respect  to  propert.v  included  In  tlie  gross  estate  where  the  donee  has  sold  it  before 
the  decedent's  death).  For  purposes  of  the  exception  with  respect  to  pa.vments  and  dis- 
tributions under  a  deferred  compensation  plan  life  insurance  proceeds  payable  under  the 
plan  and  excludible  under  section  72(m)(3)  are  to  be  treated  as  taxable  to  the  beneficiary 
and  thus  excluded  from  the  term  "carryover  basis  property." 


555 

value  is  to  be  used  to  determine  the  amount  of  appreciation  for  pur- 
poses of  making  all  the  adjustments  to  the  carryover  basis. 

It  is  also  intended  that  where  property  passes  to  an  estate  which 
has  unrealized  appreciation  which  would  have  been  subject  to  recap- 
ture (under  sec.  1245  or  sec.  1250)  if  it  had  been  sold  by  the  decedent 
prior  to  his  death,  the  potential  depreciation  recapture  is  to  be  passed 
through  to  the  beneficiary  who  receives  the  property. 

Adjustment  for  '■''fresh  start.'''' — Under  the  Act,  the  adjusted  basis  of 
property  which  the  decedent  is  treated  as  holding  on  December  31, 
1976,  is  increased,  for  purposes  of  determining  gain  (but  not  loss),  by 
the  amount  by  which  the  fair  market  value  of  property  on  December 
31,  1976,  exceeds  its  adjusted  basis  on  that  date.  In  essence,  this  modi- 
fication continues  existing  law  with  respect  to  appreciation  in  property 
accruing  before  January  1, 1977,  and  provides  everyone  with  a  "fresh 
start." 

The  "fresh  start"  rule  is  applicable  to  any  property  held  by  the 
decedent  which  reflects  the  basis  of  that  property  on  December  31, 
1976.  The  rule  also  applies  to  the  surviving  spouse's  share  of  com- 
munity property  which  was  held  on  that  date.  Property  held  by 
the  decedent  at  his  death  which  he  acquired  in  a  nontaxable  ex- 
change with  other  property  which  the  decedent  held  on  December  31, 
1976,  is  eligible  for  the  "fresh  start"  provision.  Likewise,  property 
acquired  by  the  decedent  as  a  gift  or  from  a  trust  qualifiies  for  the 
"fresh  start"  treatment  if  the  donor  or  trustee  held  the  property  on 
December  31,  1976,  even  though  the  decedent  acquired  the  property 
by  gift  or  by  distribution  from  the  trust  (with  a  carryover  basis)  after 
December  31,  1976.  Similarly,  property  which  the  decedent  held  on 
December  31, 1976,  that  he  gave  to  another  within  3  years  of  his  death 
qualifies  for  the  "fresh  start"  treatment  when  such  property  is  includi- 
ble in  the  gross  estate  of  the  decedent  (if  the  property  was  not  sold  by 
the  transferee  before  the  decedent's  death) .  The  Treasury  Department 
is  to  issue  regulations  providing  rules  where  the  decedent  has  property 
which  reflects  the  basis  of  property  held  on  December  31,  1976,  where 
the  decedent  has  made  capital  improvements  or  other  additions  to  the 
property.  The  "fresh  start"  adjustment  is  made  only  once  with  re- 
spect to  property,  e.g.,  only  one  adjustment  is  permitted  where 
property  passes  through  two  or  more  estates  after  1976. 

In  order  to  avoid  the  necessity  of  obtaining  an  appraisal  on  all 
property  held  on  December  31, 1976,  the  Act  contains  a  provision  which 
requires  that  all  property,  other  than  securities  for  which  market  quo- 
tations are  readily  available,  is  to  be  valued  under  a  special  valuation 
method.  The  special  rule  is  to  be  used  where  the  carryover  basis  prop- 
erty whose  basis  does  not  reflect  the  basis  of  property  which,  on  Decem- 
ber 31, 1976,  was  a  marketable  bond  or  security.  In  general,  the  special 
rule  determines  the  adjustment  by  assuming  that  any  appreciation  oc- 
curring since  the  acquisition  of  the  property  until  the  date  of  the  de- 
cedent's death  occurred  at  the  same  rate  over  the  entire  time  that  the 
decedent  is  treated  as  holding  the  property. 

Under  the  special  rule,  the  amount  of  the  increase  in  basis  is  equal 
to  the  sum  of  (1)  the  amount  of  all  depreciation,  amortization,  or  de- 
pletion allowed  or  allowable  with  respect  to  the  property  during  the 
period  the  decedent  is  treated  as  holding  the  property  prior  to  Jan- 


556 

iiary  1, 1977,  and  (2)  the  portion  of  the  appreciation  on  the  asset  since 
its  purchase  that  is  assumed  to  have  occurred  during  the  period  that 
the  decedent  is  treated  as  holding  the  property  prior  to  January  1, 
1977. 

The  appreciation  treated  as  occurring  before  December  31,  1976, 
is  determined  by  multiplying  the  total  amount  of  appreciation  over 
the  entire  period  during  which  tlie  decedent  is  treated  as  holding  the 
property  by  a  ratio.  The  ratio  is  determined  by  dividing  the  number 
of  days  that  the  property  is  considered  to  be  held  by  the  decedent  be- 
fore January  1,  1977,  by  the  total  number  of  days  that  the  property 
is  considered  to  be  held  by  the  decedent. 

The  total  amount  of  appreciation  is  computed  by  subtracting  from 
the  fair  market  value  of  the  property  on  the  date  of  the  decedent's 
death  a  recomputed  basis,  which  is  basically  equal  to  the  purchase  cost 
of  the  property.  For  purposes  of  this  rule,  the  fair  market  value  of 
property  on  the  date  of  the  decedent's  death  is  to  be  determined  under 
the  special  valuation  rule  for  farms  or  other  closely  held  businesses  if 
that  rule  is  elected  for  estate  tax  purposes  (sec.  2032A),  but  deter- 
mined without  regard  to  the  alternate  valuation  rule  (sec.  2032). 

The  special  valuation  method  must  be  used  for  all  property  other 
than  marketable  bonds  or  securities.  Thus,  the  special  valuation  method 
must  be  used  even  though  the  executor  or  beneficiary  of  the  decedent 
can  establish  the  fair  market  value  of  the  property  on  Dexjember  31, 
1976,  is  other  than  the  value  determined  under  the  special  valuation 
method. 

AVhere  the  decedent  (or  his  predecessor)  made  a  substantial  im- 
provement to  any  property,  the  Treasury  Department  is  to  issue  regu- 
lations under  which  that  substantial  improvement  is  treated  as  a  sepa- 
rate property  for  purposes  of  this  special  rule. 

Under  the  Act,  the  December  31,  1976,  value  of  marketable  bonds 
or  securities  must  be  determined  by  their  market  value  on  December  31, 
1976.  Marketable  bonds  or  securities  are  securities  which  are  listed  on 
the  New  York  Stock  Exchange,  the  American  Stock  Exchange,  or  any 
city  oi'  regional  exchange  in  which  quotations  appear  on  a  daily  basis, 
including  foreign  securities  listed  on  a  recognized  foreign  national 
or  regional  exchange;  securities  regularly  traded  in  the  national  or 
regional  over-the-counter  market,  foi'  which  published  quotations  are 
available;  securities  locally  traded  for  which  quotations  can  readily 
be  obtained  from  established  brokerage  firms ;  and  units  in  a  common 
trust  fund.  The  value  of  such  securities  is  to  be  detennined  using  the 
normal  methods  of  valuation  for  estate  and  gift  tax  purposes. 

Where  the  "fresh  start"  rule  applies,  the  amount  of  the  increase  in 
basis  that  is  pennitted  under  the  "fresh  start"  rule  is  not  to  be  reduced 
even  though  tlie  property  is  subject  to  depreciation,  depletion,  etc. 
The  Treasury  Department  is  to  issue  regulations  determining  the  ap- 
plication of  the  "fresh  start"  nile  where  gain  from  the  sale  of  the 
property  is  subject  to  special  niles  taxing  all  or  a  portion  of  the  gain 
as  ordinai-y  income  (sec.  306,  1245,  1250,  etc.)  and  where  the  property 
is  held  by  a  trust  or  partnership  in  which  the  decedent  was  a  benefi- 
ciary or  a  partner. 

Any  increase  in  basis  permitted  by  the  "fresh  start"  rule  is  made 
before  any  other  adjustments  are  made  to  tlie  property's  basis  for 
Federal  and  State  death  taxes  and  minimum  basis. 


557 

Adjustment  for  Federal  and  State  estate  taxes. — As  indicated,  the 
Act  increases  the  basis  of  carryover  basis  property  by  a  portion  of  the 
Federal  and  State  estate  taxes  attributable  to  the  carryover  basis  prop- 
erty. The  purpose  of  the  adjustment  for  Federal  and  State  estate  taxes 
is  to  prevent  a  portion  of  the  appreciation  from  being  subject  to  both 
the  estate  tax  and  the  income  tax.  For  this  reason,  the  adjustment  is 
limited  to  the  portion  of  the  Federal  and  State  estate  taxes  that  is 
attributable  to  the  appreciation  in  the  carryover  basis  assets.  That  por- 
tion for  each  individual  carryover  basis  asset  is  determined  by  multi- 
plying the  net  Federal  and  State  estate  tax  after  all  credits  by  a  frac- 
tion. The  numerator  of  the  fraction  is  the  amomit  of  appreciation  in 
the  individual  cari-yover  basis  asset  and  the  denominator  is  the  total 
value  of  all  property  of  the  decedent  subject  to  the  estate  tax. 

In  order  to  assure  that  the  portion  of  the  appreciation  on  each  par- 
ticular asset  is  not  also  subject  to  income  tax,  the  appreciation  on  each 
asset  is  not  to  be  reduced  by  any  depreciation  or  loss  in  value  of  any 
other  carryover  basis  property.  In  other  words,  the  appreciation  is 
determined  on  an  asset  by  asset  basis ;  there  is  no  "netting"  to  deter- 
mine unrealized  appreciation  for  the  estate  as  a  whole.  If  it  were  not 
for  this  rule,  heirs  receiving  appreciated  property  might  be  unfairly 
disadvantaged  vis  a  ins  other  heirs. 

The  term  "Federal  and  State  estate  taxes"  includes  the  tax  imposed 
by  section  2001  or  2101  reduced  by  any  credits  allowable  against  such 
tax.  It  does  not  include  any  additional  estate  tax  imposed  because  of  a 
disposition  of  property  which  qualified  for  the  special  farm  or  closely 
held  business  valuation  method.  However,  the  tax  imposed  on 
expatriated  residents  or  citizens  (sec.  2107)  is  to  be  treated  as  the  basic 
estate  tax  imposed  (sec.  2001 ) . 

Also  included  in  the  definition  of  "Federal  and  State  estate  taxes" 
are  any  estate,  inheritance,  legacy,  or  succession  taxes  imposed  by  a 
State  or  the  District  of  Columbia,  for  which  the  estate  is  liable  under 
local  law  or  the  applicable  instrument  and  which  are  actually  paid  by 
the  estate  to  the  State  or  the  District  of  Columbia.  If  the  taxes  are 
paid  by  someone  other  than  the  estate,  then  the  taxes  do  not  come 
wihin  the  definition  of  "Federal  and  State  estate  taxes."  (Nonetheless, 
an  adjustment  to  basis  may  be  permitted — see  discussions  below.) 

The  adjustment  to  carryover  basis  provided  under  the  Act  is  made 
only  with  respect  to  property  which  is  "subject  to  tax"  for  Federal 
estate  tax  purposes.  For  this  purpose,  the  Act  contains  a  special  rule 
with  respect  to  Federal  and  State  estate  taxes  which  provides  that 
property  for  which  a  charitable  or  marital  deduction  is  allowed  (sec- 
tions 2055,  2106  or  section  2056)  is  not  considered  to  be  "subject  to 
tax."  It  is  the  intent  of  the  Congress  that  the  Treasury  Department 
will  issue  regulations  providing  rules  for  determining  where  property 
that  is  bequeathed  to  charity  or  the  decedent's  surviving  spouse  is  not 
"subject  to  tax"  because  it  qualifies  for  the  charitable  and  marital 
deduction. 

However,  it  is  expected  that  such  regulations  will  provide  that  only 
property  that  is  actually  used  to  fund  the  charitable  or  marital  bequest 
will  be  deemed  to  be  not  "subject  to  tax."  For  example,  assume  that  the 
decedent  make  bequests  of  specific  property  to  his  children  and  then 
leaves  the  residue  of  his  estate  to  his  surviving  spouse.  Property  in 


558 

the  residue  that  is  used  to  pay  administration  expenses,  and  estate 
taxes  does  not  qualify  for  the  marital  deduction  and,  consequently, 
such  property  is  "subject  to  tax"  under  this  rule  even  though  the  prop- 
erty was  originally  part  of  the  residue.^ 

In  addition,  a  surviving  spouse's  share  of  community  property  is  not 
considered  to  be  "subject  to  tax"  since  it  is  not  included  in  the  deceased 
spouse's  gross  estate.  Thus,  no  adjustment  is  to  be  made  to  the  basis  of 
the  surviving  spouse's  share  of  community  property. 

As  a  rule  of  administrative  convenience,  property  qualifying  for  the 
exclusion  for  transfers  to  orphans  provided  in  the  Act  is  treated  as 
property  which  is  "subject  to  tax." 

Under  the  estate  tax  law,  property  which  "is  subject"  to  a  mort- 
gage for  which  the  estate  is  not  liable  (i.e.,  a  nonrecourse  debt)  may 
be  included  in  the  gross  estate  at  its  net  value,  that  is,  its  fair  market 
value  less  the  amount  of  the  mortgage. 

However,  it  is  possible  that  the  executor  may  include  the  full  value 
of  the  property  in  the  gross  estate  and  claim  a  deduction  for  the  lia- 
bility even  though  the  estate  is  not  liable  for  that  mortgage.  In  order 
to  assure  that  all  properties  which  are  subject  to  nonrecourse  mort- 
gages are  treated  uniformly,  the  Act  contains  a  rule  that  provides 
that  only  the  net  value  of  the  property  subject  to  a  nonrecourse  mort- 
gage is  considered  to  be  "subject  to  tax'"  regardless  of  how  that  prop- 
erty is  treated  in  the  estate  tax  return. 

For  example,  assume  that  the  decedent's  gross  estate  included  real 
estate  which  was  worth  $100,000  with  a  basis  of  $10,000,  but  which 
was  subject  to  a  nonrecourse  mortgage  of  $80,000.  Under  the  Act,  the 
fair  market  value  of  the  real  estate  for  purposes  of  increasing  the  basis 
of  the  property  by  Federal  and  State  estate  taxes  is  only  $20,000.  This 
is  the  amount  which  created  additional  estate-  taxes  and,  consequently, 
only  the  estate  tax  attributable  to  the  appreciation  in  that  amount 
should  be  allocated  to  that  asset.  Since  the  basis  of  that  property  is 
$10,000,  there  is  net  appreciation  of  $10,000.*  Consequently,  the  Fed- 
eral and  State  estate  taxes  attributable  to  the  $10,000  of  net  apprecia- 
tion is  added  to  the  basis  of  the  real  estate. 

Minimum  basis. — As  indicated  above,  the  Act  provides  that  the 
aggregate  bases  of  all  carryover  basis  property  may  be  increased  (but 
not  above  fair  market  value)  to  a  minimum  of  $60,000.  For  this  pur- 
pose, the  determination  of  whether  the  aggregate  bases  of  all  carry- 
over basis  property  exceeds  $60,000  is  to  be  determined  after  the 
increase  in  basis  for  "fresh  start"  and  for  Federal  and  State  estate 

*  Moreover,  where  property  Is  used  to  fund  the  charitable  or  marital  bequest,  but  a 
deduction  is  allowed  with  respect  to  only  a  portion  of  that  property,  only  a  portion  of  the 
property  used  to  fund  those  bequests  will  be  treated  as  "subject  to  tax."  For  example, 
assume  the  decedent  specifically  bequeathes  his  wife  $400,000  worth  of  stock  (with  a  basis 
of  $100,000)  but  only  $2.50,000  of  the  value  qualifies  for  the  marital  deduction.  In  such 
a  case  stock  with  a  value  of  $1.50.000  will  be  treated  as  subject  to  tax  and,  consequently, 
only  the  Federal  and  State  estate  tax  attributable  to  the  appreciation  on  the  portion  of 
the  stock  subject  to  tax  ($150,000  minus  the  allocable  portion  of  the  basis  of  $37,500  or 
$112,500)   can  be  added  to  the  basis  of  all  of  the  stock  passini;  to  the  surviving  spouse. 

Likewise,  where  the  decedent  leaves  property  to  a  charitable  remainder  trust  with  a 
fair  market  value  of  $400,000  and  a  basis  of  $100,000  and  the  charitable  portion  of  the 
trust  is  actuarily  computed  to  be  40  percent,  the  amount  subject  to  tax  will  be  $240,000 
(60  percent  of  $4(00,000).  Consequently,  only  the  portion  of  the  Federal  estate  tax  attrib- 
utable to  the  appreciation  on  the  portion  of  the  stock  subject  to  tax  ($240,000  minus  the 
allocable  portion  of  the  basis  of  $60,000  or  $180,000)  can  be  added  to  the  basis  of  all  of 
the  carryover  basis  property  transferred  to  the  charitable  remainder  trust. 

*  If  the  adjusted  basis  to  the  decedent  had  been  greater  than  $20,000,  no  adjustment 
to  carryover  basis  of  that  asset  would  be  permitted. 


559 

taxes  (discussed  above),  but  before  the  increase  in  basis  for  State 
succession  taxes  (discussed  below).  Thus,  if  the  aggregate  bases  of 
all  carryover  basis  property  in  the  hands  of  the  decedent  was  $55,000, 
and  the  increase  in  basis  for  "fresh  start"  or  Federal  and  State  estate 
taxes  is  $5,000  or  more,  no  additional  adjustments  are  permitted  under 
the  minimum  basis  rule. 

Once  it  is  detemiined  that  the  aggregate  bases  of  all  carryover  basis 
property  is  less  than  $60,000,  the  difference  between  that  aggregate 
amount  and  the  $60,000  is  then  allocated  among  all  appreciated  carry- 
over basis  property  on  the  basis  of  the  ratio  of  net  appreciation  of  each 
appreciated  carryover  basis  asset  ^  to  total  appreciation  of  all  ap- 
preciated carryover  basis  property. 

For  purposes  of  determining  the  aggregate  bases  of  all  carryover 
basis  property,  the  Act  limits  the  bases  of  pei*sonal  and  household 
effects  to  the  lesser  of  their  adjusted  bases  or  their  fair  market  value 
at  the  date  of  the  decedent's  death.  Often  it  is  extremely  difficult  to 
determine  the  actual  bases  of  these  items,  but  such  items  typically 
depreciate  in  value  from  their  purchase  cost.  Consequently,  under  this 
rule,  the  executor  is  relieved  of  the  burden  of  proving  the  actual 
amount  of  basis  of  the  personal  or  household  effects  if  he  can  show 
that  such  effects  have  depreciated  since  they  were  purchased. 

The  only  property  which  is  taken  into  account  in  meeting  the  $60,000 
limitation  is  property  which  is  covered  by  the  carryover  basis  rules 
(including  cash).  Thus,  items  not  counted  towards  the  $60,000  limit 
include  personal  and  household  effects  up  to  a  value  of  $10,000,  as 
designated  by  the  executor,  and  life  insurance. 

The  minimum  $60,000  basis  rule  does  not  apply  to  carryover  basis 
property  acquired  from  or  passing  from  a  decedent  who  at  his  death 
was  a  nonresident  alien. 

Adjiistme'nt  in  basis  attrihutahle  to  State  succession  taxes. — After 
the  adjustments  to  carryover  basis  have  been  made  for  Federal  and 
State  estate  taxes  and  minimum  basis,  the  carryover  basis  (as  ad- 
justed) may  be  further  increased  for  the  portion  of  any  State  suc- 
cession taxes  paid  by  the  recipient  of  the  property  which  is  attribut- 
able to  the  net  appreciation  on  that  property.  The  taxes  which  qualify 
for  this  adjustment  are  the  amount  of  estate,  inheritance,  legacy,  or 
succession  taxes  paid  by  the  recipient  of  property  with  respect  to 
that  property  to  any  State  or  the  District  of  Columbia  for  which  the 
estate  of  the  decedent  is  not  liable. 

The  adjustment  for  State  succession  taxes  can  only  be  made  to  prop- 
erty which  is  "subject  to  tax."  For  example,  if  the  State  tax  laws  con- 
tain a  provision  exempting  certain  bequests  to  orphans  from  that 
State's  death  taxes,  no  portion  of  the  death  taxes  payable  to  that  State 
can  be  used  to  increase  the  basis  of  the  property  that  qualifies  for  that 
orphan's  exclusion.  Moreover,  because  the  computation  is  made  on  the 
basis  of  the  taxes  paid  by  each  recipient,  taxes  paid  by  other  recipients 
of  property  from  the  decedent  are  not  relevant  for  this  adjustmeiit. 

The  portion  of  the  State  succession  taxes  which  is  attributable  to 

5  While  none  of  the  minimum  basis  adjustment  is  allocated  to  depreciated  assets,  the 
basis  of  the  depreciated  assets  is  nonetheless  counted  toward  meeting  the  $60,000  limita- 
tion. In  addition,  the  rule  discussed  above  relatinp  to  the  fair  market  value  of  property 
subject  to  a  mortgage  is  applicable  for  the  purpose  of  determining  whether  there  is  appreci- 
ation in  that  property  under  this  subsection. 


560 

the  net  appreciation  in  the  property  received  by  that  person  is  com- 
puted by  multiplying  the  total  amount  of  the  succession  taxes  paid  by 
that  person  by  a  fraction,  the  numerator  of  which  is  the  net  apprecia- 
tion in  that  particular  property  and  the  denominator  of  which  is  the 
fair  market  value  of  all  property  acquired  by  that  person  which  is 
subject  to  the  succession  taxes.  For  this  purpose,  the  mortgage  rule 
discussed  above  is  also  applicable  to  this  computation  where  it  is 
relevant. 

Example  illustrating  application  of  adjustments  to  carryover  basis 
rules. — For  purposes  of  computing  gain,  the  application  of  the  rules 
which  increase  the  basis  of  carryover  basis  property  can  be  illustrated 
by  the  following  example.  Assume  that  the  decedent  dies  in  1077  with 
personal  effects  with  a  fair  market  value  of  $10,000  and  an  adjusted 
basis  of  $50,000  and  marketable  stock  with  fair  market  value  of  $890,- 
000  and  a  basis  of  $25,000.  His  will  leaves  liis  entire  estate  to  his 
surviving  spouse.  The  value  of  the  stock  on  December  31,  1976,  was 
$39,000.  If  it  is  assumed  that  there  are  no  funeral  or  administration 
expenses,  there  will  be  a  gross  estate  of  $400,000,  a  marital  deduction 
of  $250,000,  and  a  taxable  estate  of  $150,000.  In  this  case,  there  is  a 
basic  tax  of  $38,800  less  a  credit  of  $30,000  leaving  an  estate  tax  of 
$8,800. 

Assume  in  this  example  that  the  State  death  taxes  paid  by  the  widow 
are  equal  to  the  maximum  State  death  tax  credit  and  that  the  entire 
amount  is  subject  to  tax.  Since  the  taxable  estate  in  this  case  is  $150,000, 
the  "adjusted  taxable  estate"  will  be  $90,000.  Consequently,  the  maxi- 
mum amount  of  the  State  death  tax  credit  is  $400  and  the  net  estate 
tax  is  $8,400. 

Assume  that  the  executor  makes  the  election  to  exclude  all  of  the 
personal  assets  from  carryover  basis  property.  Thus,  the  basis  of  the 
personal  assets  is  their  fair  market  value  as  under  existing  law.  In 
addition  the  basis  of  the  stock  under  the  "fresh  start"  ride  is  initially 
increased  to  $39,000. 

Because  of  the  marital  deduction,  $250,000  of  the  $400,000  of  gross 
estate  is  deemed  to  be  not  subject  to  tax.  Of  the  remaining  $150,000, 
$3,500  ($10,000  multiplied  by  $150,000  divided  by  $400,000)  is  deemed 
to  be  personal  effects.  Thus,  the  portion  of  the  carrvover  basis  prop- 
erty (i.e.,  the  stock)  which  is  subiect  to  tax  is  $146,250  ($150,000 
minus  $3,750).  The  adjusted  basis  of  that  carryover  basis  property  is 
$14,625  ($146,250  multiplied  by  $39,000  divided  by  $390,000).  Con- 
sequently, the  amount  of  appreciation  in  the  carryover  basis  property 
is  $131,625  ($146,250  minus  $14,625).  Thus,  the  basis  of  all  carry- 
over basis  propertv  is  increased  bv  $7,371  ($131,625  multiplied  by 
$8,400  divided  by  $150,000^  to  $46,371  ($39,000  plus  $7,371). 

The  basis  of  all  carryover  basis  property  is  then  increased  to  a 
minimum  basis  of  $60,000.  Since  the  personal  effects  are  not  consid- 
ered carryover  basis  property  by  reason  of  the  executor's  election,  the 
basis  of  these  assets  does  not  count  toward  the  minimum  basis  of 
$60,000.  As  a  result,  the  basis  of  the  stock  is  increased  by  $13,629  to 
$60,000. 

Finally,  the  basis  is  further  increased  by  any  State  inheritance  or 
estate  taxes  paid  by  the  recipient  with  respect  to  the  appreciation  on 
the  carryover  basis  property.  After  the  other  adjustments  permitted 


561 

under  the  Act,  the  appreciation  in  the  carryover  basis  property  is 
$330,000  ($390,000  less  $60,000).  The  portion  of  the  State  death  tax 
allocable  to  the  appreciation  in  the  carryover  basis  property  is  $330 
($330,000  multiplied  by  $400  divided  by  $400,000).  Consequently,  the 
basis  of  the  carryover  basis  property  is  increased  from  $60,000  to 
$60,330. 

Other  technical  amendments 

(1)  Amendments  to  section  691. — The  Act  makes  two  amendments 
to  section  691  (relating  to  income  in  respect  of  a  decedent)  in  order  to 
moi-e  nearly  equate  tlie  treatment  of  items  of  income  in  respect  of  a 
decedent  with  the  treatment  given  to  carryover  basis  property.  Under 
prior  law,  the  recipient  of  income  in  respect  of  a  decedent  was  per- 
mitted a  deduction  only  with  respect  to  Federal  estate  taxes  which  were 
attributable  to  the  income  in  respect  of  a  decedent.  The  Act  broadens 
the  types  of  taxes  for  which  a  deduction  is  allowed  to  all  Federal  and 
State  estate  taxes  (as  defined  in  section  1023  (f)(3)). 

Second,  under  prior  law,  the  amount  of  Federal  estate  taxes  for 
which  a  deduction  was  allowed  (section  691(c))  was  determined  by 
comparing  what  the  actual  Federal  estate  taxes  were  with  what  they 
would  have  been  if  the  income  in  respect  of  a  decedent  were  not  in- 
cluded in  the  gross  estate.  The  net  effect  of  this  computation  was  that 
the  deduction  for  Federal  estate  taxes  was  determined  by  reference  to 
the  estate's  highest  estate  tax  brackets.  However,  the  adjustments  to 
carryover  basis  property  for  Federal  and  State  estate  taxes  are  deter- 
mined on  the  basis  of  the  ratio  that  the  appreciation  bears  to  the  total 
fair  market  value  of  the  property  included  in  the  decedent's  gross 
estate.  The  net  effect  of  this  computation  is  that  the  Federal  and  State 
estate  taxes  are  computed  on  an  average  estate  tax  rate.  In  order  to 
more  nearly  equate  the  treatment  of  income  in  respect  of  a  decedent 
with  the  treatment  of  carryover  basis  property,  the  Act  provides  that 
the  deduction  for  Federal  and  State  estate  taxes  attributable  to  income 
in  respect  of  a  decedent  is  computed  by  multiplying  the  amount  of 
those  taxes  by  a  fraction,  the  numerator  of  which  is  the  net  amount  of 
income  in  respect  of  a  decedent  and  the  denominator  of  which  is  the 
value  of  the  gross  estate.  The  effect  of  this  amendment  is  to  compute 
the  deduction  for  Federal  and  State  estate  taxes  attributable  to  income 
in  respect  of  a  decedent  on  the  basis  of  the  average  estate  tax  rate  on 
the  decedent's  estate. 

(2)  Amendment  to  section  1015. — The  basis  of  property  acquired  by 
gift  generally  is  the  basis  of  the  property  in  the  hands  of  the  donor 
plus  any  gift  taxes  paid  on  the  arift.  The  purpose  of  the  increase  in 
basis  for  gift  taxes  paid  in  the  gift  is  to  prevent  a  portion  of  the  appre- 
ciation in  the  gift  (equal  to  the  gift  tax  imposed  on  the  appreciatioii) 
from  also  being  subiect  to  income  tax,  that  is.  to  prevent  the  imposition 
of  a  tax  on  a  tax.  However,  the  Congress  believed  that  prior  law  was 
too  generous  in  that  it  permitted  the  basis  of  the  gift  property  to  be  in- 
cT-eased  by  the  full  amount  of  the  gift  tax  paid  on  the  gift  and  not  iust 
the  gift  tax  attributable  to  the  appreciation  at  the  time  of  the  gift.  Con- 
seauentlv,  the  Act  provides  that  the  increase  in  basis  of  property  ac- 
quired by  gift  is  limited  to  the  gift  tax  attributable  to  the  net  apprecia- 
tion on  the  gift. 


562 

(S)  Repeal  of  existing  sections  101 4  (d)  and  12^6 {e). — Under  prior 
law  (sections  1014 (d)  and  1246(e)),  the  basis  of  stock  of  a  domes- 
tic international  sales  corporation  (DISC)  and  a  foreign  investment 
company  Avas  decreased  by  the  amount  of  certain  items  of  ordinarj^ 
income  deferred  in  the  corporation.  Since  stock  in  such  ortranizations 
will  be  carryover  basis  property,  except  where  the  basis  of  the  stock  in 
such  organizations  is  increased  by  the  adjustments  to  carryover  basis, 
the  repeal  of  these  sections  will  result  in  the  same  taxation  to  the 
recipient  of  the  stock  as  it  would  have  had  to  the  decedent.  Therefore, 
these  provisions  are  repealed  by  the  Act. 

Use  of  appreciated,  can^^yover  basis  property  to  satisfy  pecumai^ 
heqiiest. — Under  present  law,  the  distribution  of  property  by  an  estate 
or  trust  in  satisfaction  of  a  right  to  receive  a  specific  dollar  amount 
is  treated  as  a  taxable  transaction  resulting  in  the  recognition  of  gain 
or  loss  to  the  estate  or  trust.''  However,  under  prior  law,  where  the 
property  received  by  the  estate  or  trust  was  acquired  from  or  passed 
from  a  decedent,  the  trust  or  estate  Avas  given  a  "stepped-up"  basis  and, 
consequently,  the  trust  or  estate  recognized  only  the  appreciation  ac- 
cruing from  the  date  of  the  decedent's  death  to  the  date  of  distribution 
by  the  estate  or  trust. 

The  Code  (sec.  2056)  allows,  in  computing  the  taxable  estate  of  a 
decedent,  a  deduction  for  amounts  passing  from  the  decedent  to  his 
surviving  spouse.  However,  the  maximum  marital  deduction  allowed  is 
limited  to  50  percent  of  the  decedent's  adjusted  gross  estate  or,  if 
greater,  $250,000  under  the  Act.  In  order  to  assure  that  the  decedent 
leaves  his  surviving  spouse  property  just  sufficient  to  meet  the  maxi- 
mum marital  deduction,  the  wills  of  many  decedents  make  bequests  to 
the  surviving  spouse  determined  under  a  formula.  There  are  two  basic 
types  of  formulas  in  common  use.  In  the  first  type,  known  as  the  "frac- 
tional share  fornnda"",  the  surviving  spouse  is  given  a  fraction  of  each 
asset  in  the  estate,  of  the  decedent.  Where  the  trust  distributes  such 
share  to  the  surviving  spouse,  there  is  no  taxable  transaction.  Conse- 
quently, the  change  from  a  stepped-up  basis  to  carr^'over  basis  does  not 
result  in  additional  income  tax  at  the  time  of  distribution. 

In  the  second  type  of  formula,  known  as  a  '•^])ecuniary  bequest 
formula",  the  surviving  spouse  is  given  an  amount  equal  to  a  percent- 
age of  the  decedent's  estate.  Where  the  trust  or  estate  distributes  prop- 
erty in  satisfaction  of  this  right  to  receive  that  speeitied  dollar  amount, 
there  is  a  taxable  transaction  resulting  in  recognizable  gain  or  loss. 
Consequently,  in  such  a  case,  there  is  a  substantial  difference  in  income 
tax  consequences  upon  distribution  betAvoen  the  basis  rules  of  existing 
law  and  the  carryover  basis  rule  provided  by  tlie  Act.  A  similar 
problem  can  arise  on  the  transfer  of  pro])erty  to  a  charity  in  satisfac- 
tion of  a  bequest  of  a  fixed  dollar  amount  to  that  charity. 

The  Act  conforms  the  treatment  of  the  two  tyoes  of  bequests  by 
treating  the  distribution  by  an  estate  in  satisfaction  of  a  pecuniary 
bequest  as  a  nontaxable  transaction  exce)>t  to  the  extent  of  the  apprecia- 
tion occurring  from  the  date  of  the  decedent's  death  to  tlie  date  of  dis- 


«Treas.  Reg.  Sec.  1.661  (a)-2(£)  of  the  regulations. 


563 

tribiitioii.  However,  any  loss  occurring  between  those  tvo  dates  would 
not  be  recognized.  Where  this  section  applies,  the  basis  of  the  property 
to  the  distributee  is  the  carryover  basis  of  the  property  increased  by 
the  amount  of  any  gain  recognized  on  the  distribution.  Thus,  under 
the  rule  provided  by  the  Act,  bequests  using  the  "pecuniary  bequest 
formula"  will  receive  substantially  the  same  income  tax  treatment  to 
the  estate  upon  distribution  as  under  prior  law. 

The  Treasury  Department  is  to  issue  regulations  applying  this 
nonrecognition  treatment  to  situations  where  a  trust  distributes  prop- 
erty in  satisfaction  of  a  right  to  receive  a  specific  dollar  amount  which 
is  the  equivalent  of  a  pecuniary  bequest.  This  can  occur  where  an 
inter  vivos  trust  is  used  as  a  will  substitute  such  that  the  property  is 
never  held  by  the  decedent's  estate. 

Procedural  aspects  of  carryover  basis 

(1)  Decedents  hasis  unknown. — In  some  cases,  it  will  be  extremely 
difficult,  if  not  impossible,  for  the  executor  to  determine  the  basis  of 
some  of  the  property  owned  by  the  decedent.  Consequently,  the  Act 
contains  a  provision  which  permits  the  executor  and  the  Internal  Reve- 
nue Service  to  assume  that  the  purchase  cost  of  the  property  to  the  de- 
cedent (or  last  purchaser,  where  relevant)  is  the  fair  market  value  of 
iho,  property  on  the  date  that  it  was  purchased.  In  essence,  this  provi- 
sion permits  the  executor  and  the  Service  to  assume  that  the  decedent 
(or  other  relevant  person  who  last  purchased  the  property)  paid  fair 
market  value  for  the  property  at  the  time  of  purchase. 

{2)  Information  required  to  he  fui^ished  hy  executor. — In  order 
for  the  Service  and  the  recipients  of  property  from  a  decedent  to 
know  the  carryover  basis  of  that  property,  the  Act  adds  a  provision 
which  requires  the  executor  to  provide  such  information  concerning 
carryover  basis  property  to  the  Service  as  may  be  required  by  regula- 
tions. Failure  to  provide  this  information  by  the  executor  results  in  the 
imposition  of  a  penalty  on  the  executor  equal  to  $100  for  each  failure 
with  a  maximum  amount  for  all  such  failures  equal  to  $5,000.  It  is 
expected  that  the  Service  will  establish  a  procedure  under  which  the 
executor  will  be  deemed  to  have  met  this  reporting  requirement  if  the 
executor  has  done  everything  reasonable  to  obtain  the  information,  but 
is  still  unable  to  do  so. 

In  addition,  the  provision  requires  the  executor  to  provide  to  each 
recipient  of  property  from  a  decedent  the  adjusted  basis  of  that  prop- 
erty with  the  adjustments  provided  for  Federal  and  State  estate  taxes 
and  minimum  basis,  but  before  adjustment  for  State  succession  taxes. 
Failure  to  provide  this  information  will  result  in  the  imposition  of 
a  penalty  on  tlie  executor  of  $50  for  each  such  failure  (unless  such 
failure  is  due  to  reasonable  cause)  with  a  maximum  amount  for  all 
such  failures  of  $2,500. 

Effective  date 
Generally,  the  amendments  are  effective  for  decedents  dying  after 
December  31,  1976.  In  the  case  of  the  amendment  relating  to  adjust- 
ment to  basis  for  gift  taxes  paid,  the  amendment  is  effective  for  gifts 
made  after  December  31,  1976. 


564 

6.  Generation-Skipping  Transfers  (sec.  2006  of  the  Act  and  sees. 
2601,  2602,  2603,  2611,  2612,  2613,  2614,  2621,  and  2622  of  the 
Code) 

Prior  law 

Under  the  tax  law,  a  Federal  gift  or  estate  tax  is  generally  imposed 
upon  the  transfer  of  property  by  gift  or  by  reason  of  death.  However, 
under  prior  law,  the  termination  of  an  interest  of  a  beneficiary  (who 
is  not  the  grantor)  in  a  trust,  life  estate,  or  similar  arrangement  was 
not  a  taxable  event  \mless  the  beneficiary  under  the  trust  had  a  general 
power  of  appointment  with  respect  to  the  trust  property. 

This  result  (non taxability)  occurred  even  when  the  beneficiary 
under  the  trust  had :  ( 1 )  the  right  to  receive  the  income  from  the  trust ; 
(2)  the  power  to  invade  the  principal  of  the  trust,  if  this  power  was 
subject  to  an  ascertainable  standard  relating  to  health,  education,  sup- 
port, or  maintenance ;  (3)  a  power  (in  each  oeneficiary)  to  draw  down 
annually  from  his  share  of  the  principal  the  greater  of  5  percent  of 
its  value  or  $5,000;  (4)  a  power,  exercisable  during  life  or  by  will,  to 
appoint  any  or  all  of  his  share  of  the  principal  to  anyone  other  than 
himself,  his  creditors,  his  estate  or  the  creditors  of  his  estate;  or  (5) 
the  right  to  manage  the  trust  property  by  serving  as  trustee. 

Most  States  have  a  rule  against  perpetuities  which  limits  the  dura- 
tion of  a  trust.  Wliile  the  rules  of  the  different  States  are  not  com- 
pletely uniform,  in  general  such  laws  require  that  the  ownership  of 
property  held  in  trust  must  vest  in  the  beneficiaries  not  later  than  the 
period  of  the  lifetime  of  any  "life  in  being"  on  the  date  of  the  transfer, 
plus  21  years  (and  9  months)  thereafter. 

Reasons  for  change 

The  purpose  of  the  Federal  estate  and  gift  taxes  is  not  only  to  raise 
revenue,  but  also  to  do  so  in  a  manner  which  has  as  nearly  as  possible 
a  unifonn  effect,  generation  by  generation.  These  policies  of  revenue 
raising  and  equal  treatment  are  best  served  where  the  transfer  taxes 
(estate  and  gift)  are  imposed,  on  the  average,  at  reasonably  uniform 
intervals.  Likewise,  these  policies  are  frustrated  where  the  imposition 
of  transfer  taxes  is  deferred  for  very  long  intervals,  as  was  possible, 
under  prior  law,  through  the  use  of  generation-skipping  trusts. 

Prior  law  imposed  transfer  taxes  every  generation  in  the  case  of 
families  where  property  passed  directly  from  parent  to  child  and  then 
from  child  to  grandchild.  However,  where  a  generation-skipping  trust 
was  used,  no  tax  was  imposed  upon  the  death  of  the  child  even  where 
the  child  had  an  income  interest  in  the  trust,  and  substantial  powers 
with  respect  to  the  use,  management,  and  disposition  of  the  trust  assets. 
While  the  tax  advantages  of  generation-skipping  trusts  were  theoreti- 
cally available  to  all,  in  actual  practice  these  devices  were  more  valuable 
(in  terms  of  tax  savings)  to  wealthier  families.  Thus,  generation- 
skipping  trusts  wei"e  used  more  often  by  the  wealthy. 

Generation  skipping  resulted  in  inequities  in  the  case  of  transfer 
taxes  by  enabling  some  families  to  pay  these  taxes  only  once  every 
several  generations,  whereas  most  families  must  pay  these  taxes  every 
generation.  Generation  skipping  also  reduced  the  progressive  effect 
of  the  transfer  taxes,  since  families  with  moderate  levels  of  accumu- 


565 

lated  wealth  niigfht  pay  as  much  or  more  in  cumulative  transfer  taxes 
as  wealthier  families  who  utilized  generation-skipping  devices. 

The  Congress  recognized  that  there  are  many  legitimate  nontax 
purposes  for  establishing  trusts.  However,  it  also  believed  that  the  tax 
laws  should  basically  be  neutral  and  that  there  should  be  no  tax  advan- 
tage available  in  setting  np  trusts.  Consequently,  the  Act  provides 
generally  that  property  passing  from  one  generation  to  successive 
generations  in  trust  form  is  to  be  treated,  for  estate  tax  purposes,  sub- 
stantially the  same  as  property  which  is  transferred  outright  from  one 
generation  to  a  successive  generation.  The  Act  does  provide  one 
limited  exception  to  this  general  rule,  however,  to  cover  the  case 
where  a  trust  is  established  for  the  benefit  of  the  grantor's  grand- 
children. 

Explanation  of  provisions 

Overview. — Under  the  Act,^  a  new  chapter  13  is  added  to  the  In- 
ternal Revenue  Code,  which  imposes  a  tax  in  the  case  of  generation- 
skipping  transfers  under  a  trust  or  similar  arrangement  ^  upon  the 
distribution  of  the  trust  assets  to  a  generation-skipping  heir  (for 
example,  a  great-grandchild  of  the  transferor)  or  upon  the  tennina- 
tion  of  an  intervening  interest  in  the  trust  (for  example,  the  tennina- 
tion  of  an  interest  hold  by  the  transferor's  grandchild) . 

Basicall}',  a  generation-skipping  trust  is  one  which  provides  for  a 
splitting  of  the  benefits  between  two  or  more  generations  which  are 
younger  than  the  generation  of  the  grantor  of  the  trust.  The  genera- 
tion-skipping tax  would  not  be  imposed  in  the  case  of  outright  trans- 
fers. In  addition,  the  tax  would  not  be  imposed  if  the  grandchild  had 

(1)  nothing  more  than  a  right  of  management  over  the  trust  assets  or 

(2)  a  limited  power  to  appoint  the  trust  assets  among  the  lineal  de- 
scendants of  the  grantor. 

The  tax  is  to  be  substantially  equivalent  to  the  tax  which 
would  have  been  imposed  if  the  property  had  been  actually  transferred 
outright  to  each  successive  generation.  For  example,  where  a  trust  is 
created  for  the  benefit  of  the  grantor's  grandchild,  with  remainder  to 
the  great-grandchild,  then,  upon  the  death  of  the  grandchild,  the  tax 
is  to  be  computed  by  adding  the  grandchild's  portion  of  the  trust 
assets  to  the  grandchild's  estate  and  computing  the  tax  at  the  grand- 
child's marginal  transfer  tax  rate.  In  other  words,  for  purposes  of 
determining  the  amount  of  the  tax,  the  grandchild  would  be  treated 
under  the  Act  as  "deemed  transferor"'  of  the  trust  property. 

The  grandchild's  marginal  estate  tax  rate  would  be  used  as  a 
measuring  rod  for  purposes  of  determining  the  tax  imposed  on  the 
generation-skipping  transfer,  but  the  grandchild's  estate  would  not  be 
liable  for  the  payment  of  the  tax.  Instead,  the  tax  would  generally 
be  paid  out  of  the  proceeds  of  the  trust  property.  However,  the  tnist 
would  be  entitled  to  any  unused  poi-tion  of  the  grandchild's  imified 
transfer  tax  credit,  the  credit  foi'  tax  on  pi-ioi-  transfers,  the  charitable 


'  The  provisions  in  tlio  Act  concerning  peneration  skipping  are  the  same,  in  many 
respects,  as  the  provisions  of  H.R.  14R44.  which  was  reported  by  the  Ways  and  Means 
Committee  mouse  Report  94-1380)  but  was  not  considered  on  the  Floor  of  the  House 
due  to  the  enactment  of  the  Tax  Reform  Act. 

2  For  purposes  of  these  rules,  trust  equivalents  incluf^e  life  estates,  estate  for  years,  certain 
Insurance  and  annuity  contracts,  and  other  arrangements  where  there  is  a  splitting  of  the 
beneficial  enjoyment  of  assets  between  generations. 


234-12(1   O  -  77  -  37 


566 

deduction  (if  part  of  the  trust  property  were  left  to  charity),  the 
credit  for  State  death  taxes  and  a  deduction  for  certain  adminis- 
trative expenses.  In  addition,  the  vahie  of  the  grandchild's  gross  estate 
will  be  increased  by  the  generation-skipping  transfer  for  marital 
deduction  purposes. 

These  rules  are  discussed  in  more  detail  below. 

Generation-shipping  trust.— A  generation-skipping  trust  is  a  trust 
having  two  or  more  generations  of  "beneficiaries''  who  belong  to  gen- 
erations which  are  "younger"'  than  the  generation  of  the  grantor  of 
the  trust.  For  purposes  of  the  generation-skipping  provisions,  a 
"grantor"  of  the  trust  would  include  any  person  contributing  or  add- 
ing property  to  the  trust.  (Reg\ilations  are  to  provide  for  cases  where 
a  trust  has  more  than  one  grantor. ) 

Generally,  a  generation  would  be  determined  along  family  lines 
where  possible.  For  example,  the  grantor,  his  wife,  and  his  brothers 
and  sisters  would  be  one  generation ;  their  children  (including  adopted 
children)  would  be  the  first  "younger  generation,*'  the  grandchildren 
would  constitute  the  second  "3'ounger  generation,"  etc.  Husbands  and 
wives  of  family  members  would  be  assigned  to  the  same  generation 
as  his  or  her  spouse. 

Where  generation-skipping  transfers  are  made  outside  the  family, 
generations  are  to  be  measured  from  the  grantor.  Individuals  not  more 
than  121/^  years  younger  than  the  grantor  would  be  treated  as  mem- 
bers of  his  generation ;  individuals  more  than  I214  years  younger  than 
the  grantor,  but  not  more  than  371/^  years  younger,  would  he  considered 
members  of  his  children's  generation,  etc. 

Beneficiary ;  poioer;  interest. — For  purposes  of  these  rules,  a  per- 
son is  a  "beneficiary"  if  he  has  either  a  present  or  future  "interest"  or 
"power"  in  the  trust. 

An  interest  includes  the  right  to  receive  income  or  corpus  from  the 
trust  during  the  duration  of  the  trust,  or  the  right  to  receive  a  dis- 
tribution upon  its  termination.  Also,  a  person  has  an  interest  in  a  trust 
if  he  is  a  permissible  recipient  of  income  or  corpus  iiuder  a  power 
exercisable  by  himself  or  another.  For  example,  if  a  trist  provided 
that  the  income  was  to  be  paid  for  life  to  the  grantor's  child,  then 
to  the  gi'antor's  grandchild,  with  the  corpus  to  be  distributed  to  the 
great  grandchildren,  then  the  child,  grandchild,  and  great  grandchil- 
dren would  all  be  beneficiaries  under  the  trust  (because  all  three  gen- 
erations would  have  had  a  present  or  future  right  to  receive  income  or 
corpus)  and  the  trust  would  be  a  generation-skipping  trust  (because 
there  are  two  or  more  generations  01  younger  generation  beneficiaries) . 
During  the  life  of  the  child,  only  the  child  would  be  deemed  to  have  a 
present  interest  in  the  trust. 

Likewise,  if  a  trust  were  created  which  pro\dded  that  a  trustee  was 
to  have  discretionary  power  to  distribute  the  income  from  the  trust 
among  the  grantor's  three  children.  A,  B,  and  C,  with  the  remainder 
to  be  distributed,  in  the  trustee's  discretion,  to  the  grantor's  grand- 
children, then  the  three  children  and  the  grandchildren  of  tb»  grantor 
would  be  "beneficiaries"  under  the  trust  because  each  child  and  grand- 
child would  be  a  "permissible''  recipient  of  income  or  corpus  under  the 
trust.  Thus,  the  trust  would  be  a  generation-skipping  trust  ^  and  each 


567 

permissible  recipient  would  be  deemed  to  have  a  present  interest  in  the 
trust. 

On  the  otlier  hand,  a  trust  which  provided  that  the  income  was  to 
be  paid  for  life  to  the  grantor's  spouse,  with  remainder  to  the  grantor's 
grandchild,  would  not  be  a  generation-skipping  trust  because  there 
would  not  be  t^^'o  or  more  generations  of  beneficiaries  which  ■were 
"younger''  than  that  of  the  grantor.  If  the  trust  provided  that  the 
income  was  to  be  paid  for  life  to  the  grantor's  spouse,  Avith  remainder 
to  the  grantor's  issue  who  survived  the  spouse,  per  stirpes,  and  during 
the  spouse's  life  there  were  children  and  grandchildren  of  the  grantor 
living,  the  trust  would  be  a  generation-skipping  trust.  However,  no 
generation-skipping  transfer  would  result  from  the  death  of  the 
spouse.  In  addition,  corpus  distributions  to  the  grandchildren  during 
the  spouse's  life  would  not  be  treated  as  taxable  distributions  if  the 
children  did  not  have  a  present  interest  or  power  in  the  trust. 

Under  the  Act,  Ji.  person  having  a  "power"  with  respect  to  a  trust 
is  also  to  be  ti-eated  as  a  beneficiaiy.  For  purposes  of  these  rules,  the 
term  "power''  means  any  power  to  establish  or  alter  beneficial  enjoy- 
ment of  the  corpus  or  income  of  the  trust.  This  term  does  not  include 
a  mere  right  of  management  with  respect  to  the  trust  property.  For 
example,  if  a  trust  provided  that  the  income  was  to  be  paid  to  the 
grantor's  great  grandchild,  with  the  corpus  to  be  distributed  to  that 
great  grandchild  when  he  attained  age  35,  the  trust  would  not  be 
treated  as  a  generation-skipping  trust,  even  if  a  child  or  grandchild 
of  the  grantor  served  as  trustee,  because  the  trustee  would  not  have  the 
right  to  establish  or  alter  beneficial  enjoyment  of  the  income  or  corpus 
of  the  trust. 

On  the  other  hand,  a  limited  power  of  appointment  generallj'  would 
be  treated  as  a  "power''  for  purposes  of  these  rules,  subject  to  one  ex- 
ception. If  the  power  is  currently  exercisable,  it  is  a  present  power. 
However,  if  the  power  is  exercisable  only  by  will,  it  is  a  future  power 
until  the  death  of  the  holder  of  the  power.  Under  the  exception,  an 
individual  would  not  be  treated  as  holding  a  "power"  (and,  therefore, 
would  not  be  treated  as  a  beneficiaiy)  for  purposes  of  these  rules,  if  his 
sole  discretion  under  the  power  is  the  right  to  allocate  income  or  corpus 
of  the  trust  among  lineal  descendants  of  the  grantor  who  belong  to  a 
generation  (or  generations)  younger  than  that  of  the  individual  liold- 
ing  this  right  of  allocation.  For  example,  a  trust  for  the  benefit  of  the 
grantor's  grandchildren  would  not  be  treated  as  a  generation-skipping 
trust  merely  because  their  father  or  uncle  had  the  right  to  allocate 
income  or  coj'pus  among  them. 

A  power  to  draw  down  annually  from  the  principal  of  the  trust  the 
greater  of  5  percent  of  its  value  or  $5,000,  as  well  as  the  power  to 
in\'ade  principal  subject  to  an  ascertainable  standard  relating  to 
health,  education,  support  or  maintenance,  are  both  to  be  treated  as 
present  powers  for  purposes  of  these  rules  (unless  the  power  were 
exercisable  by  an  individual  for  the  benefit  of  lineal  descendants  of 
tlie  grantor  under  the  exception  just  described) . 

This  trust  jnight  or  might  not  be  t.Txable,  however,  because  the  committee  bill  per- 
iiilis  a  limited  generalion  slvip  on  a  tax-free  basis  where  the  generation-slcipplng  transfer 
ib  made  to  the  grantor's  grandchildren  (see  discussion  below). 


568 

In  any  event,  the  individuals  on  wliose  behalf  such  powers  were  ex- 
ercisable would  generally  be  beneficiaries  under  the  trust  since  they 
would  have  a  present  "interest"  in  the  trust  as  permissible  recipients  of 
income  or  corpus. 

Generotion-skipphig  tvonsfer. — As  indicated  above,  under  the  Act, 
a  tax  is  to  be  imposed  in  the  case  of  a  "generation-skipping  transfer." 
This  term  is  defined  to  mean  either  a  "taxable  termination"  or  a  "tax- 
able distribution." 

Termination. — A  taxable  termination  means  the  termination  of  an 
interest  or  power  of  a  younger  generation  beneficiary  who  is  a  member 
of  a  generation  which  is  older  than  that  of  any  other  younger  genera- 
tion beneficiary.  Such  a  termination  would  generally  occur  by  reason 
of  death  (in  the  case  of  a  life  interest)  or  by  lapse  of  time  (in  a  case 
where  tlie  grantor  created  an  estate  for  years) . 

For  example,  if  a  trust  provided  income  for  life  to  the  grantors 
child,  with  remainder  to  the  grantor's  great  gi'andchild.  there  w  mid 
be  a  taxable  termination  of  the  child's  interest  upon  his  death  because 
this  death  would  terminate  the  interest  (in  this  case,  a  life  income  in- 
terest) of  a  younger  generation  beneficiary  (the  child)  who  was  a 
member  of  a  generation  older  than  that  of  any  other  younger  genera- 
tion beneficiary  (the  great  grandchild)  under  the  trust.  For  purposes 
of  determining  whether  there  has  been  a  generation-skipping  trans- 
fer, the  determination  as  to  whether  there  are  younger  generation 
beneficiaries  is  to  be  made  immediately  before  the  transfer  takes 
place.* 

However,  under  the  Act,  a  taxable  termination  does  not  occur  where 
the  only  interest  or  power  which  is  terminated  is  a  future  interest  or 
power.  This  is  io  prevent  a  sitiiation  where  a  tax  might  be  imposed 
in  a  case  where  the  beneficiary  under  the  trust  never  has  a  present  in- 
terest or  power.  For  example,  if  a  trust  provided  income  to  the  child  for 
life,  then  to  the  grandchild  for  life,  with  remainder  to  the  great  grand- 
child, and  the  grandchild  was  the  first  to  die,  there  would  not  be  a  tax- 
able termination  because  the  grandchild  never  held  a  present  income 
interest  in  the  trust. 

In  certain  cases,  two  or  more  members  of  the  same  generation  may  be 
beneficiaries  who  have  present  interests  under  the  same  trust.  The  Act 
provides  that  generally,  in  such  cases  (except  as  provided  in  regula- 
tions), the  taxable  termination  with  respect  to  each  such  beneficiary 
is  to  be  treated  as  having  occurred  at  the  time  the  last  termination 
occurs  with  respect  to  that  generation. 

For  example,  assume  that  the  grantor  creates  a  trust  providing  that 
the  trustee,  in  his  discretion,  is  to  distribute  the  income  for  the  bene- 
fit of  the  grantor's  three  children.  A,  B,  and  C,  during  their  lives,  and 
is  to  distribute  the  corpus  of  the  trust  to  his  great  grandchildren  upon 
the  cessation  of  the  life  income  interests.  No  tax  would  be  imposed 
upon  the  death  of  A  and  B ;  upon  the  death  of  C,  however,  there  would 


*  For  example,  assume  that  a  trust  provides  income  for  life  to  the  grantor's  child,  then 
income  to  charity  for  10  years,  with  remainder  to  the  great  grandchild.  The  death  of  the 
child  would  constitute  a  taxable  termination  because,  immediately  prior  to  that  event, 
there  were  two  generations  of  younger  generation  beneficiaries  having  r.i  interest  in  tlie 
trust. 


569 

l^  a  taxable  termination  with  respect  to  the  trust  and  the  tax  base  (i.e., 
the  trust  assets)  would  be  valued  at  that  time.^ 

Also,  in  the  case  of  a  trust  under  which  corpus  distributions  are  dis- 
cretionary (or  sprinkling  trust),  the  tax  is  postponed  because  it  is 
difficult  to  vahie  the  terminated  interest  until  all  inembei-s  of  the  inter- 
vening generation  have  terminated  their  interests  (i.e.,  the  grantor's 
children  might  receive  all  of  the  corpus  from  the  trust,  or  none  of  it). 

Under  the  Act,  postponement  of  tax  would  also  occur  where  mem- 
bers of  several  different  generations  have  a  present  interest  or  power 
in  the  same  trust.  Under  these  circumstances,  if  the  interest  of  the 
member  (or  members)  of  the  younger  generation  terminate  first  (be- 
cause of  an  unusual  order  of  death  or  for  some  other  reason),  tax  is  to 
be  postponed  until  the  interest  of  the  older  generation  also  terminates. 
For  example,  assume  that  a  discretionary  trust  is  created  providing  the 
income  for  life  to  the  grantor's  spouse  and  his  two  children,  A  and  B, 
with  the  remainder  to  be  distributed  to  their  grandchildren.  Under 
the  Act,  if  A  and  B  both  predecease  the  spouse,  no  taxable  termination 
would  occur  until  the  death  of  the  spouse  at  which  time  a  taxable 
termination  would  occur.  (A  and  B  would  be  the  deemed  transferors, 
and  the  tax  base  would  be  determined  at  the  time  of  the  taxable  termi- 
nation, i.e.,  the  death  of  the  spouse.) 

These  rules  concerning  postponed  terminations  apply  where  two  or 
more  persons  hold  present  interests  or  powei-s  in  the  trust  simultane- 
ously, and  also  apply  where  a  beneficiary  who  is  a  member  of  the  same 
(or  a  higher)  generation  as  the  beneficiary  whose  interest  has  ter- 
mmated  holds  a  present  interest  or  power  in  the  trust  immediately 
after  the  termination.  For  example,  assume  that  the  trust  provides 
income  for  life  to  the  grantor's  nephew,  subject  to  a  limited  power 
of  appointment  exercisable  by  the  nephew  upon  his  death,  with  the 
principal  to  be  distributed  to  the  nephew's  issue.  If  the  nephew  ex- 
ercises the  power  by  providing  that  the  trust  income  is  to  be  paid  to 
his  wife  for  life  before  the  distribution  of  principal  to  his  issue,  tax  is 
postponed  until  the  death  of  the  wife.  (Of  course,  only  one  tax  is  im- 
])osed  at  that  time;  the  nephew  is  the  deemed  transferor,  and  the  tax 
base  is  computed  as  of  the  date  of  the  death  of  the  nephew's  spouse.) 

In  cei-tain  cases,  the  ride  under  the  Act  may  cause  several  taxable 
terminations  to  occur  at  the  same  time.  For  example,  assume  a  trust  is 
created  for  the  benefit  of  the  grantor's  nephew  and  his  nephew's  son 
for  life,  with  the  remainder  to  be  distributed  to  the  nephew's  grandson. 
If  the  nephew's  son  dies  before  the  nephew,  no  tax  would  be  imposed 
at  that  time ;  upon  the  death  of  the  nephew,  however,  a  tax  would  be 
imposed  on  the  termination  of  the  nephew's  interest.  The  amount  of 
this  tax  would  then  be  deducted  from  the  tax  base  (the  value  of  the 
trust  assets)  and  the  tax  which  had  been  postponed  upon  the  death  of 
the  nephew's  son  wordd  then  l>e  imposed.  (The  reason  for  deducting  the 
tax  imposed  on  the  termination  of  the  nephew's  interest  is  to  avoid  a 
double  tax ;  the  net  result  under  the  Act  is  that  the  generation-skipping 


5  This  is  not  to  sugsrest  that  all  tax  consequences  -woulfl  be  computed  by  reference  to 
C's  estate;  penerallv  C  would  be  the  "deemed  transferor"  only  with  respect  to  the  amount 
passing  to  his  grandchildren  (A  and  B  would  be  deemed  transferors  of  amounts  passing  to 
their  grandchildren)  (see  discussion  below). 


570 

tax  will  be  essentially  the  same,  even  where  there  is  an  unusual  order 
of  death.) 

However,  the  Cong^ress  intended  that  the  Treasury  Department 
is  to  have  authority  to  prescribe  regulations  covering  cases  where  the 
rules  just  outlined  are  utilized  primarily  for  the  postponement  of  tax. 
For  example,  if  tlie  trust  provided  income  for  life  to  A,  B  and  C,  the 
grantor's  children,  with  the  income  then  to  be  paid  to  X,  Y  and  Z 
(three  unrelated  members  of  the  children's  generation)  or  accumu- 
lated, in  the  discretion  of  the  trustee,  it  is  contemplated  that  the  tax- 
able termination  would  be  treated  as  having  occurred  upon  the  death 
of  the  survivor  of  A,  B  and  C  (rather  than  upon  the  death  of  the  sur- 
vivor of  A,  B,  C,  X,  Y  and  Z) .« 

In  addition,  there  are  certain  instances  where  several  individuals, 
who  are  nominally  beneficiaries  r.nder  the  same  trust,  actually  have 
interests  which  are  identifiable  and  separate  from  those  of  other  bene- 
ficiaries. Under  the  Act,  these  interests  are  to  be  treated  as  interests 
in  separate  trusts  in  accoi'dance  with  "separate  share"  rules  to  be 
prescribed  in  regulations. 

For  example,  assume  that  the  grantor  establishes  a  trust  for  the 
benefit  of  his  two  children,  A  and  B.  Under  the  terms  of  the  trust, 
50  percent  of  the  income  must  be  allocated  to  each  of  the  two  children 
and,  upon  the  death  of  either  child,  50  percent  of  the  corpus  of  the 
trust  is  to  be  distributed  to  that  child's  grandchildren.  Under  these 
circumstances,  the  separate  share  rules  would  apply,  and  there  would 
be  a  taxable  termination  upon  the  death  of  either  A  or  B  with  respect 
to  that  child's  share  of  the  trust. 

It  is  expected  that  tlie  regulations  concerning  the  separate  share 
rule  will,  to  the  extent  practicable,  prescribe  rules  which  are  vSubstan- 
tially  similar  to  those  which  apply  presently  to  the  income  taxation 
of  trusts  (under  Subchapter  J) . 

In  a  case  where  a  beneficiary  has  more  than  one  interest  or  power 
in  a  trust  tlien,  except  as  provided  in  regulations,^  the  taxable  termi- 
nation with  respect  to  all  of  these  interests  or  powers  is  to  be  treated 
as  having  occurred  at  the  time  of  the  termination  of  the  last  such 
interest  or  power.  For  example,  if  an  individual  has  a  life  income 
interest  in  the  trust,  as  well  as  a  power  to  draw  down  the  greater  of 
5  percent  of  his  shai-e  of  the  trust  principal  or  $5,000  eacli  year  over  a 
limited  period  of  time,  the  taxable  termination  would  occur  at  the 
expiration  of  the  life  interest.  In  general,  future  interests  and  powers 
will  be  disregarded  in  determining  whether  a  taxable  termination  has 
occurred. 


«  Where  there  was  a  mandatory  payout  of  aU  of  the  Income  to  X,  Y,  and  Z,  however,  the 
refpilations  might  provide  that  the  taxable  termination  would  occur  upon  the  death  of  the 
survivor  of  this  group  of  6. 

■^  It  was  anticipated  that  the  regulations  will  provide  special  rules  for  cases  involving 
nominal  or  contingent  interests.  For  example,  it'  an  individual  had  a  right  to  all  of  the 
income  from  a  trust  for  a  20-year  period,  followed  by  the  right  to  receive  $1  a  year  for  life, 
the  taxable  termination  of  the  20-year  income  interest  would  not  be  postponed  by  the 
existence  of  the  nominal  $1  per  year  interest. 

Likewise,  if  the  trust  provided  the  grantor's  child  with  an  income  interest  for  20  years, 
with  a  subsequent  life  income  interest  to  the  grandchild  and  remainder  to  the  great 
grandchild,  with  a  contingent  remainder  to  the  child  if  griiudchild  and  great  grandchild 
predecease  him,  the  existence  of  the  contingent  remainder  at  the  expiration  of  the  20- 
year  income  interest  would  not  be  sufficient  to  postpone  the  "termination"  of  the  child's 
income  interest. 


571 

The  assignment  of  a  beneficiary's  interest  in  a  generation-skipping 
trust  is  not  to  be  treated  as  a  taxable  termination.  For  example,  assume 
a  trust  provided  that  the  income  was  to  be  paid  to  the  grantor's 
nephew  for  life,  with  tlie  remainder  to  be  distributed  to  the  nephew's 
son  upon  his  death.  If  the  nephew  assigned  his  life  income  interest 
(with  or  without  receiving  consideration),  this  would  not  consti- 
tute a  termination  of  that  interest  for  purposes  of  the  tax  on  genera- 
tion-skipping transfers.  Howe\er,  the  death  of  the  nephew  would 
constitute  a  taxable  termination  and  the  tax  would  be  imposed  based 
upon  the  value  of  the  trust  at  that  time. 

Distrlhution. — Under  the  Act,  a  "taxable  distribution"  occurs  when- 
ever there  is  a  distribution  from  a  generation-skipping  trust,  other 
than  a  distribution  out  of  accounting  income  (sec.  G43(b)  of  the  Code) , 
to  a  younger  generation  beneficiary  of  the  trust  in  all  cases  where  there 
is  at  least  one  otlier  younger  generation  beneficiary  who  is  a  member 
of  an  older  generation.  For  example,  assume  that  a  discretionary  trust 
is  cstalilished  for  the  benefit  of  the  grantor's  child  and  great  grand- 
child. Tlie  trustee  exercises  his  discretion  by  distributing  accounting 
income  to  the  child  and  also  makes  a  distribution  out  of  corpus  to  the 
great  grandchild.  This  would  constitute  a  taxable  distribution  because 
there  would  be  at  least  one  younger  generation  beneficiary  (the  child) 
who  was  a  member  of  a  generation  older  than  that  of  the  great  grand- 
child.' 

The  rule  with  respect  to  accounting  income  is  primarily  a  rule  of 
administrative  convenience  in  cases  where  the  trustee  is  required,  or 
decides  under  discretionary  powers,  to  distribute  all  or  some  of  the 
trust  income  for  a  particular  year  or  years.  This  rule  does  not  fipply  to 
accumulated  income.  Also,  to  prevent  this  rule  from  being  used  for  tax 
avoidance  purposes,  the  Act  provides  that,  where  there  are  distribu- 
tions out  of  corpus  as  well  as  out  of  income,  the  distributions  to  mem- 
bers of  the  oldest  generation  (whether  or  not  they  are  younger  genera- 
tion beneficiaries)  are  to  Ix^  treated  as  having  been  made  out  of  income 
(to  the  extent  of  the  income),  and  the  distributions  to  younger  gener- 
ations are  to  be  treated  as  liaving  been  made  out  of  any  remaining  in- 
come, and  then  out  of  corpus. 

In  addition,  the  Congress  understood  that  trustees  are  sometimes 
authorized  to  make  "loans''  to  beneficiaries  of  a  trust  which  are  made 
from  (or  secured  b}- )  trust  assets.  A  loan,  particularly  if  it  is  unsecured 
and  bears  no  interest  (or  only  nominal  interest),  may  be  substantially 
equivalent  to  a  distribution.  The  Congress  intended  that  the  Internal 
Revenue  Service  may  require  reporting  with  respect  to  these  loan  trans- 
actions and  will  scrutinize  this  type  of  transaction  carefully  to  deter- 
mine whether  there  has  been  a  loan  or  a  distri})ution. 

Of  course,  the  terms  "taxable  termination"'  and  "taxable  distribu- 
tion" do  not  include  any  amounts  which  are  subject  to  estate  or  gift 
tax  (for  example,  because  the  beneficiary  Avhose  interest  in  a  trust  has 
terminated  had  a  general  power  of  appointment  with  respect  to  the 
trust  property). 


'  Of  course,  a  distribution  of  income  or  corpus  to  .he  child  would  not  be  a  taxable  distri- 
bution. The  amount  of  the  distribution  would  eventually  be  taxable  to  the  estate  of  the 
child,  just  as  any  amount  which  the  child  received  outright  from  hi'  parent,  and  no  genera- 
tion skipping  would  have  occurred. 


572 

Under  the  Act,  where  both  a  termination  and  a  distribution  result 
fi-om  the  same  occurrence  (such  as  the  death  of  a  member  of  an  inter- 
\'ening  generation) ,  the  transfer  is  to  be  treated  as  a  termination. 

Gifts  to  grandchildren. — Under  the  Act,  the  terms  "taxable  termi- 
nation" and  "taxable  distribution"  do  not  include  a  transfer  to  a 
grandchild  of  the  grantor  of  the  trust  to  tlie  extent  that  total  transfers 
from  all  terminations  and  distributions  through  a  "deemed  transferor" 
do  not  exceed  $250,000.  Under  the  Act,  the  "deemed  transferor"  of  a 
grandchild  of  the  grantor  will  be  the  grantor's  child  who  is  also  the 
grandchildren's  parent.  Thus,  if  the  grantor  has  two  children,  A  and 
B,  up  to  $500,000  could  be  transferred  from  the  generation-skipping 
trust  to  the  children  of  A  and  B  ($250,000  to  the  children  of  each) 
without  a  tax  being  imposed  upon  the  termination  of  A's  or  B's  in- 
terest in  the  trust. 

This  $250,000  exclusion  is  also  to  apply  if  the  transfer  from  a  trust 
to  a  grandchild  (which  would  result  in  tax  but  for  the  exclusion) 
were  in  the  form  of  a  taxable  distribution  rather  than  a  taxable  termi- 
nation. AVhere  there  are  several  distributions  or  terminations  from 
one  or  more  trusts  which  flow  through  the  same  deemed  transferor, 
the  $250,000  exclusion  is  to  be  applied  against  the  first  of  these  dis- 
tributions or  terminations,  then  the  second,  and  so  forth,  until  the 
exclusion  has  been  fully  utilized.^  (Where  there  are  simultaneous 
transfers,  Avhich  are  triggered  by  the  same  event  and  flow  through 
the  same  deemed  transferor,  and  which  benefit  more  than  one  grand- 
child of  the  grantor  of  the  trust,  the  $250,000  exclusion  is  to  be  al- 
located pro  rata  between  the  simultaneous  transfers,  in  accordance 
with  their  fair  market  value.) 

Tliis  $250,000  exclusion  is  to  be  available  in  any  case  where  the 
property  vests  in  tlie  grandchild  (i.e.,  the  property  interests  will  be 
taxable  in  the  grandchild's  estate)  as  of  the  time  of  the  termination 
or  distribution,  even  where  the  property  continues  to  be  held  in  trust 
for  the  grandchild's  benefit,  and  regardless  of  whetlier  the  grandchild 
receives  his  interest  under  the  express  terms  of  the  trust,  or  as  the 
result  of  the  exercise  (or  lapse)  of  a  power  of  appointment  with  re- 
spect to  the  trust. 

Tax  imposed  only  once  each  generation. — Under  the  Act,  the  tax 
on  generation-skipping  transfers  is  to  be  imposed  only  once  each 
genei-ation  with  respect  to  the  same  trust  share  or  interest.  To  achieve 
this  result,  the  Act  provides  that  where  the  deemed  transferor  of  the 
property  which  is  being  transferred  is  a  member  of  the  same  genera- 
tion as,  or  a  higher  generation  than,  any  prior  deemed  transferor  of  the 
same  property,  and  the  transferee  in  the  prior  transfer  is  a  member  of 
the  same  generation  as,  or  a  higher  generation  than,  the  transferee  of 
the  current  transfer,  then  the  current  transfer  is  not  to  be  treated  as  a 
taxable  termination  or  distribution  (to  the  extent  that  the  prior  trans- 
fer was  taxable). 

For  example,  assume  a  trust  is  created  which  provides  that  the  in- 
come for  life  is  to  go  to  the  grantor's  son,  then  to  the  grantor's  great 


»  All  trusts  established  by  a  grandparent  or  his  spouse  for  any  child's  children  would  be 
attributed  to  that  child  as  deemed  transferor  ;  thus,  only  one  $250,000  exclusion  Is  to  be 
allowed  to  flow  through  a  child  of  the  grantor  (for  the  ultimate  benefit  of  the  grand- 
children. 


573 

grandchild  A,  then  to  the  grantor's  daughter,  with  the  remainder  to 
be  distributed  to  the  grantors  great  grandchild  B.  The  death  of  the 
grantor's  son  would  constitute  a  taxable  termination.  However,  the 
death  of  the  grantor's  daughter  would  not  constitute  a  taxable  ter- 
mination "to  the  extent  that'  "  the  value  of  her  interest  which  termi- 
nated had  previously  been  subject  to  tax  upon  the  death  of  the  son. 
This  is  because  the  deemed  transferor  (the  daughter)  belonged  to  same 
generation  as  a  previous  deemed  transferor  with  respect  to  the  prop- 
erty (the  son),  and  the  transferee  of  the  property  (great  grandc^hild 
B)  is  a  member  of  the  same  generation  as  a  previous  transferee  (great 
grandchild  A).^^ 

Also,  under  the  Act,  these  rules  preventing  the  imposition  of  a 
second  tax  (where  there  are  two  or  more  deemed  transfers  of  the 
same  trust  property  attributable  to  the  same  generation)  are  not  to  be 
applied  where  this  would  have  the  effect  of  avoiding  the  tax  with 
respect  to  any  othei"  transfer. 

The  tax  hose. — In  the  case  of  a  taxable  distribution,  the  amount 
subject  to  tax  is  the  value  of  the  money  and  propert}'  distributed 
(determined  as  of  tlie  time  of  the  distribution).  The  tax  base  includes 
the  transfer  taxes  paid  imder  tliese  rules  watli  respect  to  the  distribu- 
tion, regardless  of  whether  these  taxes  are  paid  by  the  beneficiary  out 
of  the  proceeds  of  the  distribution,  or  the  taxes  are  paid  by  the  trustee 
out  of  trust  monies  which  are  paid  over  directly  to  the  Government. 

In  the  case  of  a  taxa})le  termination,  the  tax  base  equals  (1)  the 
value  of  the  trust  property  in  which  an  interest  has  terminated  and/or 
(2)  the  value  of  the  property  which  w-as  the  subject  of  a  power  (where 
a  power  has  terminated)  .^- 

For  example,  if  the  grantor  established  a  trust  providing  income  for 
life  to  his  nephew,  then  income  for  life  to  his  nephew's  son,  with  the 
remainder  to  be  distributed  to  his  nephew's  grandchildren,  the  tax 
base  upon  the  death  of  the  nephew  would  l>e  the  value  of  the  trust 
assets,  determined  as  of  the  date  of  the  nephew's  death  or  the  alternate 
valuation  date.  (A  similar  rule  would  apply  upon  the  death  of  the 
nephew's  son.) 

Under  the  Act,  where  a  beneficiary  has  more  than  one  interest  or 
power  in  a  generation-skipping  trust,  tlie  imposition  of  the  generation- 
skipping  tax  is  generally  delayed  until  the  termination  of  the  last 
power  or  interest  of  that  beneficiary  in  the  trust.  For  example,  where 
an  individual  is  entitled  to  receive  all  of  the  trust  income  until  the 
individual  dies  or  reaches  age  35  and  also  has  a  power  commencing  at 
age  35  to  withdraw  5  percent  of  the  trust  corpus  for  life,  the  genera- 
tion-skipping tax  will  be  imposed  at  the  death  of  the  individual  and 
not  wlien  the  individual  reaches  age  35. 

The  amount  subject  to  tax  at  the  death  of  the  individual  is  the  cumu- 
lative value  (not  in  excess  of  100  percent  of  the  value  of  the  trust  assets 


^0  Assume  that,  upon  tho  death  of  the  son.  the  value  of  the  trust-assets  subieot  to  tax  Is 
$100  000  and  that  upon  the  death  of  the  daughter  the  value  of  the  trust  assets  is  !«200.000. 
tJnder  the  Act.  only  $100,000  is  to  be  subject  to  tnx  upon  the  denth  of  the  daughter  because 
SIOO.OOO  of  value  was  previously  subject  to  a  {,'encration-skipping  tax  upon  the  death  of 
the  son. 

^iThe  same  result  would  follow  If  the  daughter  had  been  a  member  of  a  higher. genera- 
tion than  the  son  (mother,  aunt,  or  uncle,  etc.)  and/or  B  had  been  a  member  of  a  same  or 
higher  generation  tban  credit  crsindchild  .\. 

1=  Of  course,  where  a  beneficiary  has  both  an  interest  and  a  power  with  resnect  to  a 
trust,  the  total  amount  subject  to  tax  is  never  to  exceed  the  value  of  the  trust  assets, 
determined  as  of  the  time  of  the  termination. 


574 

determined  as  of  the  time  of  the  termination  or  the  alternate  valuation 
date)  subject  to  these  interests  and  powers.  In  this  case,  the  individual 
held  a  full  income  interest  in  the  trust  until  age  35,  so  the  tax  base  is  the 
value  of  the  trust  assets  (determined  as  of  the  time  of  the  taxable 
termination,  i.e.,  the  individual's  death).  If  the  individual  had  held 
only  a  power  to  withdraw  5  percent  of  the  trust  cor])us  annually  (or 
$5,000,  w^hichever  is  greater) ,  the  tax  base  equals  the  entire  value  of  the 
trust  corpus  determined  as  of  the  date  of  tiie  individual's  death  (i.e., 
the  date  of  the  taxable  termination)  because  the  entire  trust  was 
"subject  to  the  power."  (This  is  the  result  regardless  of  the  number 
of  years  for  which  the  power  was  hold,  exorcised,  or  allowed  to  lapse 
and  regardless  of  the  average  value  of  the  trust  during  this  period.) 
Likewise,  if  the  individual  were  a  beneficiary  under  a  power  to  invade 
corpus  subject  to  an  ascertainable  standard  relating  to  his  health,  ed- 
ucation, support  or  maintenance,  the  tax  is  to  be  the  value  of  the  trust 
corpus  (determined  as  of  the  date  of  the  termination)  because  the  full 
trust  is  subject  to  the  poAver. 

Deducfi07is,  credit,  etc. — Under  the  Act,  property  passing  under  a 
trust  is  to  be  entitled  to  many  of  the  benefits  which  are  available  under 
the  estate  tax  laws  in  the  case  of  property  which  passes  in  an 
outright  transfer  (to  the  extent  that  property  passing  under  the  trust 
is  subject  to  the  tax  on  generation-skipping  transfers). 

For  example,  where  the  generation-skipping  transfers  occur  at  the 
same  time  as,  or  after,  the  death  of  the  deemed  transferor,  the  trust 
would  Ix*-  entitled  to  any  unused  porticm  of  the  unified  credit  which 
had  not  u^^ili'^.od  in  connection  with  the  deemed  transferor's  estate.  In 
addition,  tiic  cl^nritablo  doduciion  is  to  be  allowed  for  purposes  of 
determining  the  tax  on  the  generation-skipping  transfer  if  part  of  the 
trust  property  passes  to  charity. 

Also  (where  the  generation-skipping  transfer  occurs  at  the  same 
time  as,  or  within  nine  months  of  the  deemed  transferor's  death),  the 
Act  provides  that  in  determining  the  size  of  the  gross  estate  of  the 
deemed  transferor,  for  purposes  of  computing  the  marital  deduction, 
the  amount  of  any  taxable  termination  or  taxable  distribution  is  to  be 
taken  into  account.  In  certain  cases,  the  result  will  be  tl^at  the  maxi- 
mum allowable  marital  deduction  will  increase,  the  transfer  tax  pay- 
able with  respect  to  the  deemed  transferor's  estate  Avill  decrease,  and 
the  deemed  transferor's  marginal  rate  bracket  will  also  decrease  (thus 
reducing,  indirectly,  the  tax  that  will  be  payable  with  respect  to  the 
property  passing  under  the  generation-skipping  transfer).  The  Con- 
gress intended  that  any  permitted  incre^ase  in  the  amount  of  tlie  marital 
deduction  by  reason  of  a  generation-skipping  transfer  occurring  after 
the  death  of  the  decedent  is  not  to  be  treated  as  a  terminable  interest 
solely  by  reason  of  the  fact  that  the  maximum  amount  of  the  deduc- 
tion is  not  known  as  of  the  date  of  the  decedent's  death. 

The  previously  taxed  property  credit  is  also  to  be  allowable  Avhere 
an  estate  tax  had  been  imposed  with  respect  to  the  creation  of  the 
trust  and,  witinn  a  10-year  period  thereafter,  the  generation-skipping 
tax  is  imposed  upon  the  death  of  the  deemed  transferor.  LikeAvise, 
where  the  deemed  transferor  is  deceased  at  the  time  of  a  generation- 
skipping  transfer,  property  which  is  subject  to  the  tax  on  generation- 
skipping  transfers  is  to  be*  treated  as  passing  from  the  deemed  trans- 
feror to  the  transferee  and  tlie  generation-skipping  tax  is  to  be  treated 


575 

as  an  estate  tax  for  purposes  of  tlie  })ieviously  taxed  property  credit. 
The  Act  also  provides  tliat  in  oonneetion  Avitii  tiie  credit  for  previously 
taxed  pi-o])erty,  the  value  of  the  proi)erty  subject  to  the  tax  on  genera- 
tion-ski])pin<r  transfers  which  is  not  taken  into  account  for  purposes 
of  tiie  estate  tax  (e.^r.,  the  excess  over  the  actuarial  value  of  the  deemed 
transfer(n''s  life  interest  taken  into  account  iind<M  i)resent  law)  is  to 
be  taken  into  account  for  purposes  of  the  credit  allowed  for  the  ven- 
eration-skipping transiei-  tax. 

In  addition,  the  credit  for  state  death  and  inheritance  taxes  is  to  be 
available  to  the  extent  that  these  taxes  are  levied  with  respect  to  the 
generation-skippin<^  transfer  (subject  to  the  limitation  under  sec. 
2011  (b),  ai)j)lied  as  if  all  deemed  transfers  occurring  on  or  after  the 
deemed  transferor's  death  were  part  of  his  estate) . 

In  addition,  ti'ustee's  fees,  costs  of  administratitm,  and  other  losses 
and  expenses  which  arc  deductible  (under  sec.  205?>  or  2054)  in  the 
case  of  an  estate  may  Iw  deducted  from  the  amount  of  any  taxable 
generation-skijiping  tiansfer  to  the  extent  that  such  items  are  i)aid 
for  or  sustained  by  the  trust,  are  attributable  to  property  which  is 
included  in  the  ocneration-skipping  transfer,  and  have  not  previously 
been  deducted  for  estate  or  income  tax  purposes. 

The  Act  also  jn-ovides  that,  where  certain  rights  to  income  are  sub- 
ject to  the  tax  on  generation-skipping  transfers,  the  income  tax  treat- 
ment of  so-called  "income  in  respect  of  a  decedent"  will  apply  to  cer- 
tain tyj)es  of  income.  Thus,  the  reci})ient  of  this  income  (wliether  the 
trustee  or  a  beneficiary  of  the  trust)  is  entitled  to  a  deduction  (in  com- 
puting the  income  tax  on  this  income)  for  the  generation-skipping  tax 
in  the  same  way  as  the  reci])ient  is  allowed  a  deduction  for  the  estate 
tax  under  present  law  (sec.  (U)l  (c) ).  Also,  under  the  Act,  where  a  gen- 
eration-skipping transfer  which  is  subject  to  tax  occurs  after  the  death 
of  the  deemed  transferor,  section  HOo  treatment  is  to  be  available.  The 
trust  and  the  actual  estate  of  the  deemed  ti'ansferor  are  to  be  treated 
separately  for  purposes  of  the  section  oO.')  (jualification  requirements. 

Computation  of  tax, — Under  the  Act,  the  tax  v.-ould  be  substantially 
equivalent  to  the  estate  or  gift  tax  which  would  have  been  imposed 
if  the  ]>roperty  had  actually  been  transferred  outright  to  each  genera 
tion.  This  is  achieved  by  adding  the  amount  subject  to  tax  as  a  result 
of  the  generation-skipping  transfer  to  the  other  taxable  transfers  of 
the  "deemed  transferor." "  The  net  eifect  is  that  the  generation- 
skipping  transfer  is  taxed  at  the  marginal  transfer  tax  rate  of  the 
deemed  transferor. 

Foi-  example,  where  a  trust  is  created  for  the  benefit  of  the  grantor's 
child,  Avith  remainder  to  the  grantor's  great  grandchild,  then,  upon 
the  death  of  the  cliild,  the  rax  would  be  computed  by  adding  tlie 
child's  ])ortion  of  the  trust  assets  to  the  child's  estate  and  computing 
the  tax  at  the  child's  marginal  estate  tax  rate.  The  child  would  be 
treated  as  the  "deenied  nansferor"  of  the  trust  property  and  the 
child's  transfer  tax  brackets  would  be  used  as  a  measuring  rod  for 


^^Tlif  v;)lup  of  tlif-  property  whlrh  is;  the.snbicct  of  the  Roneratiori-skippins  traiisfvr  Sa 
added  to  (1)  prior  peiioration-skipplnfr  transfers  of  the  deemed  transferor,  (2)  any  tax- 
able prifls  maiJe  \<y  liini  after  Decem'oer  81.  lOTd.  and  (:■!)  where  t)ie  (.vnernticnskipplnir 
transfer  occurs  after  (or  as  a  result  of)  the  death  of  tlie  deemed  transferor,  the  deemed 
transferor's  taxable  estate.  A  tentative  transfer  tax  is  oot)))>uted  on  the  total  value  of 
these  transfers;  from  the  tentative  tax  is  subcontracted  the  transfer  tax  on  all  transfers 
in  the  tentative  tax  base  other  than  the  gencration-sliipping  transfer  in  tiiiestlon. 


576 

purposes  of  determining'  the  tax  imposed  on  the  generation-skipping 
transfer. 

Also,  under  the  Act,  in  a  case  where  there  are  simultaneous  genera- 
tion-skipping transfers  which  flow  through  the  same  deemed  trans- 
feror and  result  from  the  same  event  (usually  the  death  of  the  deemed 
transferor) ,  the  tax  on  all  such  transfers  is  to  be  allocated  pro  rata 
(spreading  the  effect  of  the  progressive  marginal  rates  rather  than 
stacking  one  transfer  on  top  of  anotlier).  For  example,  assume  that 
the  grantor  establishes  trust  A,  liaving  a  value  of  60,  for  his  child  for 
life  with  remainder  to  great  grandchild  A;  the  grantor's  spouse 
establishes  trust  R,  having  a  value  of  40,  for  the  child  for  life  with 
remainder  to  great  grandchild  B.  Upon  the  death  of  tlie  child,  the 
value  of  trusts  A  and  R  would  be  added  to  the  child's  estate,  a  tax 
would  be  computed  on  the  total  value  of  100  and  (assmning  no  change 
in  relative  value  of  trusts  A  and  R  after  they  are  created)  60  percent 
of  the  tax  would  be  imposed  on  the  transfer  of  trust  A,  and  40  percent 
of  the  tax  would  be  imposed  on  trust  R, 

Deemed  tranfiferor. — TTuder  the  Act,  the  deemed  transferor  of  the 
generation-ski))ping  transfer  is  always  the  parent  (whether  or  not 
Jiving  at  the  time  of  the  transfer)  of  the  transferee  of  the  trust  prop- 
erty who  is  most  closely  related  to  the  grantor  of  the  trust  in  all  cases 
except  where  (1)  that  parent  is  not  a  younger  generation  beneficiary 
of  the  trust  at  any  time,  and  (2)  there  is  another  ancestor  (g-rand- 
parent,  great  grandparent,  etc.)  of  the  transferee  who  is  related  by 
blood  or  adoption  (and  not  by  marriage)  to  the  grantor  of  tlie  trust 
who  is  a  younger  ffoneration  beneficiary  of  the  trust.  If  both  of  these 
conditions  ai-e  satisfied,  then  the  ancestor  who  is  also  a  younger  genera- 
tion beneficiary  will  be  considered  the  deemed  transferor. 

For  purposes  of  these  rules,  an  individual  i-elated  to  the  grantor  by 
blood  or  adoption  is  always  to  be  treated  as  being  more  closely  related 
than  an  individual  who  is  related  to  the  grantor  by  marriage. 

For  example,  assume  a  trust  for  the  benefit  of  the  grantor's  frraiul- 
child  foi-  life  wnth  remainder  to  the  grantor's  great  grandchild;  the 
grandchild  is  the  deemed  transferor  Avhen  the  trust  property  passes 
to  the  great  grandchild.  Also,  if  the  trust  is  for  the  benefit  of  the  s])ouse 
of  the  gi'antor's  ornndchild  for  life,  with  remainder  to  the  great  grand- 
child, the  grandchild  (not  his  spouse)  is  the  deemed  transfei^or  (be- 
cause he  is  the  parent  of  the  transferee  more  closely  related  to  the 
grantor)  and  when  the  grandchild's  spouse  dies,  the  value  of  the  trust 
property  will  be  added  to  the  grandchild's  taxable  transfers  for  pur- 
poses of  determining  the  tax  rate.""^ 

If  the  trust  were  for  the  benefit  of  the  grantor's  child  for  life,  with 
remainder  to  the  grantor's  great  grandchild,  the  child  would  be  the 
deemed  transferor  (because  the  great  grandchild's  parent  was  not  a 
you.nger  generation  beneficiary  under  the  trust) . 

If  the  trust  were  for  the  benefit  of  the  grantor's  nephew  for  life,  then 
the  nephew's  son  for  life,  with  the  remainder  to  the  grantor's  great 


■'''If  tlip  jrrandohlld  is  still  alive  when  the  frenpration-skippinff  transfer  oc<'iirs.  the 
deeniPd  trnnsfer  is  to  be  taken  into  account  for  purposes  of  determinlnjr  the  maririnal  tax 
rate  to  he  imposed  with  respect  to  later  deemed  transfers  attributable  to  him  :  however,  the 
deemed  transfer  Is  not  to  be  taken  into  account  for  purposes  of  determining  transfer  tax 
rates  on  the  grandcl. lid's  gifts,  or  J.ls  estate. 


577 

grandcliild,  the  nepliew  would  be  tlie  deemed  transferor  upon  his  death, 
but  upon  the  death  of  the  nephew's  son,  the  grantor's  jscrandchild  (the 
great  grandcliild's  parent)  wo\ikl  be  treated  as  the  deemed  transferor 
(because  no  ancestor  of  the  great  grandcliild  was  a  younger  genera- 
tion beneficiary  under  the  trust) , 

If  tlie  trust  were  a  discretionary  trust,  with  the  trustee  having  the 
power  to  allocate  income  between  the  grantor's  grandchild  and  the 
grantor's  nephew's  son,  with  remainder  to  the  grantor's  great  grand- 
child, the  grantor's  grandchild  would  be  the  deemed  transferor  (be- 
cause he  was  the  parent  of  the  ti'ansferee  and  was  also  one  of  the 
younger  generation  beneficiaries  under  the  trust  as  that  term  is  defined 
in  tJie  Act), 

Where  the  trust  is  created  for  the  benefit  of  persons  outside  of  the 
grantor's  family  (i.e.,  friends,  emploj^ees,  etc.),  the  deemed  transferor 
is  the  parent  of  the  transferee  having  the  closest  ''affinity"  or  relation- 
ship with  the  grantor.  Generally,  this  will  be  the  person  named  in  the 
trust  instrument  or  tlie  lineal  descendant  of  that  person  having  the 
intervening  interest  or  power  in  the  trust. 

For  example,  if  a  trust  were  created  for  the  benefit  of  the  grantor's 
butler  (who  is  1-3  years  younger  than  the  grantor)  for  life,  then  the 
butler's  children  for  life,  with  the  remainder  to  their  issue,  the  butler 
would  become  a  deemed  transferor  upon  his  death,  and  each  of  his 
children  would  l>ecome  a  deemed  transferor  upon  his  or  her  death.^" 

As  noted  above,  in  the  case  of  a  sprinkling  trust,  the  taxable  termi- 
nation doe^  not  occur  until  the  interest  of  the  last  member  of  a  genera- 
tion of  beneficiaries  lias  terminated.  At  that  point,  each  member  of  that 
generation  becomes  the  deemed  transferor  with  respect  to  trust  prop- 
erty transferred  to  his  descendants. 

For  example,  assume  that  the  grantor  creates  a  sprinkling  trust  for 
the  benefit  of  his  grandchildren  A,  B,  and  C  for  life,  with  remainder 
to  his  great  grandchildren.  Upon  the  death  of  the  survivor  of  A,  B,  and 
C,  each  of  these  three  individuals  becomes  a  deemed  transferor  with 
respect  to  any  trust  property  passing  to  his  children. 

The  Act  also  contains  a  rule  to  cover  the  situation  where  it  is  not 
clear  under  the  will  or  trust  instrument  how  the  trust  property  is  to 
be  allocated.  Under  this  rule,  the  property  is  presumed  to  pass  pro  rata 
to  each  beneficiary  in  proportion  to  the  amount  he  would  receive  under 
a  maximum  exercise  of  discretion  in  his  favor. ^*^  It  is  also  to  be  pre- 
sumed that  discretion  will  always  be  exercised  per  stirpes  (unless  a 
contrary  intention  is  expressed  in  the  will  or  trust  instrument). 

For  example,  assume  a  trust  for  the  lifetime  benefit  of  grandchildren 
A,  B,  and  C,  with  the  remainder,  in  the  discretion  of  the  trustee,  to  the 
grantor's  great  grandchildren.  A  has  two  children,  B  has  one  child  and 
C  has  three  children.  Upon  the  death  of  the  survivor  of  A,  B,  and  C, 
each  would  be  treated  as  the  deemed  transferor  witli  respect  to  one- 


'=^  This  assumes  that  each  of  the  butler's  children  are  more  than  371/2  years  yoivnger  than 
tlip  crantor. 

1"  Where  someone  hoUls  a  power  of  appointment  allowing  him  to  appoint  trust  property 
to  anyone  other  than  himself,  his  estate,  or  creditors,  there  would  be  numerous  persons 
who  theoretically  niipht  benefit  under  the  trust.  The  Congress  anticipated  that  the  regu- 
lations will  i)rovide  a  series  of  i)resnmptions  to  cover  sucli  cases  and  will  provide,  for  ex- 
ample, that  sucii  a  power  will  ho  exercised  first  on  behalf  of  lineal  descendants  of  the 
grantor  who  are  members  of  the  younger  generation  immediately  succeeding  the  generation 
whose  interests  hare  all  been  terminated. 


578 

third  of  the  trust  property  (because  it  would  be  presumed,  in  the  ab- 
sence of  a  contrary  indic4ition,  that  the  discretion  would  be  exercised 
per  stirpes,  and  the  maximum  amount  transferred  to  each  of  the  three 
sets  of  great  grandchildren  under  this  presumption  would  be  one-third 
of  the  trust  property). 

Under  another  rule  in  the  Act,  if  any  beneficiary  of  a  generation- 
skipping  trust  is  an  estate,  trust,  partnership,  corporation,  or  other 
entity  (other  tlian  certain  charities,  cliaritable  trusts  and  tax-exempt 
trusts),  eacli  individual  having  an  indirect  interest  (as  defined  in  regu- 
lations) in  the  generation-skipping  trust,  through  means  of  the  entity, 
is  to  be  treated  as  a  beneficiary  of  the  generation-skipping  trust  for 
purposes  of  these  rules. 

Transferee. — In  the  case  of  a  taxable  distribution,  the  "transferee" 
for  purposes  of  the  tax  on  generation-skipping  transfers  is,  of  course, 
the  person  receiving  tlie  distribution.  In  the  case  of  a  taxable  termi- 
nation the  "transferee"  is  generally  any  person  who  has  a  present 
interest  or  power  in  the  trust  or  trust  property  after  the  termination.^" 
For  example,  assume  that  a  trust  is  created  for  the  benefit  of  the 
grantor's  nephew  for  life,  then  to  the  nephew's  son  for  life  and,  upon 
the  death  of  tlie  nephew's  son,  the  entire  trust  is  to  be  distributed  to 
the  issue  of  the  nephew's  son,  ']>er  stirpes.  Upon  the  death  of  the 
nephew,  the  nephew's  son  is  the  transferee  with  respect  to  the  entire 
trust  (because  he  is  entitled  to  all  of  the  trust  income).  Upon  the 
death  of  the  nephew's  son,  each  of  his  issue  entitled  to  receive  a  portion 
of  the  trust  assets  is  to  be  treated  as  a  ti-ansferee  to  the  extent  of  that 
portion.  The  same  result  would  follow  in  the  case  of  a  trust  which 
provided  that,  upon  the  dearh  of  the  nephew,  the  income  was  to  be 
distributed,  on  a  discretionary  basis,  to  the  nephcAv's  ?on  and  the  son's 
issue  with  the  principal  to  be  distributed  to  the  issue  of  the  nephew's 
son  upon  the  son's  death ;  in  this  case,  the  nephew's  son  would  be  the 
transferee  of  the  entire  trust  upon  the  death  of  the  nephew.^*  Upon 
the  death  of  the  nephew's  son,  his  issue  would  become  the  transferees. 

The  term  "transferee"  is  to  be  further  defined  in  regulations.  The 
Congress  intended  that  these  regulations  will  prevent  situations  where 
attempts  are  made  to  minimize  tax  through  the  use  of  nominal 
transferees. 

Liability  for  tax. — Neither  the  deemed  transferor  nor  his  estate  is 
liable  for  the  tax  imposed  under  these  provisions.  (lenerally,  it  was  an- 
ticipated that  the  tax  will  be  paid  out  of  the  proceeds  of  the  trust 
property. 

In  the  case  of  a  taxable  distribution,  however,  the  distributee  of  the 
property  is  pereonally  liable  for  the  tax  to  the  extent  of  the  fair  mar- 


"  GeneraUy  the  person  would  receive  his  present  interest  immediately  after  the  taxable 
termination.  However,  in  certain  cases,  there  mlpht  be  an  intervening  interest  in  a  person 
(i.e.  a  charity)  which  is  not  a  transferee  (sec.  2611(c)  (7)).  In  this  case,  the  transferee  is 
the  person  having  the  next  succeeding  interest.  (In  the  example  which  api)ears  in  the  text, 
the  nephew's  son  would  be  the  transferee  upon  the  death  of  the  nephew,  even  if  the  trust 
provided  that  the  income  was  to  be  paid  to  charity  for  10  years  after  the  date  of  the 
nephew's  death.  Of  course,  if  the  nej)hew's  son  died  before  the  expiration  of  the  10-year 
intervening  interest,  no  taxable  termination  would  occur  upon  his  death  under  the  Act 
because  the  nephew's  son  would  never  have  held  anything  other  than  a  "future  interest" 
in  the  trust  (sec.  2613(h)  (1)).) 

1"  The  nephew's  son  has  an  income  interest  in  the  entire  trust,  he  represents  the  oldest 
generation  then  having  a  present  interest  or  po.ver  and,  for  purposes  of  deternilng  who 
is  a  transferee,  it  Is  presumed  under  the  Act  that  any  discretion  with  respect  to  the  trust 
will  be  exercised  per  stirpes  (sec.  2613(b)  (S) ). 


579 

ket  value  of  the  property  which  lie  receives  (determined  as  of  the  date 
of  the  distribution). 

In  the  case  of  a  taxable  termination,  the  trustee  is  personally  liable 
for  the  tax.  However,  to  minimize  any  imduc  administrative  burden 
or  hardship  for  the  trustee,  under  the  Act,  the  trustee  is  permitted 
to  file  a  request  with  the  Internal  Revenue  Service  for  information 
concerning  the  transfer  tax  rate  bracket  of  the  deemed  transferor. 
Where  the  transfer  is  to  a  grandchild  of  the  grantor  of  the  trust,  the 
trustee  may  also  request  information  concerning  the  extent  to  which 
the  $250,000  exclusion  of  the  deemed  transferor  has  not  been  fully 
utilized.^^  Under  the  Act,  the  trustee  is  not  to  be  liable  for  tax  to  the 
extent  that  any  shortfall  in  the  payment  of  the  tax  ultimately  deter- 
mined to  be  due  results  from  the  trustee's  reliance  on  the  information 
supplied  by  the  Internal  Revenue  Service. 

In  addition,  any  property  transferred  in  a  generation-skipping 
transfer  is  to  be  subject  to  a  lien  for  the  full  amount  of  the  tax  payable 
with  res])ect  to  that  transfer  until  the  tax  lias  been  paid  in  full,  or 
becomes  unenforceable  due  to  the  expiration  of  the  statute  of 
limitations. 

Other  rvles 
(1)  Basis  adjustment. — The  basis  of  property  which  is  subject  to 
tax  as  a  generation-skipping  transfer  is  to  be  increased  (but  not  above 
the  value  of  this  property  used  in  determining  the  amount  of  the  tax) 
by  an  amount  equal  to  the  tax  imposed  with  respect  to  the  appreciation 
element  in  the  value  of  the  property  (determined  as  of  the  applicable 
valuation  date).  Property  in  a  generation-skipping  trust  is  also  to 
receive  the  benefit  of  the  ''fresh  start"  based  on  a  December  31,  1976, 
valuation  date,  which  is  provided,  under  the  Act,  for  property  passing 
or  acquired  from  a  decedent  (in  connection  with  the  rules  under  the 
Act  concerning  "carryover  basis") .  Of  course,  this  "fresh  start"  is  only 
to  be  available  to  the  extent  that  property  passing  through  the  trust  is 
subject  to  the  tax  on  generation-skipping  transfers  and  the  taxable 
transfer  occurs  at  or  after  the  death  of  the  deemed  transferor.  Where 
these  conditions  are  satisfied,  property  held  in  a  generation-skipping 
trust,  or  by  the  grantor  of  a  generation-skipping  trust,  on  December  31, 
1976,  is  to  receive  an  adjustment  to  basis  equal  to  the  excess  (if  any)  of 
the  fair  market  Aalue  of  the  property  on  that  date  over  the  basis  of  the 
property  in  the  hands  of  the  trust  or  its  grantor,  for  purposes  of  deter- 
mining gain  but  not  loss.  Other  issues  in  this  area  are  to  be  determined 
under  regulations  and,  to  the  extent  practicable,  the  rules  with  respect 
to  carryover  basis  in  the  case  of  property  which  is  subject  to  the  tax 
on  generation-skipping  transfers  are  to  be  similar  to  the  rules  which 
apply  in  the  case  of  other  pi-operty  passing  or  acquired  from  a  de- 
cedent. The  trust  is  not  to  be  eligible  for  the  $60,000  minimum  basis 
or  the  $10,000  exclusion  for  personal  or  household  effects.  (Even  if 
tliese  provisions  were  apjdicable,  they  would  be  fully  utilized  by  the 
estate  of  the  deemed  transferor  in  almost  every  case.) 


1*  The  trustee  Is  also  entitled  to  reqiiest  from  the  Service  a  statement  roncerning  the 
Service's  basis  for  valuinfr  proiterty  included  in  the  ireneration-skippina:  transfer.  See  sec. 
Rfa)  below,  "Furnishing  On  Request  of  Statement  Explaining  Estate  or  Gift  Tax  Valua- 
tion." 


580 

(2)  Alternate  rahmtion  date. — The  Act  provides  that  the  alternate 
valuation  date  is  to  be  available  where  a  taxable  termination  occurs 
at  the  doatli  of  the  deemed  transferor.  In  this  case,  the  election  to  use 
the  alternate  valuation  date  is  to  be  made  by  the  trustee  of  the  genera- 
tion-skipping trust  (who  is  also  the  person  liable  for  the  tax  under 
these  circumstances)  and  it  is  not  required  that  the  executor  of  the 
deemed  transferor's  estate  also  elect  the  alternate  valuation  date 
(since  different  persons  are  liable  for  the  tax  and  the  estate  and  the 
trust  may  have  a  different  investment  experience  during:  the  6-month 
period).  The  trustee  is  required  to  make  a  timely  filing  of  the  tax  re- 
turn (including  any  extensions)  in  order  to  receive  the  alternate  valua- 
tion date.  Each  trustee  of  a  trust  in  wliich  there  is  a  taxable  termina- 
tion may  elect  the  alternate  valuation  date  for  the  property  subject 
to  tax,  regardless  of  whether  any  trustee  of  any  other  trust  as  to  which 
there  is  a  taxable  termination  upon  the  death  of  the  deemed  trausferor 
also  elects  tlie  alternate  valuation  date.  However,  where  more  than  one 
taxable  tennination  occurs  in  the  same  trust  at  the  same  time,  the 
trustee  must  select  the  same  valuation  date  for  all  the  transferred 
property. 

As  explained  above,  where  two  or  more  members  of  the  same  genera- 
tion have  present  interests  in  the  same  trust,  a  taxable  termination 
generally  does  not  occur  until  the  last  of  these  interests  terminates. 
Under  the  Act,  the  alternate  valuation  date  is  also  to  be  available  in 
these  circumstances.  For  example,  if  a  trust  is  created  providing  dis- 
cretionary distribution  of  income  to  the  grantors  children,  A,  B,  and 
C,  with  the  remainder  to  be  distributed  to  the  grantor's  great-grand- 
children, then  upon  the  death  of  the  sur\  ivor  of  A,  B,  and  C,  the 
trustee  could  elect  to  use  the  alternate  valuation  date  (6  months  from 
the  death  of  the  survivor)  with  respect  to  all  of  the  trust  assets. 

(3)  Transfers  in  eontemj)Jation  of  death. — The  Act  also  provides 
that  where  the  deemed  transferor  dies  within  three  years  after  a  gen- 
eration-skipping transfer,  the  transfer  is  to  be  treated  as  a  generation- 
skipping  ti-ansfer  at  the  time  of  the  decedent's  death  for  pur- 
poses of  the  tax  on  generation-skippinir  ti-ansfers.  (This  is  closely 
analogous  to  ihi^  estate  tax  treatment  of  gifts  made  within  3  years  of 
the  decedent's  death  under  the  Act  for  estate  tax  purposes.)  In  other 
words,  the  generation-skipping  transfer  is  to  be  taxed,  under  these 
circumstances,  at  the  deemed  transferor's  ti-ansfer  tax  rate  taking  into 
account  his  cunuilati\e  lifetime  and  deathtime  generation-skipping 
transfers  (and  not  just  his  adjusted  taxable  gifts  as  of  the  date  of  the 
generation-skipping  transfer). 

(4)  Nonresident  aliens. — If  the  deemed  transferor  of  any  genera- 
tion-skipping transfer  is  a  nonresident  alien,  the  generation"-skipi)ing 
tax  is  to  be  imposed  only  to  the  extent  that  an  estate  or  gift  tax  would 
be  imposed  in  similar  circumstances  in  the  case  of  an  outright  gift  or 
bequest  by  the  alien. 

(5)  Diselaimers. — A  beneficiai-y  under  a  generation-skipping  trust 
is  permitted  to  disclaim  his  interest  in  that  trust  within  the  same  time 
period  and  in  the  same  manner  as  would  any  beneficiary  of  an  outright 
gift  or  bequest.  (For  a  more  detailed  discussion  of  the  rules  under  the 
Act  concerning  disclaimers,  see  sec.  9(b)  below,  "Disclaimers.")  The 


581 

Congress  also  wished  to  clarify  that  for  purposes  of  the  new  disclaimer 
rules  (sec.  2518),  the  event  which  triggers  the  9-month  period  allowed 
for  an  effective  disclaimer  is  the  genera;tion -skipping  transfer  (either 
a  taxable  termination  or  a  taxable  distribution) . 

(6)  Coordination  wiih  other  estate  and  gift  tax  provisions. — ^The 
Act  provides  that,  to  the  extent  consistent  with  the  specific  provisions 
concerning  generation-skipping  transfers,  the  rules  of  the  Internal 
Revenue  Code  relating  to  gift  tax  are  to  apply  in  the  case  where  the 
deemed  transferor  is  alive  at  the  time  of  the  generation-skipping  trans- 
fer, and  the  rules  relating  to  the  estate  tax  are  to  apply  where  the 
generation-skipping  transfer  occurs  at  or  after  the  death  of  the  deemed 
transferor. 

(7)  Filing  requiremerds. — Generally,  the  reporting  procedures  to 
be  followed  in  the  case  of  a  generation-skipping  transfer  are  similar 
to  those  which  apply  in  the  case  of  a  gift  or  estate  tax  (except  that 
returns  are  to  l)e  filed  with  respect  to  all  such  transfers,  regardless 
of  whether  the  amount  involved  is  sufficient  to  equal  the  amount  of 
the  minimum  filing  requirement  with  respect  to  the  estate  or  ^ift 
tax).  Filing  is  also  to  be  required  in  the  case  of  a  generation-skipping 
transfer  even  if  no  tax  is  payable  because  of  the  $250,000  exclusion. 
More  detailed  rules  with  respect  to  reporting  are  to  be  prescribed  in 
regulations. 

To  the  extent  practicable,  the  regulations  are  to  provide  that  the 
return  is  to  be  filed  by  the  trustee  in  the  case  of  a  taxable  termination 
and  by  the  distributee  in  the  case  of  a  taxable  distribution.  In  the  case 
of  a  generation-skipping  transfer  occurring  before  the  death  of  the 
deemed  transferor  (generally  a  taxable  distribution),  the  return  is  not 
due  until  90  days  after  the  close  of  the  taxable  year  of  the  trust  in 
which  the  transfer  occurs.  In  the  case  of  a  transfer  occurring  at  or 
after  the  death  of  the  deemed  transfei'or,  the  return  is  due  at  the 
later  of  (1 )  90  days  after  the  estate  tax  return  of  the  deemed  transferor 
is  due,  or  (2)  9  months  after  the  generation-skipping  transfer  occurs. 
(Rule  (2)  will  generally  be  used  in  cases  where  a  taxable  termination 
is  postponed  because  there  are  several  present  interests  in  the  same 
trust.)  The  Treasury  Department  is  given  regulatory  authoi'ity  to 
require  the  filing  of  such  information  returns  as  may  be  needed.  The 
CV)ngress  intended  that  the  Service  will  establish  procedures  whereby 
the  person  required  to  file  a  return  in  connection  with  any  generation- 
skipping  transfer  may  receive  information  from  the  Service  concern- 
ing the  deemed  transferor's  marginal  transfer  tax  rate  base  and  other 
information  which  is  necessary  in  order  to  properl}'  prepare  the  return 
(or  anv  refund  claim) . 

Under  the  Act,  generation-ski])ping  transfers  are  generally  subject 
to  the  procedural  lules  of  Subtitle  F  which  are  applicable  to  gift  and 
estate  taxes  but,  of  course,  the  si^ecific  provisions  of  the  Act  override 
this  general  rule  in  the  area  of  filing  requirements.  However,  where 
not  inconsistent  with  the  Act,  the  provisions  of  Subtitle  F  apply  and 
the  Internal  Revenue  Service,  for  example,  may  grant  an  extension  of 
up  to  6  months  for  filing  any  return  required  with  respect  to  a  qenera- 
tion-skipping  transfer  (sec.  6081),  or  grant  an  extension  for  the  pay- 
ment of  the  tax  (see  sec.  6161). 


234-120  O  -  77 


582 

Effective  dates 

Under  the  Act,  these  provisions  apply  generally  to  transfers  made 
after  A.pril  30,  197().  However,  the  tax  does  not  apply  in  the  case  of 
transfers  under  irrevocable  trusts  in  existence  on  April  30.  1976,  or 
in  the  case  of  decedents  dyino-  before  Jaiuiary  1,  1982,  pursuant  to  a 
will  (or  revocable  trust)  which  was  in  existence  on  April  30,  1970, 
and  which  was  not  amended  (except  in  respects  which  do  not  result 
in  the  creation  of,  or  increase  the  amount  of,  a  generation-skipping 
ti-ansfer)  at  any  time  after  that  date.  The  1982  date  is  extended  in 
certain  cases  where  the  testator  is  incompetent  to  change  the  disposi- 
tion of  his  property. 

For  purposes  of  this  transition  rule,  a  change  of  trustee  is  not  a 
change  creating  or  increasing  the  amount  of  a  generation-skipping 
transfer.  Also,  an  amendment  changing  the  beneficiaries,  or  a  change 
in  the  size  of  the  share  used  for  the  benefit  of  a  particular  beneficiary, 
does  not  disqualify  the  trust  under  the  transition  rule,  so  long  as  the 
number  of  younger  generations  provided  for  under  the  trust  (or  the 
potential  duration  of  the  trust  in  terms  of  younger  generation  bene- 
ficiaries) is  not  expanded  and  the  total  value  of  the  interests  of  all 
beneficiaries  in  each  generation  below  the  grantor's  generation  is  not 
increased.  For  example,  assume  a  revocable  trust  was  created  prior  to 
April  30, 1976,  for  the  benefit  of  the  grantor's  ne])hews,  A,  B,  and  C,  in 
equal  shares  for  life,  with  the  remainder  to  be  distributed  to  the  chil- 
dren of  A,  B,  and  C.  A  becomes  disabled  and  tiie  trust  is  modified  to 
increase  his  share  of  the  income;  this  does  not  disqualify  the  trust  be- 
cause it  does  not  create  or  increase  the  amount  of  a  generation-skipping 
transfer.  Likewise,  if  the  trust  is  amended  to  include  nephew  D  as  an 
income  beneficiary,  this  would  not  dis(jualify  the  trust  under  the  tran- 
sition rules.  However,  if  the  trust  were  amended  so  that  the  income  was 
to  be  held  in  trust  for  the  lives  of  the  children  of  A,  B,  and  C,  with  the 
remainder  distributed  to  the  nephews'  grandchildren,  this  would  in- 
crease generation-skipping  (by  increasing  the  number  of  generations 
skipped)  and  would  disqualify  the  trust.  An  amendment  creating  a 
power  of  appointment  would  also  disqualify  the  trust  if  there  were 
any  possibility,  under  the  power  of  appointment,  of  increasing  the 
number  of  generations  which  might  be  skipped. 

In  some  cases,  a  trust  which  is  irrevocable  on  April  30,  1976,  might 
also  be  subject  to  a  power  of  ai)pointment  under  which  it  might  be 
possible  for  the  property  to  continue  to  be  held  in  trust  for  the  benefit 
of  new  beneficiaries,  some  of  whom  might  be  members  of  the  generation 
younger  than  any  beneficiaries  expressly  covered  under  the  trust  prior 
to  the  exercise  of  the  power.  Under  the  Act,  the  grandfather  provision 
will  apply  to  such  a  trust  which  includes  a  limited  pon'er  of  appoint- 
ment, so  long  as  the  exercise  of  the  power  (including  the  creation  of  a 
MOW  trust)  does  not  result  in  the  creation  of  an  interest  which  post- 
pones, or  suspends,  the  vesting  of  any  estate  or  interest  in  the  trust 
property  for  a  period  ascertainable  without  regard  to  the  date  of  the 
creation  of  the  trust.  In  the  case  where  the  power  is  exercised  after 
April  30,  1976,  by  creating  another  power  and  the  applicable  rule 
against  perpetuities  is  stated  in  terms  of  sus])ension  of  ownership  or 
power  of  alienation,  the  grandfather  provision  will  not  apply  if  the 


583 

second  power  can  be  exercised  to  suspend  the  absolute  ownership  or 
power  of  alienation  of  the  property  ascertainable  without  regard  to 
the  date  of  creation  of  the  first  power.  For  tliis  purpose,  the  second 
power  of  alienation  of  the  property  for  a  period  ascertainable  without 
regard  to  the  date  of  ciention  of  tlie  first  power.  For  this  purpose,  the 
second  power  will  not  result  in  a  loss  of  the  grandfather  piotection  if 
(1)  the  1)0 wer  can  only  be  exercised  so  that  it  satisfies  the  suspension  of 
ownership  or  power  of  alienation  requirements,  and  (2)  the  applicable 
provisions  in  default  of  appointment  also  satisfy  these  requirements. 

7.  Orphans'  Exclusion  (sec.  2007  of  the  Act  and  new  sec.  2057  of  the 
Code) 

Prior  law 
Prior  to  the  Act,  there  was  no  provision  which  allowed  an  estate  tax 
deduction  from  the  value  of  the  gross  estate  for  the  value  of  any 
interest  in  property  which  passes  or  has  passed  to  an  orphaned  child 
of  the  decedent. 

General  reasons  for  change 

For  purposes  of  the  Federal  estate  tax  law,  transfers  to  charities 
and  surviving  spouses  are  generally  the  only  testamentary  transfers 
which  are  treated  more  favorably  than  other  testamentary  transfers. 
The  Congress  believed,  however,  Avhere  an  interest  in  property  passes 
or  has  passed  to  a  minor  orphan,  a  limited  deduction  from  the  value 
of  the  gross  estate  of  tlie  decedent  for  such  interest  should  bo  allowed. 
This  is  based  on  the  view  that  during  the  child's  minority  there  was  a 
generally  accepted  i-esponsibility  on  the  part  of  the  decedent  to  sup- 
port the  child,  a  responsibility  "whicli  cannot  be  satisfied  in  this  case 
by  passing  property  to  a  surviving  spouse  to  bo  used  for  the  child's 
support. 

Explanatton  of  provision 

The  Act  adds  a  new  provision  (sec.  2057)  which,  in  general,  pro- 
vides a  limited  deduction  from  the  value  of  the  gross  estate  of  a  de- 
cedent for  an  amount  equal  to  the  value  of  any  interest  in  property 
which  passes  or  has  passed  to  a  minor  child  of  the  decedent.  The  de- 
duction is  allowed  only  if  the  child  has  no  known  surviving  parent 
and  the  decedent  doesnot  have  a  surviving  spouse.  For  purposes  of 
this  provision,  a  minor  child,  whether  natural  or  by  legal  adoption,  is 
any  child  of  the  decedent  who  has  not  attained  the  age  of  21  years 
before  the  date  of  the  decedent's  death. 

The  aggregate  amount  of  the  deduction  allowed  under  this  pro- 
vision may  not  exceed  an  amount  equal  to  $5,000  multiplied  by  the 
excess  of  21  over  the  child's  attained  age,  in  years,  on  the  date  of  the 
decedent's  death.  For  example,  Avhere  interests  in  pioperties  pass  from 
the  decedent  to  the  decedent's  minor  child  (and  the  other  qualifica- 
tions of  this  provision  are  met)  whose  acre  on  the  decedent's  date  of 
death  is  15.  the  maxinmm  amount  allowable  as  n  deduction  is  e(|ual  to 
$30,000  (the  excess  of  21  over  the  child's  age  of  15,  i.e.,  6,  multiplied 
by  $5,000). 

In  the  case  of  divorced  parents,  where  the  decedent  is  survived  by 
the  other  known  parent,  a  deduction  under  this  section  will  not  be 


allowed.  However,  a  relationship  by  lethal  adoption  supplants  the  rela- 
tionship by  blood  for  purposes  of  this  provision.  Thus,  the  provision 
will  allow  a  deduction  to  tlie  estate  of  a  deceased  adoptive  parent  who 
is  not  survived  by  a  sj)Ouse  even  thou<2;li  one  or  botlj  of  the  natural  par- 
ents of  the  child  arc  known  and  survi\  ing.  However,  an  adoption  will 
not  supplant  the  relationship  by  blood  where  it  can  be  shown  that  the 
adoption  was  motivated  to  obtain  the  benefits  of  this  provision. 

Subject  to  the  limitations  below,  the  amount  allowed  as  a  deduc- 
tion cannot  exceed  the  value  of  property  which  is  included  in  deter- 
mining the  value  of  the  gross  estate  and  which  passes  or  has  passed 
from  the  decedent  to  the  minor  cliild.  The  determination  of  whether 
an  interest  in  property  passes  or  has  passed  from  the  decedent  to  a  par- 
ticular person  is  to  be  made  in  accordance  with  rules  prescribed  under 
present  law  foi-  marital  deduction  pui-poses  (sec.  20.56(d) ). 

With  respect  to  interests  in  property  which  pass  or  iiave  passed  to 
a  minor  child,  generally,  only  those  interests  w^ill  be  taken  into  account 
which  are  of  the  quality  that,  if  they  passed  to  a  surviving  spouse, 
would  have  been  allowable  as  a  marital  deduction  under  section  2056 
(b)  (pertaining  to  life  estates  or  other  terminable  interests) .  However, 
an  interest  will  not  be  treated  as  a  terminable  interest  solely  because  the 
property  will  pass  to  another  person  if  the  child  dies  before  the  young- 
est then  living  child  of  the  decedent  attains  age  21. 

Effective  date 
The  amendments  made  by  this  provision  are  to  apply  to  the  estates 
of  decedents  dying  after  December  31, 1976. 

8.  Administrative  Changes 

a.  Furnishing  On  Request  of  Statement  Explaining  Estate  or 
Gift  Valuation  (sec.  2008(a)  of  the  Act  and  sec.  7517  of  the 
Code) 

Prior  law 
Under  the  estate  tax  law ,  the  value  of  the  gross  estate  or  the  value  of 
a  gift  is  reported  by  the  executor  of  an  estate  or  donor  of  a  gift,  as  the 
case  may  be,  at  what  he  belicAes  to  be  fair  market  value  at  tlie  date  of 
death  of  a  decedent  (or  alternate  valuation  date,  if  elected),  in  the 
case  of  an  estate  oi-  at  the  time  the  gift  was  made  in  the  case  of  a  gift. 
The  Internal  Revenue  Service  is  authorized  to  make  such  inquiry  as  is 
necessary  to  determine  the  correctness  of  the  return  of  the  taxpayer 
and  make  a  deteiniination  or  proposed  determination  as  to  tlu  value 
of  any  interests,  rights,  or  powers  with  respect  to  property,  whether 
real  or  personal,  for  estate  or  gift  tax  i)urposes.  In  these  situations, 
there  was  no  administrative  provision  under  jn-ior  law  which  provided 
an  affirmative  requirement  on  the  part  of  the  Internal  Revenue  Service 
to  disclose  the  method  or  basis  by  wh.ich  the  Service  arrived  at  its 
determination  of  value. 

Reasons  for  change 

The  Congress  believed  that,  in  those  situations  where  the  Service 
has  made  a  determination  as  to  the  value  of  an  item  of  property  which 
differs  from  the  value  of  the  property  as  reported  by  the  execu- 
tor or  donor  taxpayer,  it  should  encourage  resolution  of  differences  at 


585 

the  earliest  time.  The  Congress  believed  that  this  problem  can  best 
be  resolved  by  each  having  full  information  as  to  how  the  other 
ai'rived  at  liis  valuation.  Therefore,  it  appeared  appropriate  for  the 
executor  of  an  estate  or  the  donor  of  .i  gift  to  be  able  to  ascertain 
by  what  method  the  Service  arrived  at  a  valuation. 

Explc.nation  of  provision 

The  Act  provides  that  if  the  Internal  Revenue  Service  makes  a  de- 
termination or  a  proposed  determination  of  the  value  of  an  item  of 
property  for  purposes  of  the  estate  or  gift  tax  law,  then,  upon  written 
request  of  the  executor  or  donor  (as  the  case  may  be),  the  Service 
is  to  furnish  a  written  statement  with  respect  to  the  value  of  such 
item  of  property.^  This  statement  is  to  be  furnished  within  45  days 
of  the  later  of  the  date  the  request  for  the  statement  is  made  or  the 
date  of  the  determination,  or  proposed  determination,  by  the  Service. 

The  w^ritten  statement  required  to  be  furnished  to  the  executor  or 
donor,  as  the  case  may  be,  under  this  provision,  is  to  explain  the  basis 
on  which  the  valuation  was  determined  or  proposed  and  to  set  forth  the 
details  of  any  computation  used  in  arriving  at  such  value.  In  addi- 
tion, the  statement  is  to  contain  a  copy  of  any  written  expert  appraisal 
of  the  property  made  by  or  for  the  Service. 

The  statement  to  be  furnished  by  the  Service  is  intended  to  provide 
the  executor  of  an  estate  or  the  donor  of  a  gift  with  sufficient  informa- 
tion for  such  executor  or  donor  to  determine  the  methods  of  valua- 
tion and  computations  used  by  the  Service.  The  statement  is  not 
intended  to  be  a  final  representation  of  the  Service's  position  and,  con- 
sequently, the  value  of  the  item  of  property  as  determined  or  jjroposed 
by  the  Service  with  respect  to  which  the  statement  is  furnished,  and 
the  method  and  computations  used  in  arriving  at  such  value,  is  not  to 
be  binding  on  the  Service. 

Efective  date 
This  amendment  is  effective  for  estate  tax  purposes  as  to  estates  of 
decedents  dying  after  December  31,  1976,  and  for  gift  tax  purposes 
to  gifts  made  after  December  31, 1976. 

b.  Special  Rule  for  Filina  Returns  Where  Gifts  in  Calendar  Quar- 
ter Total  $25,000  or  Less  (sec.  2008(b)  of  the  Act  and  sec.  6075 
of  the  Code) 

Prior  Imo 

Under  prior  law,  a  gift  tax  return  generally  had  to  be  filed  for  each 
calendar  quarter  in  which  a  donor  transferred  by  gift  a  present  interest 
of  an  amount  in  excess  of  the  annual  $3,000  exclusion  per  donee.  Any 
gift  of  a  future  interest  must  be  reported  on  a  gift  tax  return  for  the 
quarter  in  which  the  gift  is  made,  regardless  of  the  amount  of  the 
gift.  Special  filing  requirements  are  provided  for  qualified  charitable 
transfers. 

A  Federal  gift  tax  return,  if  required,  is  due  on  or  before  the  15th 
day  of  the  second  month  following  the  close  of  the  calendar  quarter 
in  which  a  gift  is  made,  unless  an  extension  of  time  has  been  granted. 


1  These   provisions    are    also    intended    to    apply    with    respect    to    generation-skipping 
transfers. 


586 

General  reasons  for  change 

Prior  to  the  enactment  of  the  Excise,  Estate  and  Gift  Tax  Adjust- 
ment Act  of  197().^'  tlio  due  date  for  tiling  a  gift  rax  return  was 
April  15  following  the  calendar  year  in  which  a  gift  was  made.  This 
Act  provided  a  requirement  for  the  (juarterly  tiling  of  gift  tax  returns, 
except  for  certain  gifts  to  a  charity,  to  ])rovide  for  the  more  current 
payment  of  gift  tax  liabilities.  Thus,  it  sul)stantially  limited  the  de- 
ferral of  tax  liability  which  had  been  available  under  prior  law  (tliis 
deferi-al  could  have  been  as  much  as  151/^  months  during  which  time 
the  donor  had  the  interest-free  use  of  the  funds  due  on  the  gift  tax 
liability).  Since  the  enactment  of  this  provision,  the  total  number  of 
gift  tax  returns  filed  has  continually  increased. 

For  the  three  vears  prior  to  the  enactment  of  the  quarterly  gift 
tax  return  filing  requirement,  the  Internal  Kevenue  Service  processed 
an  average  of  142,000  gift  tax  returns.  More  specifically,  for  the  calen- 
dar years  ending  December  81,  1967.  ISHW,  and  19()9,  the  Service  proc- 
essed 1'37,00(),  i;39,000  and  151,000  gift  tax  returns,  respectively.  Since 
the  enactment  of  the  ipiarterly  gift  tax  return  filing  requirement,  the 
total  number  of  gift  tax  returns  processed  by  the  Service  has  in- 
creased. For  the  three  calendar  years  ending  Decendjer  31,  1973,  1974 
and  1975,  for  which  data  are  available,  the  total  nu.ml)er  of  gift  tax 
returns  processed  by  the  Service  was  '244.000. 253,000,  and  270,000  (pre- 
liminary), respectively.  \\  is  anticipated  that  with  the  modification 
of  the  quarterly  gift  tax  retuin  filing  lequirement  provided  for  in  this 
Act,  rhe  administrative  burden  will  l)e  alleviated  somewhat. 

In  addition,  an  unintended  substantive  change  in  the  law.  because 
of  tlie  quarterly  filing  requirement,  was  brought  to  the  attention  of 
(^ongress.  Under  pi'ior  law.  a  nuirital  deduction  was  allowed  equal 
to  one-half  the  value  of  the  gifts  made  to  a  spouse  (sec.  2523).  Plow- 
ever,  tlie  gift  tax  marital  deduction  is  limited  to  the  amount  of  gifts 
remaining  after  the  annual  exclusion  of  $3,000  has  been  deducted  from 
the  total  amount  of  the  gifts  ))assing  to  the  spouse  (sec.  2524). 

Prior  to  the  change  in  the  gift  tax  law  which  recpiired  the  quarterly 
filing  of  gift  tax  returns,  the  limitation  on  the  marital  deduction 
allowed  was  computed  on  the  basis  of  tlie  aggi'egate  amount  of  gifts 
made  to  a  spouse  during  a  calendar  year.  If  the  aggregate  amount 
of  gifts  made  to  a  spouse  during  a  calendar  year  was  equal  to  or 
greater  than  $0,000,  the  marital  deduction  was  unaffected  by  the 
limitation. 

The  limitation  on  the  marital  deduction  allowed  with  respect  to 
interspousal  gifts  made  after  December  31,  1970,  is  applied  on  a  quar- 
terly basis  rather  than  on  a  calendar  year  basis,  which  places  a  pre- 
mium on  the  amount  and  timino-  of  an  interspousal  gift  in  order  not  to 
lose  part  of  the  ma)'iial  dedn<'tion. 

The  effect  of  the  cliange  in  the  filing  requirements  may  be  illustrated 
by  the  following  example.  If.  prior  to  the  filinii:  requirements  changes, 
the  don(yr  made  separate  gifts  of  $4,000  and  $2,000  in  different  calen- 
dar quarters  of  a  vear,  no  jrift  tax  would  be  imposed  with  respect 
to  those  gifts  (total  gifts  of  $6,000  less  $3,000  for  the  marital  deduc- 
tion and  $3,000  for  the  annual  exclusion).  I.'  the  same  amount  of 
gifts  were  giA-en  in  different  quarters  under  the  quarterly  filing  sys- 


2  Public  Law  91-614. 


587 

tern,  no  ^ift  tax  would  be  imposed  witli  respect  to  the  $4,000  ofift 
($4,000  ojift  less  $1,000  marital  deduction  and  $8,000  annnal  exclu- 
sion). The  marital  deduction  is  only  $1,000  because  it  is  limited  to 
the  amount  of  p;ifts  i-emainino-  after  deduction  for  the  annual  exclu- 
sion. However,  for  the  subsequent  quarter  in  which  the  $2,000  gift  is 
made,  the  donor  would  have  been  treated  as  making-  $1,000  in  taxable 
gifts  ($2,000  gift  less  $1,000  marital  deduction  and  no  amount  of  the 
exclusion  is  taken  into  account  since  it  has  been  used  against  the  value 
of  the  gift  made  in  the  preceding  quarter).  Thus,  the  donor's  taxable 
gifts  for  the  year  have  been  increased  by  $1,000  solely  because  of  the 
quarterly  filing  requirements. 

The  Act  alleviates,  in  part,  this  problem  by  providing  an  exception 
to  the  quarterly  gift  tax  return  filing  requirement  where  total  cumu- 
lative taxable  gifts  made  during  a  calendar  quarter  do  not  exceed  $25,- 
000.  The  problem  will  also  be  alleviated  by  the  gift  tax  marital  deduc- 
tion changes  made  by  the  Act.  This  change  also  decreases  the  burden  of 
compliance  for  donors  of  smaller  amounts  of  taxable  gifts. 

Explanation  of  jwovision 

The  Act  provides  that  a  gift  tax  return  is  required  to  be  filed  on  a 
quarterly  basis  only  when  the  sum  of  (1)  the  taxable  gifts  made  dur- 
ing the  calendar  quarter  plus  (2)  all  other  taxable  gifts  made  during 
the  calendar  year  (and  for  which  a  return  lias  not  yet  been  required  to 
be  filed)  exceeds  $25,000.  For  example,  where  a  donor  makes  a  taxable 
gift  valued  at  $23,000  in  the  first  quarter  of  a  calendar  year  and  an 
additional  taxable  gift  valued  at  $6,000  in  tlie  second  quarter  of  the 
same  calendar  year,  a  gift  tax  return  reporting  tlie  aggregate  amount 
of  taxable  gifts  is  not  required  until  the  15th  day  of  the  second  month 
following  the  close  of  the  second  quarter.  If,  in  addition  to  these  two 
taxable  gifts,  a  third  taxable  gift  valued  at  $10,000  is  made  during 
the  third  quarter  of  the  same  calendar  year  and  no  other  taxable  gifts 
are  made  during  such  calendar  year,  the  gift  tax  return  reporting  the 
taxable  gift  made  during  the  third  quarter  is  required  by  the  15th  day 
of  the  second  month  following  the  close  of  the  fourth  calendar  quarter 
of  the  calendar  year  in  which  the  $10,000  taxable  gift  was  made. 

For  all  transfers  made  in  the  calendar  year  which  are  subject  to 
the  gift  tax  filing  requirements  but  do  not  exceed  $25,000  in  taxable 
gifts,  a  return  need  be  filed  only  bv  the  filing  date  for  gifts  made 
in  the  fourth  calendar  quarter  of  the  calendar  year.  In  the  case  of 
nonresidents  not  citizens  of  the  United  States,  the  same  rules  are  to 
apply  except  that  $12,500  is  substituted  for  $25,000. 

Effective  date 
This  provision  is  effective  for  gifts  made  after  December  31,  1976. 

c.  Public  Index  of  Filed  Tax  Liens  (sec.  2008(c)  of  the  Act  and 
sec.  6323  of  the  Code) 

Pj^ior  lav 
Under  prior  law  (sec.  6323),  a  Federal  tax  lien  takes  ]>riority,  with 
certain  relatively  limited  exceptions,  over  interests  in  the  property 
subject  to  the  lien  which  are  held  by  purchasers,  holders  of  a  security 
interest,  mechanic's  lienors  and  judgment  lien  creditors,  if  notice  of 
the  tax  lien  has  been  appropriately  filed  before  such  interests  are 
acquired. 


588 

Reasons  for  change 
Under  prior  law,  the  filing  of  a  notice  of  lien  was  effective  even  if 
the  notice  of  lien  had  not  been  recorded ;  thus,  it  was  possible  that  pro- 
spective purchasers  or  secured  creditors  of  the  particular  property 
may  not  had  an  opportunity  to  discover  the  existence  of  the  lien. 
The  Congress  was  made  aware  of  a  recent  case*  in  which  the 
Government  was  held  to  have  satisfied  the  requirements  for  filing 
notices  of  lien  even  though,  through  an  oversight  by  a  State  official, 
the  notices  of  lien  were  not  recorded  on  the  public  Federal  tax  lien 
index.  A  title  search  of  the  property  did  not  reveal  the  existence  of 
the  tax  liens  and,  despite  the  lack  of  actual  notice,  purchasers  of  the 
property  took  title  subject  to  the  Federal  tax  liens. 

Explanation  of  provision 

The  Act  provides  that  a  notice  of  a  lien  is  not  to  be  treated  as  meet- 
ing the  filing  requirements  unless  a  public  index  of  the  lien  is  main- 
tained at  the  district  Internal  Revenue  Service  office  in  which  the  prop- 
erty subject  to  the  lien  is  situated.  For  this  purpose,  an  index  of  liens 
affecting  real  property  would  be  maintained  in  the  district  office  for 
the  area  in  which  the  real  property  is  physically  located.  In  the  case  of 
liens  affecting  personal  property,  the  index  would  be  maintained  in  the 
district  office  for  the  area  in  which  the  residence  of  tho.  taxpayer  is  lo- 
cated at  the  time  the  notice  of  lien  is  filed. 

The  Congress  understood  that  the  Internal  Revenue  Service  also 
will  use  its  best  efforts  to  make  follow-up  checks  on  the  recordation  or 
indexing  notices  of  lien  which  are  filed  after  the  date  of  enactment 
v.dth  offices  designated  under  local  law  as  the  place  for  filing  notices 
of  effective  date  lien. 

The  Act  is  effective  on  February  1,  1977,  in  the  case  of  notices  filed 
on  or  after  October  4,  1976.  In  the  case  of  liens  filed  before  October  4, 
1976,  the  Act  is  effective  on  July  1, 1977. 

9.  Miscellaneous  Provisions 

a.  Inclusion  of  Stock  in  Decedent's  Estate  Where  Decedent  Re- 
tains Voting  Rights  (sec,  2009(a)  of  the  Act  and  sec,  2036  of 
the  Code) 

Prior  law 
Under  prior  law,  an  inter  vivos  transfer  of  property  which  had  been 
made  by  a  decedent  is  required  to  be  included  in  the  decedent's  gross 
estate  if  he  retained  for  his  lifetime  either  the  right  to  possess  or  enjoy 
the  property  or  the  right  to  designate  the  person  who  will  possess  or 
enjoy  the  property.^  In  United  States  v.  Byrum,^  the  Supreme  Court 
held  tliat  the  stock  of  a  closely  held  corporation  was  not  includible  in 
the  decedent's  gross  estate  where  the  decedent  had  irrevocably  trans- 
ferred the  stock  in  trust  reserving  the  power  to  (1)  remove  the  trustee 
and  appoint  another  corporate  trustee.  (2)  vote  the  closely  held  stock. 
(3)  veto  the  sale  or  other  transfer  of  the  trust  property,  and  (4)  veto 
any  change  in  investments.  The  Court  found  that  the  reserved  rights 


*Adams  v.  Utiited  States,  F.  Supp.  ,  76-1  USTC  H  9457   (S.D.N.Y.  Ift76). 

'  Sec    2036. 

»  408  U.S.  125  (1972). 


589 

did  not  constitute  retained  enjoyment  of  the  stock  or  the  right  to  des- 
ignate the  person  or  pereons  who  would  enjoy  the  stock  or  the  income 
from  the  stock. 

Reasons  for  change 
The  Congress  believed  that  the  voting  rights  are  so  significant  with 
respect  to  corporate  stock  that  the  retention  of  voting  rights  by  a 
donor  should  be  treated  as  the  retention  of  the  enjoyment  of  the  stock 
for  estate  tax  purposes.  The  Congress  believed  that  this  treatment  is 
necessary  to  prevent  the  avoidance  of  estate  taxes.^ 

Eivplanation  of  provision 
The  Act  would  provide  that  the  retention  of  voting  rights  in  trans- 
ferred stock  is  to  be  treated  as  a  retention  of  the  enjoyment  of  the 
stock.  Tlie  value  of  the  stock  is  to  be  includible  in  a  decedent's  gross 
estate  if  the  decedent  retained  the  voting  rights  for  his  life,  for  any 
period  not  ascertainable  without  reference  to  his  death,  or  for  any 
period  which  does  not  in  fact  end  before  his  death.  The  provision  is 
to  apply  even  if  the  stock  is  issued  by  a  corporation  which  had  not 
been  directly  or  indirectly  controlled  by  the  decedent.  For  purposes 
of  the  provision,  the  capacity  in  which  the  decedent  could  exercise  the 
voting  rights  is  immaterial. 

Effectin)e  date 
The  amendment  is  to  apply  to  transfers  made  after  June  22,  1976. 

h.  Treatment  of  Disclaimers  (sec.  2009  of  the  Act  and  sees.  2041, 
2045, 2055,  2056,  2514,  and  2518  of  the  Code) 

Prior  Jaw 

In  general,  a  disclaimer  (or  renunciation)  is  a  refusal  to  accept  the 
OAvnership  of  property  or  rights  with  respect  to  property.  If  recog- 
nized for  Federal  transfer  tax  purposes,  a  disclaimer  of  property  re- 
ceivable by  inheritance  or  gift  is  not  treated  as  a  taxable  transfer  by 
the  person  making  the  disclaimer.  In  addition,  a  disclaimer  may  result 
in  increasing  the  amount  to  the  estate  tax  charitable  or  marital  deduc- 
tion if  the  property  disclaimed  passes  to  a  charity  or  a  surviving 
spouse. 

Under  prioi-  law,  the  tax  consequences  resulting  from  an  effective 
disclaimer  in  certain  cases  was  prescribed  under  several  code  provi- 
sions. Under  the  provisions  relating  to  powers  of  appointment,  a 
disclaimer  of  a  general  power  of  appointment  is  not  treated  as  a  re- 
lease of  the  power  and,  tlierefore.  is  not  a  taxable  transfer.*  Under  the 
estate  tax  charitable  and  marital  deduction  provisions,  property  is 
considered  to  pass  from  the  decedent  to  the  person  who  receives  it  by 


3  One  commentator  has  suggested  that  "[t]he  'ultimate'  In  estate  planning  for  most 
controlling  stockholders  of  closely  held  corporations  is  the  avoidance  of  a  Federal  estate 
tax  on  corporate  voting  shares  that  they  have  transferred  to  a  trust  in  which  they  have 
reserved  the  uninterrupted  right  to  continue  voting  the  shares."  Pressment.  "Effect  of 
Tax  Court's  Oilman  Dp  *sion  on  ^"stUe  Ti'anninc  for  the  Close  Corporation."  44  The  Jour- 
nal of  Taxation,  160  (March  1976).  This  commentator  further  suggests  that  the  value 
of  the  gift  micrht  he  re'n  ed  hv  t>ie  v.olue  -ittribut-ible  to  the  retained  voting  rights.  If  this 
is  done,  the  value  attributed  to  voting  rights  would  not  be  subject  to  either  the  gift  tax 
at  the  time  of  the  gift  or,  under  the  Bijrutn  decision,  the  estate  tax  upon  the  death  of 
the  donor. 

*  Sections  2041(a) (2)  and  2514(b). 


590 

reason  of  the  discLaimer.^  Under  the  gift  tax  regulations  relating  to 
transfers  in  general,  a  disclaimer  must  comply  with  local  law  in  order 
to  be  valid  for  gift  tax  purposes.*^ 

Prior  law  does  not  provide  either  definitive  rules  as  to  what 
constitutes  a  "disclaimer"  or  rules  of  general  application  concerning 
the  tax  consequences  of  a  disclaimer.  The  Federal  tax  consequences  of  a 
disclaimer  has  largely  depended  upon  its  treatment  under  local  law, 
i.e.,  its  treatment  as  a  disclaimer  so  that  the  person  disclaiming  is  not 
considered  to  have  held  title  to  the  property  at  any  time.  Although 
the  Commissioners  on  Uniform  State  Laws  proposed  a  Uniform  Dis- 
claimer Act  in  1973,  the  State  laws  relating  to  disclaimers  are  not 
\miform.  In  addition,  some  States  have  not  enacted  any  statutory 
provisions  and  the  disclaimer  rules,  if  any,  have  been  developed  b}^  the 
courts.  As  a  result,  identical  refusals  to  accept  property  may  be  treated 
differently  for  estate  and  gift  tax  purposes  depending  upon  applicable 
local  law. 

For  many  of  the  estate  and  gift  tax  provisions  described  above,  no 
specific  time  period  is  prescribed  within  which  a  disclaimer  must  be 
made  in  order  to  be  recognized  for  Federal  transfer  tax  purposes. 
Except  in  the  case  of  the  treatment  of  disclaimers  affecting  the  estate 
tax  marital  or  charitable  deductions  (which  must  be  made  before  the 
due  date  of  the  return) ,  the  disclaimer  is  required  to  be  made  within  a 
"reasonable"  time  after  the  person  disclaiming  learns  of  the  existence 
of  his  interest  in  a  property  transfer.  In  one  case,  a  remainderman,  who 
was  aware  of  his  interest,  was  considered  to  have  made  a  disclaimer  of 
his  remainder  interest  within  a  "reasonable"  time  for  gift  tax  purposes 
when  he  disclaimed  shortly  after  the  expiration  of  a  life  tenancy 
which  had  continued  for  19  years  after  the  grantor's  death. ^  The  deci- 
sion in  this  case  might  not  applj^  in  other  cases  involving  the  same 
facts  depending  upon  the  applicable  local  law. 

Reasons  for  change 
The  Congress  believed  that  definitive  rules  concerning  disclaimers 
should  be  provided  for  estate  and  gift  tax  purposes  to  achieve  uni- 
form treatment.®  In  addition,  the  Congress  believed  that  a  uniform 
standard  should  be  provided  for  determining  the  time  within  which  a 
disclaimer  must  be  made. 

Explanation  of  provision 
The  Act  provides  definitive  rules  relating  to  disclaimers  for  pur- 
poses of  the  estate,  gift  and  generation-skipping  transfer  taxes.  If  the 
requirements  of  the  provision  are  satisfied,  a  refusal  to  accept  prop- 
erty is  to  be  gi\en  effect  for  Federal  estate  and  gift  tax  purposes  even 
if  the  applicable  local  law  does  not  technically  characterize  the  refusal 
as  a  "disclaimer"  or  if  the  person  refusing  the  property  Mas  considered 
to  have  been  the  owner  of  the  legal  title  to  the  property  before  refusing 

"Sections  205.^(a)  and  2056(d). 

«  Troas.  Keg.  Sec.  25.2511-l(c). 

'Kenneth  v.  Commissioner,  480  F.  2d  57  (8th  Cir.  1973),  rcx^'g  58  T.C.  852  (1972). 

*  It  Is  noted  that  many  professional  stud.v  sronps  have  recommended  that  definitive 
rules  l)e  iirovided  with  respect  to  the  treatment  of  disclaimers  for  estate  and  pift  tax 
purposes.  See  American  Bar  Association  recommendation  number  1974-2,  27  Tax  Lawyer 
81.8  (1974)  ;  American  Law  Institute  recommendations  21  and  22.  "Federal  Estate  and 
Gift  Taxation  :  Recommendations  Adopted  by  the  American  Law  Institute."  ip.  39-41 
(1908)  :  "Ta.K  Reform  Studies  and  Proposals:  U.S.  Treasury  Department."  v.  387  (19(>9)  ; 
American  Bankers  Association,  "Commentary  on  Proposed  Tax  Reform  Affecting  Estates 
and  Trusts,"  p.  166  of  appendix  A  (1973). 


591 

acceptance  of  the  property.  If  a  qualified  disclaimer  is  made,  the  Fed- 
eral estate,  gift,  and  generation-skipping  transfer  tax  provisions  are  to 
apply  with  respect  to  the  property  interest  disclaimed  as  if  the  interest 
had  never  been  transferred  to  the  person  making  the  disclaimer. 

A  person  making  a  qualified  disclaimer  is  not  to  be  treated  as  hav- 
ing made  a  gift  to  the  person  to  whom  the  intere.st  passes  by  reason  of 
the  disclaimer.  In  addition,  the  disclaimer  is  to  be  taken  into  account 
for  purposes  of  the  estate  tax  charitable  and  marital  deduction  as 
under  present  law.  A  qualified  disclaimer  of  a  general  power  of  ap- 
pointment is  not  to  be  treated  as  a  release  of  the  power. 

Under  the  Act,  a  "qualified  disclaimer''  means  an  irrevocable  and 
unqualified  refusal  to  accept  an  interest  in  property  that  satisfies 
four  conditions.  First,  the  refusal  must  be  in  writing.  Second,  the 
written  refusal  must  be  received  by  the  transferor  of  the  interest,  his 
legal  representative,  or  the  holder  of  the  legal  title  to  the  property 
not  later  than  9  months  after  the  day  on  which  the  transfer  creating 
the  interest  is  made.  However,  if  later,  the  period  for  making  the  dis- 
claimer is  not  to  expire  in  any  case  until  9  months  after  the  day  on 
which  the  person  makin^g  the  disclaimer  has  attained  age  21.  For  pur- 
poses of  this  requirement,  a  transfer  is  considered  to  be  made  when  it 
is  treated  as  a  taxable  transfer,  i.e.,  a  completed  transfer  for  gift  tax 
purposes  with  respect  to  inter  vivos  transfers  or  upon  the  date  of  the 
decedent's  death  with  respect  to  testamentary  transfers.  Third,  the  per- 
son must  not  have  accepted  the  interest  or  any  of  its  benefits  before 
making  the  disclaimer.  For  purposes  of  this  requirement,  the  exercise 
of  a  power  of  appointment  to  any  extent  by  the  donee  of  the  power  is 
to  be  treated  as  an  acceptance  of  its  benefits.  In  addition,  the  accept- 
ance of  any  consideration  in  return  for  making  the  disclaimer  is  to  be 
treated  as  an  acceptance  of  the  benefits  of  the  interest  disclaimed. 
Fourth,  the  interest  must  pass  to  a  person  other  than  the  pei-son  mak- 
ing the  disclaimer  as  a  result  of  the  refusal  to  accept  tlie  property. 
For  purposes  of  this  requirement,  the  person  making  the  disclaimer 
cannot  have  the  authority  to  direct  the  redistribution  or  transfer  of  the 
proj)erty  to  another  person  and  be  treated  as  making  a  "qualified" 
disclaimer. 

The  Congress  intended  to  make  it  clear  that  the  9-month  period  for 
making  a  disclaimer  is  to  be  determined  in  reference  to  each  taxable 
transfer.  For  example,  in  the  case  of  a  general  power  of  appointment, 
v/here  the  other  requirements  are  satisfied,  the  ]:)erson  who  would  be 
the  holder  of  the  power  will  have  a  9-month  period  after  the  creation 
of  the  power  in  which  to  disclaim  and  the  person  to  whom  the  property 
would  pass  by  reason  of  the  exercise  or  lapse  of  the  power  Avould  have 
a  9-month  period  after  a  taxable  exercise,  etc.,  by  the  holder  of  the 
power  in  which  to  disclaim.  Further,  in  the  case  where  the  transfer  is 
for  the  life  of  an  income  beneficiency  with  remainder  to  another  person, 
both  the  life  tenant  and  the  remainderman  would  have  to  disclaim  with 
the  9-month  period  after  the  transfer  is  made.  However,  in  the  case 
where  a  lifetime  transfer  is  included  in  the  transferor's  gross  estate 
because  he  had  retained  an  interest  in  the  property,  the  ]:)erson  who 
would  receive  an  interest  in  the  property  durinir  the  lifetime  of  the 
grantor  will  have  a  9-montli  period  after  the  original  transfer  in  which 
to  disclaim  and  a  person  who  would  receive  an  interest  in  the  property 
on  or  after  the  grantor's  death  would  have  a  9-month  period  after  the 


592 

grantor's  death  in  which  to  disclaim  if  the  other  requirements  of  the 
provision  are  satisfied  (e.g.,  tliat  person  Jiad  not  accepted  the  interest 
or  any  of  tlie  benefits  attributable  to  the  interest  before  making  the 
disclaimer). 

Under  the  Act,  a  disclaimer  with  respect  to  an  undivided  portion 
of  an  interest  is  to  be  treated  as  a  qualified  disclaimer  of  the  portion 
of  the  interest  if  the  requirements  are  satisfied  as  to  the  undivided 
portion  of  an  interest.  Also,  a  power  with  respect  to  property  is  to  be 
treated  as  an  interest  in  the  property  for  purposes  of  the  provisions. 

Effective  date 
The  amendments  apply  with  respect  to  transfers  creating  an  inter- 
est in  the  person  disclaiming  made  after  December  31,  1976.  In  the 
case  of  transfers  made  before  January  1,  1977,  the  rules  relating  to 
disclaimers  under  prior  law,  including  the  period  within  which  a 
disclaimer  must  be  made,  are  to  continue  to  apply  to  disclaimers  made 
after  December  31, 1976. 

c.  Changes  Relating  to  Certain  Retirement  Benefits:  Estate  and 
Gift  Tax  Exclusions  for  Qualified  Retirement  Benefits  (sec. 
2009  of  the  Act  and  sees.  2039  and  2517  of  the  Code) 

Prior  laic 

Since  1954  the  value  of  an  annuity  or  other  payment  receivable  by 
any  beneficiary  (other  than  the  executor)  under  certain  retirement 
programs  has  been  excludible  from  an  individual's  gross  estate,  except 
to  the  extent  that  the  value  is  attributable  to  payments  or  contributions 
which  were  made  by  the  decedent  during  his  lifetime.  The  exemption 
applies  to  benefits  under  an  employee's  trust  forming  part  of  a  quali- 
fied pension,  stock  bonus,  or  profit-sharing  plan  (sec.  401(a)),  a  re- 
tirement annuity  contract  purchased  by  an  employer  pursuant  to  a 
qualified  plan  (sec.  403(a))  or  a  retirement  annuity  contract  pur- 
chased for  an  employee  b}^  an  employer  which  is  a  tax-exempt  edu- 
cational institution,  public  charit}-  or  religious  organization.^  aiid  to 
survivor  benefits  payable  to  certain  members  of  the  armed  forces. 

Under  prior  law  the  estate  tax  exclusion  (sec.  2039(c) )  did  not  ap- 
ply to  benefits  payable  under  an  individual  retirement  account,  an  in- 
dividual retirement  annuity,  or  an  individual  retirement  bond  ("in- 
dividual retirement  account"),^"  although  these  programs  qualified 
for  favorable  income  tax  treatment  on  account  of  provisions  adopted  as 
part  of  the  Employee  Retirement  Income  Security  Act  of  1974 
("ERISA"),  This  limitation  paralleled  the  treatment  of  benefits  pay- 
able upon  the  death  of  a  self-employed  individual  under  an  H.R.  iO 
plan. 

Under  the  estate  tax  law,  the  estate  tax  exclusion  is  limited  to  the 
part  of  the  value  of  qualifying  benefits  which  represent  payments  or 
contributions  made  by  the  employer.  However,  under  prior  contribu- 
tions made  on  behalf  of  an  individual  while  he  was  s^lf-employed 
were  regarded  as  employee  contributions. 

The  gift  tax  provisions  (under  sec.  2517)  which  were  adopted  in 
1958,  parallel  the  estate  tax  exclusion.  The  exercise  or  noncxercise  by  an 


8  The  Code  refers  sr>eo1fiea11.v  to  an  orsanizntion  referred  to  in  section  ITOCb)  (1)  (A)  (li) 
or   (vl)   or  a  relipious  organization  other  than  a  trust. 

'8  Individual  retirement  accounts  nnd  a"nuities  ore  ''escribed  in  sections  40S  (a)  and  (b>. 
Individual  retirement  bonds  are  described  in  section  409(a). 


593 

employee  of  an  election  or  option  whereby  an  annuity  or  other  payment 
becomes  payable  to  any  beneficiary  at  or  after  the  employee's  death  is 
not  regarded  as  a  transfer  subject  to  the  gift  tax  if  two  conditions  are 
satisfied.  First,  the  annuity  or  other  payment  must  be  provided  under  a 
tax-qualified  employee's  trust  or  retirement  annuity  contract,  or  a  re- 
tirement annuity  contract  purchased  by  a  qualifymg  tax-exempt  or- 
ganization, or  for  certain  retired  members  of  the  anned  forces.  Second, 
the  exclusion  does  not  apply  to  that  part  of  the  value  of  the  annuity  or 
other  payment  available  to  employee's  contributions. 

Under  prior  law,  the  gift  tax  exclusion  did  not  apply  to  transfers 
made  in  connection  with  an  individual  retirement  account.  Moreover, 
payments  or  contributions  made  on  behalf  of  a  self-employed  indi- 
vidual were  regarded  as  though  they  had  been  made  by  an  employee, 
so  that  the  gift  tax  exclusion  did  not  apply. 

Reasons  for  cluinge 

The  Congress  believed  that  the  estate  and  gift  tax  exclusions  pres- 
ently available  to  taxpayers  participating  in  many  retirement  pro- 
grams should  be  extended  to  cover  those  who  establish  an  individual 
retirement  account,  as  well  as  the  self-employed.  Both  the  individual 
retirement  account  provisions  adopted  as  part  of  ERISA  and  the 
provisions  of  H.R.  10  were  designed  to  encourage  the  establishment 
of  voluntary  retirement  plans  and,  therefore,  these  plans  should  be  ac- 
corded the  same  estate  and  gift  tax  exclusions  available  to  employees 
covered  under  other  qualified  retirement  plans. 

The  Congress,  however,  believed  that  it  is  no  longer  appropriate 
to  continue  the  estate  tax  exclusion  with  respect  to  amounts  payable 
in  a  single  lump  sum  under  a  retirement  plan.  Benefits  paid  in  a  lump 
sum  will  normally  generate  sufficient  cash  to  cover  the  estate  tax 
liability  attributable  to  the  inclusion  of  the  benefits  in  the  decedent's 
gross  estate. 

Explanation  of  provisions 

The  Act  amends  present  law  (sec.  2039)  generally  to  exclude  from 
the  value  of  a  decedent's  gross  estate  the  value  of  an  annuity  receivable 
by  a  beneficiary  under  an  individual  retirement  account.  The  exclusion 
applies  only  to  the  portion  of  the  account  attributable  to  contributions 
w^Mch  were  allowable  as  a  deduction  for  income  tax  purposes  (sec. 
219)."  The  exclusion  also  is  to  be  available  with  respect  to 
a  roll-over  contribution  of  a  distribution  from  another  quali- 
fied plan  even  though  no  income  tax  deduction  is  allowable  for  the  roll- 
over contribution.  Where  the  individual  retirement  accounts  contains 
contributions  for  which  a  deduction  was  not  allowable,  the  decedent's 
gross  estate  will  include  that  portion  of  the  value  of  the  amount  receiv- 
able under  his  individual  retirement  account  as  the  total  amount  which 
was  not  allowable  as  an  income  tax  deduction  (other  than  a  rollover 
contribution)  bears  to  the  total  amount  paid  to  or  for  the  individual  re- 
tirement account  (including  rollover  contributions).  This  limitation 
will  not  apply  if  the  nondeductible  amounts  were  returned  to  the  de- 
cedent prior  to  his  death. 


iiTlie  exclusion  is  also  to  he  avnllnblp  In  the  rase  where  contributions  were  dednctlble 
for  ineome  tnx  purposes  under  a  spouse-covered  Indlvidunl  retirement  account  because  the 
deduction  allowed  under  section  220  for  si:'jh  an  account  is  In  lieu  of  the  deduction  pro- 
vided under  section  219.  (See  sec.  408  et  seq.). 


d94 

The  Act  also  piovides  that  contributions  or  payments  made  on 
behalf  of  a  decedent  to  a  qualified  retirement  plan  while  he  was  a 
self-employed  individual  are.  to  the  extent  allowable  as  a  tax  tleduc- 
tion,  to  be  treated  tlie  same  as  a  contribution  made  by  an  employer.  As  a 
result,  benefits  payable  on  account  of  the  death  of  a  self-employed  indi- 
vidual under  an  H.R.  1()  i)lan  are  to  be  exempt  from  estate  taxation, 
unless  they  are  attributable  to  plan  contributions  made  on  tlie  individ- 
ual's behalf  which  were  not  allowable  a-s  a  deduction  for  income  tax 
purposes  (sec.  404). 

As  a  result  of  the  Act,  the  interest  of  a  taxpayer's  spouse  under 
the  communit}'  property  laws  in  benefits  ac^^umulated  imder  an  indi- 
vidual's retirement  account  or  H.R.  10  plan  is  also  to  qualify  for  the 
estate  tax  exclusion  when  the  spouse  predeceases  the  taxpayer. 

The  Act,  howevei',  limits  the  estate  tax  exclusion  to  an  annuity  or 
payments  other  than  a  lump  sum  distribution  (described  in  sec  402 
(e)  (4) )  receivable  undei*  a  qualifying'  progTam.  Qualification  for  the 
estate  tax  exclusion  is  not  affected  by  tlie  m.ei-e  existence  of  a  rijiht  in  a 
party,  such  as  the  i)lan's  benefits  committee,  to  select  whether  the 
benefits  are  paid  in  a  lump  sum  or  as  an  amiuity  so  long  as  the  right 
to  select  is  irrevocably  exercised  no  later  than  the  earliei-  of  the  date 
the  estate  tax  return  is  filed,  or  the  date  on  which  the  return  is  recjuired 
to  be  filed  (including  extensions  of  time  to  file). 

In  the  case  of  an  individual  retirement  account,  tlie  estate  tax  exclu- 
sion applies  only  to  amounts  receivable  as  an  annuity.  For  this  [)urpose, 
a  distribution  from  an  individual  retirement  account  to  a  beneficiary 
does  not  have  to  be  in  the  form  of  a  typical  commercial  annuity  con- 
tract to  qualify  for  the  exclusion.  Generally,  the  exclusion  is  to  be 
available  in  situations  where  a  liquidity  problem  might  exist  because 
the  schedule  of  payments  to  be  made  from  the  account  will  not  provide 
current  funds  to  pay  the  estate  tax.  TTnder  the  Act.  the  exclusion  will 
be  available  if  the  distribution  from  an  individual  retirement  account 
to  the  beneficiary  consists  of  an  annuity  contract  oi'  other  arrangement 
providing  for  a  series  of  substantially  eijual  ])eriodic  pavments  to  be 
made  to  a  beneficiary  (other  than  the  executor)  foi'  his  life  or  over  a 
period  extending  for  at  least  30  months  after  the  date  of  the  decedent's 
death.  For  this  purpose,  payments  under  an  annuity  contract  are  to  be 
considered  to  be  "substantially  equal"  under  a  variable  annuity  if  the 
variance  in  payments  is  not  solely  attributable  to  tax  avoidance  mo- 
tiA'es.  Of  course,  the  annuity  or  other  arrangement  need  not  [uovide 
payments  for  the  life  of  the  beneficiary.  Generally,  satisfaction  of  the 
3-year  payment  standard  will  be  based  on  the  payntent  pi-ovisions  of 
the  account  or  the  settlement  option,  if  any.  elected  no  later  than  the 
earlier  of  the  date  tlie  estate  tax  return  is  filed  or  the  date  on  which 
the  return  is  required  to  be  filed  (including  extensions  of  time  to  file). 

Compara})le  extensions  are  made  by  the  Act  in  the  gift  tax  exclu- 
sion. The  exclusion  is  modified  to  cover  an  annuity  or  other  ])ayment 
provided  under  an  individual  retirement  account.  Tn  addition, 
contributions  or  payments  made  under  a  qualified  I'etii'ement  plan  on 
behalf  of  a  self-em])lo\ed  individual  are,  to  the  extent  allowable  as  an 
income  tax  deduction,  to  be  deemed  to  have  been  made  hv  an  employer 
so  that  the  gift  tax  exclusion  will  be  available  (sec,  2517(a) ). 


595 

Ejfectvce  date 
The  amendments  made  by  the  Act  apply  to  the  estates  of  decedents 
dying:  after  December  31,  1976.  The  modifications  apply  to  transfers 
by  gift  made  after  December  31, 1976. 

d.  Changes  Relating  to  Certain  Retirement  Benefits:  Gift  Tax 
Treatment  of  Certain  Community  Property  (sec.  2009  of  the 
Act  and  sec.  2517  of  the  Code) 

Prior  law 

In  1972,  the  estate  tax  exclusion  for  interests  in  certain  qualified 
plans  was  amended  to  ensure  that  no  portion  of  the  employer  contri- 
butions would  be  includible  in  the  gross  estate  of  the  employee's 
spouse  if  the  spouse  predeceased  the  employee  and  the  couple  had 
resided  in  a  conmiunity  property  State.  This  amendment  was  de- 
signed to  overturn  a  revenue  ruling  (Eev.  Rul.  67-278,  1967-2  C.B. 
323),  which  held  that,  if  under  community  property  laws  the  deceased 
spouse  had  a  vested  interest  in  one-half  of  such  amounts,  this  half 
was  includible  in  the  spouse's  gross  estate  but  was  not  eligible  for  the 
exclusion  because  the  deceased  spouse  was  not  an  employee  covered 
under  the  plan. 

However,  no  corresponding  change  was  made  in  the  gift  tax  pro- 
visions. As  a  result,  the  Internal  Revenue  Service  ruled  (Rev. 
Rul,  75-240,  1975-1  C.B.  314)  that,  if  an  employee  predeceases  the 
employee's  spouse  in  a  community  property  State,  the  surviving  spouse 
is  to  be  treated  as  having  made  a  gift  of  one-half  of  any  benefit  payable 
to  other  beneliciaries.  This  result  would  not  occur  in  a  non-community 
property  State. 

Reasons  for  change 
The  Congress  believed  that  the  treatment  described  above  is  dis- 
criminatory and  should  not  be  allowed  to  continue.  It  was  the  view  of 
the  Congress  that  the  ])rovisions  excluding  from  the  estate  and  gift 
tax  interests  in  qualified  plans  should  have  uniform  application  in 
•"ommon  law  and  community  property  States  regardless  of  which 
spouse  dies  first. 

Explanation  of  provision 

Consequently,  the  Act  provides  a  gift  tax  exclusion  for  the  value,  to 
the  extent  attributable  to  tax  deductible  contributions,  of  any  interest 
of  a  spouse  in  specified  employee  contracts,  or  trust  or  plan  payments, 
where  two  conditions  exist. 

First,  an  employer  must  have  made  contributions  or  payments  on 
behalf  of  an  employee  (or  former  emplovee)  under  an  employee's 
trust  forming  a  part  of  a  qunlified  pension,  stock  bonus,  or  profit- 
sharina:  plan,  a  retirement  annuity  contract  purchased  under  a  qualified 
plan,  Of  a  re  tirement  annuity  contract  purchased  for  an  emplovee  by 
an  employer  which  is  a  tax-exempt  educational  or.Tanizalion,  charity 
or  relifrious  organization;  or  a  taxpaver  (re.*Tarded  as  an  employee 
for  gift  tax  purposes)  must  ha^  e  made  contributions  or  pavments  to 
an  individual  retirement  account.  Second,  the  amount  involved  cannot 
be  considered  a  non-tax  deductible  employee  contribution.  Wliere  these 
two  conditions  exist,  the  value  of  the  non-employee's  interest  payable 


596 

to  other  boioficiaries  upon  the  employee's  deatli  is  to  be  excluded 
from  the  taxable  frifts  of  the  surviving  spouse  to  the  extent  the  value 
arises  solely  by  leasoii  of  the  sjiouse's  interest  in  ihe  connnunity  income 
of  (lieeinpioyco  under  Ihe  conuuuiiity  projH'rly  laws  of  the  State. 

However,  the  Act  does  not,  in  the  case  of  the  nonemidoyee  spouse 
in  the  coininimity  ])ropcrty  State,  ])i-OAi(le  any  exclusion  for  a  prop- 
eity  interest  to  the  extent  that  it  is  attributable  to  the  non-tax  decbicti- 
ble  contributions  of  the  enn)lovee  S{)ouse.  Thus,  the  survivinj>"  spouse's 
cominunity  interest  attributable  to  conti'ibutions  made  by  the  de- 
ceased employee  spouse  could  be  subject  to  the  gift  tax,  as  under 
prior  law. 

The  Act  will,  therefore,  have  the  effect  of  equating  the  gift  tax 
treatment  that  occurs  in  a  comnnmity  property  State  upon  the  death 
of  an  employee's  spouse  with  that  lesulting  u})on  the  death  of  the 
em})loyee. 

The  provisions  of  the  Act  will  also  equate  the  gift  tax  treatment 
that  occurs  upon  the  lifetime  transfer  of  qualified  benefits  by  employees 
in  a  comnnniity  property  State  with  the  result  that  occurs  in  a  com- 
mon law  State. 

Effectwe  date 
The  nmendment  applies  to  transfers  made  after  December  81,  1076. 

e.  Income  Tax  Treatment  of  Certain  Selling  Expenses  of  Trusts 
and  Estates  (sec.  2009  of  the  Act  and  sec.  642(g)  of  the  Code) 

Prior  law 
Generally,  an  estate  or  trust  is  not  permitted  to  deduct  any  item  for 
income  tax  purposes  if  that  item  is  deducted  for  estate  tax  purposes 
as  an  administration,  funeral,  etc.,  expense  or  as  a  loss.  Under  prior 
law,  a  munber  of  courts  held  that  selling  expenses  may  be  used  to  reduce 
the  amount  realized  on  the  sale  of  property  by  an  estate  trust  even 
though  those  selling  expenses  are  deducted  for  estnto  lax  purposes. 
See,  for  example,  Estate  of  T\  E.  Bray  v.  Commissioner,  ;U)()  F.  'id  452 
(OthCir.  1908). 

Iiea,^o)i.<^  for  change 
The  (\ingress  believed  that  there  should  not  be  diiferent  tax  treat- 
ment for  items  which  are  considei-ed  oll'sets  to  the  amount  i-ealized  on 
the  sale  of  property  as  opposed  to  items  for  which  deductions  would 
be  allowed. 

E.vplanatioii  of  prorision 
The  Act  amends  prior  law  to  provide  that  amounts  cannot  be  used 
to  offset  the  amount  of  the  sale  ]>rice  of  property  if  such  amount  is 
also  deducted  for  estate  tax  pur])Oses  as  administration,  funeral,  etc., 
exj^enses  or  as  losses. 

Effertire  date 
This  amendment  is  etl'ective  for  taxable  years  ending  after  the  date 
of  enactment  (October  4, 1976). 


597 

f.  Estate  Tax  Credit  for  Payment  in  Kind  (sec.  2010  of  the  Act) 

Prior  law 
In  addition  to  le^jal  tender,  it  is  lawful  for  the  Secretary  of  the 
Treasury  to  accept  checks  or  money  orders  in  payment  foi*  estate  tax 
liability.  Under  prior  law,  there  was  no  provision  authorizing  the  Sec- 
retary of  the  Treasury  to  accept  other  foi-ms  of  payments,  such  as  the 
conveyance  of  real  property. 

Reasons  for  the  change 
The  Congress  believed  that  the  Secretary  of  the  Treasury  should  be 
authoi'ized  to  accei)t  payment  of  estate  tax  in  kind  in  the  case  of  the 
estate  of  La  Vere  Redfield.  In  this  way,  a  forced  sale  of  certain  land  bor- 
dering the  Toiyabe  National  Forest  could  be  avoided  and  the  pi-op- 
erty  could  be  transferred  to  the  Secretary  of  Agriculture  for  admin- 
istration b}^  the  National  Forest  Service. 

Exflanatlon  of  provision 
The  Act  allows  the  Secretary  of  the  Treasury  to  accept  conveyance 
of  real  property  bordeiino;  the  Toiyabe  National  Forest  as  payment  of 
estate  tax  imposed  on  the  estate  of  La  Vere  Red  field.  The  Act  provides, 
however,  that  interest  will  accrue  if  the  property  is  not  conveyed 
expeditiously. 

Effective  date 
This  amendment  is  effective  on  the  date  of  enactment  (October  4, 
1976). 

Revenue  Effect  of  Estate  and  Gift  Tax  Provisions 

It  is  estimated  that  the  Estate  and  Gift  Tax  provisions  will  reduce 
receipts  by  $728  million  in  fiscal  year  1978  and  $1,449  million  in  fiscal 
year  1981.  However,  in  tlie  long  run  (18  to  20  years),  it  is  estimated 
there  will  be  a  net  revenue  gain  from  these  provisions  which  will 
result  in  a  net  increase  in  receipts  of  $260  million.  These  estimates  are 
set  forth  in  the  table  immediately  following: 

ESTIMATED  EFFECT  ON  FISCAL  YEAR  RECEIPTS  OF  THE  ESTATE  AND  GIFT  TAX  CHANGES 
|ln  millions  of  dollars] 

Fiscal  year— 


1977  1978  1973  1980              1381         Long  ru 

Unified  rates  and  credit -541  -756  -1,012         -lr380           -1,230 

Marital. -153  -162  -171 

valuation —14  —15  —16 

extension  ot  time —20  —24  —28 

yPification (•)  (•)  (•)  (*) 

generation  skippmg (*) 

carryover  of  basis (*)  (*)  36  93 

Total - -728  -921  -1,134         -1,449                 263 


-181 

-154 

-17 

-14 

-33 

(•) 

(*) 

300 

(♦) 

280 

162 

1,080 

234-120  O  -  77  -  39 


T.  MISCELLANEOUS  PROVISIONS 

1.  Tax  Treatment  of  Certain  Housing  Associations  (sec.  2101  of 
the  Act  and  sees.  216  and  528  of  the  Code) 

Prior  law 

In  developinp;  a  real  estate  subdivision  or  a  oondominiuni  project, 
it  is  common  for  developers  to  form  owners'  associations  as  an  integral 
part  of  the  overall  development.  Generally,  membership  in  the  asso- 
ciation is  open  only  to  owners  of  lots  or  dwelling  units  and  is  nor- 
mally required  as  a  condition  of  ownership.  These  associations  are 
formed  to  allow  individual  homeowners,  etc.,  to  act  together  in  man- 
aging, maintaining,  and  improving  certain  areas  wdiere  they  live.  The 
purposes  of  the  organization  may  include,  for  example,  the  adminis- 
tration and  enforcement  of  covenants  for  pi-eserving  the  architectural 
and  general  appearance  of  the  development,  the  ownership  and  man- 
agement of  common  areas  such  as  streets,  sidewalks,  parks,  swimming 
pools,  etc.,  and  the  exterior  maintenance  and  repair  of  property  owned 
by  its  members. 

The  association  is  funded  by  either  annual  or  periodic  assessments 
of  the  members.  Generally,  there  are  two  categories  of  assessments 
and  expenditures  made  by  the  association.  First,  operating  assessments 
are  made  to  acquire,  construct,  administer,  manage,  maintain,  and  op- 
erate the  areas  and  facilities  common  to  all  residential  units.  This  in- 
cludes the  maintenance  of  parking  areas,  hallways,  elevators,  roofs,  ex- 
terior of  buildings,  etc.  Second,  capital  assessments  are  made  to  build 
up  reserves  for  the  replacement  of  equipment  and  facilities  used  in 
common.  This  includes  the  equipment  and  facilities  used  with  respect 
to  swimming  pools,  tennis  courts,  clubhouse  facilities,  etc. 

Under  prior  law,  generally  a  homeowners'  association  could  qualify 
as  an  organization  exempt  from  federal  income  tax  (under  sec,  501 
(c)  (4)  of  the  Code)  only  if  it  met  three  requirements  (Rev  RuL 
74-99,  1974-1  C.B.  131).  First,  the  homeowners'  association  was  re- 
quired to  serve  a  "community''  which  bears  a  reasonable,  recognizable 
relationship  to  an  area  ordinarily  identified  as  a  governmental  sub- 
division or  unit.  Second,  it  could  not  have  conducted  activities  directed 
to  the  exterior  maintenance  of  any  private  residence.  Third,  common 
areas  for  facilities  that  the  homeowners'  association  owned  and  main- 
tained must  be  for  the  use  and  enjoyment  of  the  general  public. 

If  an  association  w'as  unable  to  meet  these  three  requirements,  it  or- 
dinarily was  taxed  as  a  corporation.  In  general,  this  meant  that  the 
excess  of  current  receipts  over  current  expenditures  at  the  end  of  the 
year  was  taxable  to  it  unless  the  excess  was  refunded  to  the  mem- 
bers or  applied  to  the  subsequent  year's  assessment.  "With  respect  to 
assessments  for  capital  improvements,  if  the  assessments  were  desig- 
nated to  be  used  solely  for  the  purpose  of  making  capital  improve- 
ments and  if  the  association  homeowners  had  an  equity  interest  in  the 

(598) 


999 

association,  the  assessments  were  not  treated  as  cnrrent  income  to  the 
association  but  were  treated  as  contributions  to  capital.  Also,  to  the 
extent  that  the  association's  accumulated  funds  earn  income,  this 
income  has  Ween  taxable  to  the  association. 

In  contrast  with  the  individual  ownership  of  dwelling  units  in  con- 
dominium projects  and  projects  involving  residential  real  estate  man- 
agement associations,  the  dwelling  units  iu  a  cooperative  housing  proj- 
ect are  owned  by  tlie  cooperative  housing  corporation  which  leases  the 
apartments  or  other  dwelling  units  to  tenant-stockholders  who  are 
required  to  purchase  stock  to  be  able  to  lease  dwelling  units.  If  a  coop- 
erative housing  corporation  meets  certain  requirements,  a  tenant-stock- 
holder may  deduct  amounts  which  he  pays  to  the  corporation  which 
represents  liis  proportionate  share  of  the  corporation's  real  property 
taxes  and  mortgage  interest.^  Also,  if  a  tenant-stockholder  utilizes 
depreciable  property  leased  from  the  cooperative  housing  corporation 
in  a  trade  or  business  or  for  the  production  of  income,  the  tenant-stock- 
holder is  allowed  to  take  depreciation  deductions  with  respect  to  his 
stock  in  the  corporation  (sec.  216(c) ).  In  general,  for  a  tenant-stock- 
holder to  qualify  for  these  deductions,  80  percent  or  more  of  the  gross 
income  of  the  cooperative  liousing  corporation  must  have  been  derived 
from  individual  tenant-shareholders.  (However,  stock  owned,  and 
dwelling  units  leased,  by  governmental  entities  empowered  to  acquire 
shares  in  a  cooperative  housing  corporation  for  the  purpose  of  pro- 
viding housing  facilities  are  not  to  be  taken  into  account  in  determin- 
ing whether  this  80-percent  test  is  satisfied.) 

Cooperative  housing  corporations  have  generally  been  treated  as 
taxable  corporations.  However,  under  prior  law  there  was  some 
ambiguity  as  to  whether  a  cooperative  housing  corporation  was  entitled 
to  deduct  depreciation  with  respect  to  depreciable  property  leased  to 
a  tenant -shareholder  (and  with  respect  to  which,  if  such  property 
were  used  in  a  trade  or  business  or  for  the  production  of  income,  the 
tenant-shareholder  would  take  deductions  for  depreciation  with  re- 
spect to  his  stock  in  the  corporation).^ 

Reasons  for  change 

Most  homeowners'  associations  have  found  it  difficult  to  meet  the 
three  requirements  set  fortli  in  Rev.  Rul.  74-99,  discussed  above,  and 
therefore,  have  not  been  a])le  to  cjualifv  for  tax  exemption.  To  avoid 
being  taxed  ou  the  excess  of  current  receipts  over  current  expenditures, 
the  associations  were  required  to  refund  such  excess  to  the  members  or 
apply  the  excess  to  the  subsequent  years'  assessment.  In  addition,  it  Avas 
not  clear  that  assessments  earmarked  for  maior  repair  and  improve- 
ments of  a  member's  individual  dwelling  unit  would  not  have  been 
taxable. 

Since  homeowners'  associations  generally  allow  individual  home- 
owners to  act  together  in  order  to  maintain  and  improve  the  area  in 
which  they  live.  Con.qfress  believes  it  is  not  appropriate  to  tax  the 
revenues  of  an  association  of  homeowners  who  act  together  if  an 


1  The  aUowance  of  these  amounts  ns  deductions  to  the  tenant-stckholders  does  not  pre- 
vent a  cooperative  hoiislnir  corporntinn  from  deductlnR  the  mortgage  interest  and  real 
projiertv  taxes  it  pays.  Rev.  Rnl.  fi2-17S.  19fi2-2  C.B.  91. 

=  A  recent  case  has  held  that  the  corporation  was  not  entitled  to  such  deductions,  yark 
Place ,  Inc.,  57  T.C.  767  (1972). 


600 

individual  homeowner  acting  alone  would  not  be  taxed  on  the  same 
activity.  Consequently,  these  provisions  exempt  from  income  tax  any 
dues  and  assessments  received  by  a  qualified  homeowners"  association 
which  are  paid  by  residential  property  owners  who  are  members  of  the 
association,  where  the  assessments  are  used  for  the  maintenance  and 
improvement  of  association  property.  This  treatment  is  essentially 
equivalent  to  the  tax  treatment  of  individual  homeowners  who  set  aside 
amounts  to  maintain  and  improve  their  property. 

Also,  under  these  provisions  an  association's  net  investment  hicome, 
and  net  trade  or  business  income,  is  to  be  taxable,  since  an  individual 
homeowner  would  be  similarly  taxed  on  investment  income,  such  as 
interest  earned  on  money  set  aside  for  improvements. 

In  the  case  of  cooperative  housing  corporations,  Congress  believed 
that  it  was  appropriate  to  resolve  the  ambiguity  in  prior  law  as  to 
whether  a  cooperative  housing  corporation  is  entitled  to  a  deduction 
for  depreciation  wnth  respect  to  personal  property  leased  to  tenant- 
stockholders.  Congress  also  believed  that  the  provision  of  prior  law 
which,  in  eU'ect,  required  that  most  tenant-stockholders  of  cooperative 
housing  corporations  be  individuals  should  be  revised  so  that  banks 
and  other  lending  institutions  which  lend  money  for  the  purchase  of 
stock  in  these  corporations  can  hold  stock  obtained  through  foreclosure 
for  a  limited  period  of  time. 

Explanat'wn  of  provisions 

Under  the  Act,  a  qualified  homeowners'  association  (that  is,  a  condo- 
minium management  association  or  a  residential  real  estate  associa- 
tion) generally  may  elect  to  be  treated  as  a  tax-exempt  organization. 
If  an  election  is  made,  the  association  is  not  to  be  taxed  on  any  "exempt 
function  income".^  Exempt  function  income  means  membership  dues, 
fees,  and  assessments  received  from  persons  who  own  residential  units 
in  the  particular  condominium  or  subdivision  and  who  are  members  of 
the  association.* 

The  association  is  to  be  taxed,  however,  on  any  net  income  which  is 
not  exempt  function  income.  For  example,  any  interest  earned  on 
amounts  set  aside  in  a  sinking  fund  for  future  improvements  is  tax- 
able. Similarly,  any  amount  paid  by  persons  who  are  not  members  of 
the  association  for  use  of  the  association's  facilities,  such  as  tennis 
courts,  swimming  pools,  golf  courses,  etc.,  would  be  taxable.  Further, 
any  amount  paid  by  members  for  special  use  of  the  association's  facili- 
ties, the  use  of  which  would  not  be  available  to  all  the  members  as  a 
result  of  having  paid  the  membership  dues,  fees,  or  assessments  re- 
quired to  be  paid  by  all  members  of  the  association,  would  be  taxable. 
For  example,  if  the  membership  dues,  fees,  or  assessments  do  not  en- 
title a  member  to  use  the  association's  party  room  or  to  use  the  swim- 
ming pool  after  a  certain  time  period,  then  amounts  paid  for  this  use 
are  taxable  to  the  association.  Deductions  are  allowed  for  expenses 
directly  connected  with  the  production  of  taxable  income. 


3  If  the  provisions  of  the  Act  are  not  met  (or  an  election  Is  not  made  to  be  treated  as 
tax-exempt),  a  homeowners'  association  is  to  continue  to  be  treated  as  H  was  under  prior 
law. 

<  Assessments  for  the  current  management,  maintenance  and  care  of  association  prop- 
erty are  to  be  exempt  from  tax  as  exempt  function  income.  Also,  as  under  prior  law,  assess- 
ments to  finance  current  or  future  capital  Improvements  to  association  property  are  capital 
contributions  and  are  not  subject  to  tax. 


601 

The  Act  provides  a  $100  deduction  against  taxable  income  so  that 
associations  with  only  a  minimal  amount  of  taxable  income  will  not 
be  subject  to  tax.  However,  a  net  operating  loss  deduction  is  not  al- 
lowed, and  the  special  deductions  for  corportitions  (such  as  the 
dividends  received  deduction)  are  not  allowed. 

A  homeowners'  association  is  taxed  as  a  corporation  on  its  taxable 
income.^  The  tax  rate  to  be  applied  is  the  corporate  rate  without  the 
surtax  exemption.  If  the  association  has  net  long-term  capital  gain, 
the  capital  gain  portion  of  the  taxable  income  is  taxed  at  a  30-percent 
rate. 

Generally,  two  different  types  of  homeowners'  associations  are 
treated  as  tax-exempt  under  the  Act :  condominium  management  as- 
sociations and  residential  real  estate  management  associations. 

In  order  to  qualify  for  this  treatment  under  the  Act,  a  homeoAvners' 
association  must  meet  several  common  requirements.  First,  the  associa- 
tion must  be  organized  and  oj^erated  to  provide  for  tlie  management, 
maintenance,  and  care  of  association  property.  Althougli  the  property 
maintained  b}^  the  association  is  generally  property  owned  by  the  as- 
sociation and  available  for  common  use  by  all  the  men]bers  or  property 
owned  by  a  governmental  unit  and  available  for  the  common  benefit 
of  residents  of  the  unit,  tlie  association  may  maintain  areas  that  are 
privately  owned  but  affect  the  overall  appearance  and  structure  of  the 
project.  For  example,  in  a  condominium  project,  the  condominium  as- 
sociation may  enforce  covenants  with  regard  to  the  appearance  of  the 
individual  units  and  may  maintain  the  exterior  walls  and  roof  of  the 
individual  condominium  units.  Although  the  property  maintained 
is  private,  its  appearance  may  directly  affect  the  condition  of  the  entire 
project.  As  a  consequence,  the  exterior  walls  and  roofs  may  be  con- 
sidered as  association  property  which  may  be  maintained  by  a  qualified 
association.  However,  for  this  property  to  qualify  as  association  prop- 
erty, it  is  intended  that  tliere  be  a  covenant  of  appearance  applying  on 
the  same  basis  to  all  property  in  the  project,  that  there  be  pro  rata 
annual  mandatory  assessments  for  maintaining  this  property  on  all 
members  of  the  association,  and  that  membership  in  the  association 
be  compulsorily  tied  to  every  person's  ownership  of  property  in  the 
project. 

Second,  a  homeowners'  association  must  meet  certain  income  and 
expenditure  tests.  Generally,  these  tests  are  to  insure  that  the  primary 
activity  of  the  association  is  to  manage,  maintain,  and  improve  associ- 
ation property,  and  that  the  owner-members  of  the  association  finance 
these  activities. 

Under  the  Act.  at  least  60  percent  of  the  association's  gross  income 
must  consist  solely  of  membership  dues,  fees,  or  assessments  from 
owners  of  residential  units  or  owners  of  i-esidences  or  residential  lots, 
(exempt  function  income),  as  the  case  may  be. 

For  this  purpose,  amounts  that  qualify  "for  the  60-percent  test  arc 
not  to  include  assessments  for  capital  improvements  which  otherwise 
would  not  be  treated  as  income  to  the  association  but  would  be  treated 
as  capital  contributions.  Qualified  income  includes  fixed  annual  mem- 
bership dues  or  fees  and  assessments  that  vaiy  depending  upon  the 


^  Fvpry  hoiripownprs'  nssooiatloii  whlrh  elects  to  he  taxed   under  these  provisions  and 
has  taxable  Income  Is  to  file  an  annual  return. 


602 

need  of  the  association  to  pay  for  acquisition  or  construction  of,  and 
management,  maintenance,  improvements,  real  property  taxes,  etc., 
on  the  common  property. 

Qualifying  i-eceipts  must  be  derived  from  members  in  the  capacity 
of  owner-membei*s  and  not  in  the  capacity  as  customers  for  services 
provided  by  the  association.  For  example,  payments  by  owner-mem- 
bers for  maid  service,  secretarial  service,  cleanine;,  etc.,  do  not  qualify. 

Qualified  income  does  not  include  assessments  that  are  related  to 
particular  work  done  on  the  privately-owned  property  of  an  individ- 
ual's residence,  etc.,  since  this  is  more  in  the  nature  of  providing  serv- 
ices in  the  course  of  a  trade  or  business  than  in  the  nature  of  a  common 
activity  undertaken  by  a  collective  group  of  owners.  However,  pro 
rata  assessments  Avhich  are  paid  by  all  owners  in  the  proiect  and  are 
used  for  maintaining  exterior  walls  and  roofs  will  be  qualified  income 
if  the  conditions  described  above  for  treating  this  property  as  associa- 
tion property  are  met.  To  the  extent  that  a  condominium  association 
or  subdivision  association  owns  mortgaged  property,  assessments  to 
pay  principal  and  interest  on  the  mortgage  debt  will  be  qualified  in- 
come for  the  60-percent  test. 

Amounts  received  from  persons  who  are  not  owners  of  residential 
property  in  the  proiect,  or  who  are  otherwise  not  association  members, 
are  not  exempt  function  and  thus  are  not  includable  in  the  numerator 
of  the  fraction  used  to  determine  whether  the  60-percent  income  test  is 
met,  but  are  includable  in  income  of  the  association. 

In  addition  to  the  income  test,  the  Act  pT'ovides  an  expenditure  test. 
Under  this  test,  at  least  90  percent  of  all  of  the  annual  expendiiures 
of  the  homeowners'  association  must  be  to  acquire,  construct,  manage, 
maintain,  and  care  for,  or  improve,  association  property.  Qualifying 
expenditures  inclurle  both  current  and  capital  expenditures  on  asso- 
ciation property.  For  example,  qualifying  expenditures  include  sala- 
ries paid  to  an  association  manager  or  secretary  and  expenses  of  main- 
taining association  news-letters.  Qualifving  expenditures  will  also  in- 
clude expenses  for  gardening,  paving,  street  signs,  security  personnel, 
property  taxes  assessed  on  propertv  owned  by  the  association,  and 
current  operating  expenses  of  tennis  courts,  swimming  pools,  recrea- 
tion rooms  and  halls,  etc.  In  addition,  expenses  for  replacement  of 
common  buildings,  equipment  and  facilities  such  as  replacemicnt  of 
heating,  air  conditioninar.  elevators,  etc.,  will  qualify.  However,  as 
discussed  above,  expenditures  on  privately  owned  property — as  op- 
posed to  common  property — are  to  qualify  only  in  the  limited  situa- 
tion of  repair  of  exterior  walls  and  roofs  where  the  walls  and  roofs 
qualify  as  association  property.  Since  association  propertv  includes 
property  owned  by  a  governmental  unit  for  the  common  benefit  of 
residents  of  that  unit,  qualifyin.q-  expenditures  incbulo  funds  which  the 
association  may  expend  on  roads  or  common  utility  facilities  which 
are  owned  by  a  governmental  unit,  such  as  a  county  or  municipal  util- 
ity district. 

Investments  or  transfers  of  funds  to  he-  held  to  meet  future  costs 
are  not  to  be  taken  into  account  as  exnenrlituies.  For  example,  trans- 
fers to  a  sinkinc:  fujid  account  for  tlie  replacement  of  a  roof  would 
not  qualify  as  expenditures  for  the  90-minute  test. 


603 

Followino;  existing  law  with  respect  to  other  exempt  organizations 
generally,  tlie  Act  also  provides  that  no  part  of  the  net  earnings  of 
an  exempt  homeowners'  association  may  inure  to  the  benefit  of  any 
private  shareliolder  or  individual.  To  the  extent  that  members  receive 
a  benefit  from  the  general  jnaintenance,  etc.,  of  association  property, 
this  benefit  would  not  constitute  inurement.  A  rebate  to  members  of 
excess  assessments  would  generally  not  constitute  inurement.  How- 
ever, if  an  association  pays  rebates  from  its  net  earnings,  such  pay- 
ment will  constitute  inurement. 

In  addition  to  the  general  I'equirements,  in  tlie  case  of  a  condo- 
minium management  association,  substantially  all  of  the  dwelling 
units  must  be  used  as  residences.  Similarly,  in  the  case  of  a  residential 
real  estate  management  association,  substantially  all  the  lots  or  build- 
ings must  be  usecl  by  individuals  for  residences.® 

The  Act  does  not  allow  cooperative  housing  corporations  to  elect  to 
be  treated  as  subject  to  the  new  rules  applicable  to  condominium  man- 
agements associations  and  residential  real  estate  management  associa- 
tions because  cooperative  housing  corporations  have  a  long  history  of 
being  treated  as  taxable  organizations.  Instead,  the  Act  clarifies  prior 
law  (sec.  216(c))  to  insure  that  a  cooperative  housing  corporation  is 
entitled  to  a  deduction  for  depreciation  with  respect  to  property  it 
leases  to  a  tenant-stockholder  even  through  such  tenant-stockholder 
may  be  entitled  (under  sec.  216(c) )  to  depreciate  his  stock  in  the  co- 
operative housing  corporation  to  the  extent  sucli  stock  is  related  to  a 
proprietary  lease  or  right  of  tenancy  which  is  used  by  the  tenant-stock- 
holder in  a  trade  or  business  or  for  the  production  of  income.  Congress 
believes  tliat  when  section  216(c)  was  added  to  the  Code  in  1962,  Con- 
gress did  not  intend  the  allowance  for  depi-eciation  on  such  stock  to 
affect  the  availability  to  the  cooperative  housing  corporation  of  depre- 
ciation deductions  on  property  leased  to  tenant -stockholders.  How- 
ever, the  Tax  Court  in  one  case.  Park  Place.  Inc.,  57  T.C.  767  (1972), 
reached  a  contrary  conclusion,  and  th.e  Act  adds  specific  statutory  lan- 
guage to  reflect  what  Congress  believes  to  be  the  appropriate  interpre- 
tation of  section  216(c)  under  prior  law.'' 

Congress  does  not  believe  that  a  clarification  of  the  rules  relating  to 
the  cooperative  housing  corporation's  ability  to  take  depreciation  de- 
ductions with  respect  to  property  leased  to  tenant-stockholders  will 
create  tax  avoidance  possibilities  because  the  provisions  of  existing 
law  (sec.  277)  generally  prevent  nonexempt  membership  organizations 
from  offsetting  nonmember  income  with  losses  from  dealings  with 
members. 

The  Act  also  modifies  the  prior  law  rule  tliat  a  tenant-stockholder  in 
a  cooperative  housing  corporation  must  be  an  individual  by  permitting 
a  bank  or  other  lendino;  institution  which  obtains  stock  in  a  cooperative 
housing  corporation  through  foreclosure  to  be  treated  as  a  tenant-stock- 
holder for  up  to  three  years  after-  the  date  of  accpisition. 


"It  is  Intcnrlod  that  if  fi  lot  is  zoned  for  residential  use  it  will  be  treated  as  being  used 
for  residential  purposes  as  long  as  a  nonresidential  improvement  hns  not  becun  on  the 
lot.  It  is  also  intended  that  land  uses  which  are  auxiliary  to  residential  use  (such  as 
parking  spaces,  swimming  pools,  tennis  courts,  sclu  )ls,  fire  stations,  libraries,  etc.)  are 
to  he  fonsidered  as  residential  uses. 

"  This  provision  is  not  intended  to  j-ffect  the  deductibility  by  .-  cooperative  housing 
corporation  of  real  estate  taxes  and  interest  referred  to  in  section  MR  (a).  See  Rev.  Rul. 
62-178,  1962-2  C.B.  78. 


604 

Effective  date 
These   provisions    generally    apply    to    payments    received    after 
December  31,  1973,  in  taxable  years  ending  after  such  date.  However, 
the  provision  relating  to  foreclosures  by  lending  institutions  applies  to 
stock  acquired  after  the  date  of  enactment  (October  4,  1976). 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 

receipts  of  less  than  $5  million  annuall}'. 

2.  Treatment  of  Certain  Crop  Disaster  Payments  (sec.  2102  of  the 
Act  and  sec.  451(d)  of  the  Code) 

Prior  law 

Insurance  proceeds  received  by  a  taxpayer  as  a  result  of  destruc- 
tion or  damage  to  cix>ps  may  be  included  in  income  in  the  taxable  year 
following  the  year  of  their  receipt,  if  it  can  be  established  that  the  in- 
come from  the  crops  which  were  destroyed  or  damaged  would  other- 
wise have  been  properly  included  in  income  in  the  following  taxable 
year  (sec.  451(d) ).  The  reason  for  this  provision  is  to  avoid  the  prob- 
lem of  doubling  up  income  for  a  cash  basis  farmer  by  including  crop 
insurance  proceeds  in  income  in  the  taxable  year  they  are  received 
rather  than  in  the  taxable  year  following  the  year  of  receipt,  which 
would  generally  be  the  pattern  of  income  receipt  from  sales  of  crops. 

Because  of  this  doubling  up  of  income  in  the  year  of  receipt,  the 
farmer  would  have  only  deductions  and  no  income  to  report  in  the  next 
year  and  therefore  would  be  likely  to  have  a  net  operating  loss  to  carry 
l)ack  and  offset  against  income  in  the  prior  year.  However,  the  farmer 
in  such  cases  was  faced  with  the  payment  of  tax  and  subsequent  filing 
for  a  refund.  He  also  loses  the  benefit  of  his  personal  exemption  and 
his  standard  or  itemized  deductions  in  the  year  of  loss. 

Reasons  for  change 

The  Agriculture  and  Consumer  Protection  Act  of  1973  (Public  Law 
93-86,  which  amended  the  Agricultural  Act  of  1949)  provides  that 
specified  payments  by  the  Department  of  Agriculture  are  to  be  made 
to  farmers  in  the  event  that  they  are  either  prevented  from  planting 
certain  crops  because  of  drought,  flood,  or  other  natural  disaster  or 
condition  or.  because  of  such  a  disaster  or  condition,  the  total  quantity 
of  certain  planted  crops  which  the  farmers  are  able  to  harvest  on  any 
farm  is  less  than  66%  percent  of  the  projected  yield  of  the  crop.  The 
crops  covered  by  these  disaster  payments  are  wheat,  corn,  grain, 
sorghum,  barley,  and  upland  cotton.*^  Premium  payments  are  not  re- 
quired for  this  protection. 

The  Service  ruled  that  the  provisions  of  prior  law  were  not  ap- 
plicable to  the  payments  provided  to  the  farmers  who  are  covered 
by  the  Agriculture  and  Consumer  Protection  Act  of  1973  on  the 
grounds  that  the  proceeds  are  not  insurance  proceeds  since  no  premium 
was  paid  bv  the  farmer.  As  a  result  of  the  Service's  position  with  re- 
spect to  the  payments  received  by  a  taxpayer  under  the  Agriculture 
and  Consumer  Protection  Act  of  1973,  these  payments  had  to  be  re- 
ported as  taxable  income  in  the  year  of  receipt  and  not  in  the  year 
in  which  the  income  from  the  sale  of  the  crops  would  normally  be 
reported. 


605 

Explanation  of  provision 
The  Act  provides  that  in  the  case  of  a  taxpayer  using  the  cash  re- 
ceipts and  disbursements  method  of  accountincr,  certain  payments 
received  pursuant  to  the  Agricultural  Act  of  1949,  as  amended  is  to  be 
included  in  the  taxable  income  of  the  taxpayer,  at  his  election,  in  the 
year  in  which  the  income  normally  received  from  the  crops  would 
have  been  reported.  This  provision  is  to  apply  only  to  such  payments 
received  as  a  result  of  (1)  destruction  or  damage  to  crops  caused  by 
drought,  flood  or  any  other  natural  disaster,  or  (2)  the  inability  to 
plant  crops  because  of  such  a  natural  disaster. 

EffeMlve  date 

This  provision  applies  to  payments  received  after  December  31, 1973, 
in  taxable  years  ending  after  such  date. 

Revenue  effect 
This  provision  will  reduce  budget  receipts  by  $48  million  in  fiscal 
year  1977,  $42  million  in  fiscal  year  1978,  and  $42  million  in  fiscal 
year  1981. 

3.  Tax  Treatment  in  the  Case  of  Certain  1972  Disaster  Loans  (sec. 
2103  of  the  Act) 

Taxpayers  are  generally  allowed  to  deduct  their  losses  sustained 
during  the  taxable  year,  including  losses  attributable  to  fire,  storm 
and  other  casualty,  to  the  extent  that  such  losses  are  not  compensated 
for  by  insurance  or  otherwise.^  In  the  case  of  any  loss  attributable  to  a 
major  disaster  which  occurred  in  an  area  authorized  by  the  President 
to  receive  disaster  relief,  a  special  rule  allows  the  loss,  at  the  election  of 
the  taxpayer,  to  be  deducted  on  the  return  for  the  year  immediately 
preceding  the  year  of  the  disaster  (that  is,  the  loss  mav  be  deducted  on 
the  return  which  is  gcjierally  filed  in  the  year  in  which  the  disaster 
occurs).  In  a  case  where  a  deduction  resulting  from  a  loss  is  claimed 
in  one  year,  and  compensation  is  paid  with  respex?t  to  that  loss  in  a 
later  year,  the  amount  of  compensation  is  generally  required  to  be 
taken  into  income  by  the  taxpayer  under  the  tax  benefit  theory. 

Reasons  for  change 
Certain  cases  arising  in  the  past  have  come  to  the  attention  of  the 
Congress  in  which  individuals  who  were  hard  hit  by  disasters,  such 
as  a  flood,  claimed  a  deduction  with  respect  to  the  disasters,  unaware, 
in  many  cases,  that  thev  might  later  receive  compensation,  or  partial 
compensation,  for  their  loss.  In  some  instances,  the  compensation 
may  be  received  in  a  year  for  which  the  taxpayer  is  in  a  higher  tax 
bracket  than  he  was  in  for  the  year  for  which  the  disaster  loss  deduc- 
tion was  claimed.  As  a  result,  the  taxpayer  may  be  required  to  pay 
more  tax,  with  respect  to  the  compensation  or  reimbursement,  than 
would  have  been  owing  if  he  had  not  claimed  the  deduction  in  the 
first  place. 

Explanation  of  provision 
The  Act  provides  that,  under  certain  circumstances,  jn  the  case  of 
a  loss  attributable  to  a  disaster  which  occui-red  in  1972,  in  an  area 


1  Individuals  generally  are  allowed   to  deduct  their  losses  of  property    (not  connecteji 
with  their  trade  or  business)  only  to  the  extent  that  the  loss  exceeds  $100  :  losses  attrib- 

iitnhlo  in  nn  Indl vlHiml'o  hnsinpas  nre  fnllv  dpdiictihle. 


Willi    Liit^ii     iiiiiir    ui     ini»iiirar<;    uiiij'     n-»    mc    cvuruu    i.ixo 

utable  to  an  indiyldual's  business  are  fully  deductible 


606 

designated  by  the  President  as  a  disaster  relief  area,  the  tax  on  the  first 
$5,000  of  compensation  i-eceived  witli  respect  to  that  loss  is  not  tc  ex- 
ceed the  tax  which  would  have  been  payable  if  the  $5^000  (or  lesser) 
deduction  had  not  been  claimed.  This  treatment  applies  only  if  the 
taxpayer  elects  to  come  under  these  provisions,  in  a  time  and  manner 
to  be  prescribed  in  regulations  and  must  meet  certain  conditions. 

In  order  for  the  taxpayer  to  elect  the  benefits  of  this  provision,  he 
must  have  suffered  a  disaster  loss  for  the  year  1972,  and  to  be  fully 
eligible  under  this  provision  his  adjusted  gross  income  for  the  year 
in  which  he  claimed  the  disaster  loss  as  a  deduction  (either  1972  or 
1971,  as  the  case  may  be)  cannot  have  exceeded  $15,000  ($7,500  in  the 
case  of  a  married  individual  filing  a  separate  return).  In  those  cases 
where  an  individual  who  is  otherwise  eligible  under  this  provision  has 
adjusted  gross  income  in  excess  of  $15,000  (or  $7,500,  whichever  ap- 
plies), the  $5,000  limit  is  to  be  reduced  dollar-for-dollar  to  the  extent 
his  adjusted  gross  income  exceeds  $15,000. 

The  election  may  be  made  with  respect  to  up  to  $5,000  of  compen- 
sation which  is  paid  in  a  year  after  the  year  for  which  the  loss  deduc- 
tion is  claimed  and  which  results  either  (1)  from  the  forgiveness  or 
cancellation  of  a  disaster  loan  under  section  7  of  the  Small  Business 
Act  or  an  emergency  loan  under  subtitle  C  of  the  Consolidated  Fann 
and  Rural  Development  Act,  or  (2)  from  a  payment  made  to  the  tax- 
payer in  settlement  of  a  tort  claim  which  the  taxpayer  had  against 
another  jDerson. 

Any  compensation  or  reimbursement  in  excess  of  the  $5,000  limita- 
tion must  be  taken  into  income  by  the  taxpayer  for  the  year  in  which 
the  ])ayme:;t  is  received. 

If  these  condition^  are  satisfied,  and  the  taxpayer  makes  the  elec- 
tion, as  provided  for  under  the  Act,  then  tlie  tax  with  respect  to 
the  compensation  or  reimbursement  is  not  to  exceed  the  tax  which 
would  have  been  payable  if  the  loss  had  not  been  claimed  as  a  deduc- 
tion for  1971  or  1972  (as  the  case  may  be).  For  example,  if  a  $5,000 
deduction  was  claimed  for  1972  which  had  the  effect  of  reducing  the 
taxpayer's  taxable  income  for  that  year  to  $5,000  and  the  taxpayer 
was  a  married  taxpayer  who  filed  a  ]oint  return  for  that  year,  the 
tax  liability  with  respect  to  $5,000  of  compensation  received  in  a  later 
year  from  disaster  loan  forgiveness  or  settlement  of  tort  claim  lia- 
bility is  not  to  exceed  the  marginal  rate  on  the  difference  between 
$5,000  and '$10,000  of  taxable  income. 

In  addition,  since  many  of  the  taxpayers  affected  by  this  provision 
may  still  be  suffering  hardships  from  the  effects  of  the  flood,  the  Act 
provides  that  any  tax  with  respect  to  this  $5,000  amount  which  was 
still  unpaid  on  October  1,  1975,  may  be  paid  in  three  equal  annual 
installments,  with  the  first  such  installment  due  and  payable  on 
April  15,  1977.  Also,  under  the  amendment,  no  interest  on  any  de- 
ficiency with  respect  to  this  $5,000  amount  is  to  be  payable  for  any 
period  prior  to  April  16,  1977,  and  no  interest  is  to  be  payable  with 
respect  to  any  installment  payment  (made  under  this  rule  as  just  out- 
lined) before  the  due  date  for  that  installment. 

Effective  date 
This  provision  shall  apply  to  payments  received  after  1971  in  con- 
nection with  a  1972  disaster  loss,  even  if  the  year  involved  is  closed. 


607 

provided  a  claim  for  refund  is  made  within  one  year  of  the  date  of 
enactment  (October 4, 1976). 

ReTeime  effect 
This  provision  will  reduce  revenue  hy  $60  million  in  fiscal  year  1977, 
$15  million  in  fiscal  year  1978,  and  $15  million  in  fiscal  year  1979,  with 
no  revenue  loss  thereafter. 

4.  Tax  Treatment  of  Certain  Debts  Owed  by  Political  Parties  to 
Accrual  Basis  Taxpayers  (sec.  2104  of  the  Act  and  sec.  271  of 
the  Code) 

Prior  Law 

Under  prior  law,  any  deduction  generally  allowable  for  bad  debts 
(sec.  160)  or  for  worthless  securities  (sec.  165(o;) )  was  not  allowed  foi' 
a  worthless  debt  owned  by  a  political  party.  This  provision  applied  to 
all  taxpayers  other  than  a  bank  (as  defined  in  sec.  581),  but  where  the 
debt  arose  out  of  the  sale  of  g:oods  or  services,  the  provision  affected 
only  taxpayers  utilizing;  the  accrual  method  of  accounting  (because 
these  taxpayers  would  have  taken  into  income  the  receipts  which  give 
rise  to  the  debt) . 

The  provision  defined  political  parties  to  include  all  committees  of 
a  political  part}'  and  all  committees,  associations,  or  other  organiza- 
tions wliich  accept  contributions  or  make  expenditures  on  behalf  of 
any  individual  in  any  Federal.  State  or  local  election. 

Reasons  for  change 

The  disallowance  of  a  bad  debt  deduction  for  debts  owed  by  politi- 
cal parties  caused  a  substantial  hardship  for  taxpayers  in  the  busi- 
ness of  providing  goods  or  services  (such  as  polling,  media,  or  orga- 
nizational services)  to  political  campaigns  and  candidates.  The  busi- 
ness of  providing  these  types  of  services  has  grown  substantially  in 
recent  years.  As  a  result,  a  significant  number  of  taxpayers  have  been 
placed  in  a  less  favorable  position  than  taxpayers  in  virtually  any 
other  business  because  they  have  not  been  able  to  deduct  bad  debts 
which  arise  in  the  ordinary  course  of  their  business. 

The  provision  disallowing  any  bad  debt  deduction  was  originally 
enacted  to  prevent  tax  deductions  for  concealed  campaign  contribu- 
tions. However,  since,  in  the  case  of  the  sale  of  goods  or  services,  the 
deduction  was  allowed  only  if  the  amount  of  gross  receipts  which  gave 
rise  to  the  debt  was  included  in  taxable  income,  the  effect  of  the  pro- 
vision was  to  tax  these  individuals  on  income  Avhich  they  never 
received. 

Furthermore,  since  prior  law  did  not  afl'ect  cash  basis  taxpayers 
who  sell  services  for  political  campaigns  because  in  that  cas«  no  amount 
is  taken  into  income,  the  provision  discriminated  against  taxpayers 
whose  business  differs  from  others  only  in  that  they  were  on  the  ac- 
crual method  of  accounting. 

Explanation  of  provision 
The  Act  adds  an  exception  to  the  provision  disallowing  a  deduction 
for  bad  debts  owed  by  political  parties  (sec.  271).  The  exception  ap- 
plies only  to  taxpayers  who  use  \\\q  accrual  method  of  accounting. 
These  taxpayers  are  to  be  allowed  a  bad  debt  deduction  with  respect 
to  debts  which  are  accrued  as  a  receivable  in  a  hona  fide  sale  of  goods 


or  services  in  the  ordinary  course  of  their  trade  or  business.  Thus,  the 
receipts  giving  rise  to  the  debt  must  have  been  taken  into  income  in 
order  for  the  deduction  to  be  obtained. 

The  Act  limits  this  exception  to  those  cases  in  which  30  percent  of 
all  of  the  receivables  accrued  in  the  ordinary  course  of  all  of  the 
trades  or  businesses  of  the  taxpayer  are  due  from  political  parties. 
Thus,  the  exception  is  limited  to  those  taxpayers  whose  sales  to  politi- 
cal parties  (inchiding  political  campaigns  and  candidates)  constitute 
a  major  portion  of  their  trades  or  businesses.  In  determining  the 
amount  required  to  meet  the  30  percent  rule,  all  of  the  taxpayer's 
trades  and  businesses  are  to  be  considered.  Thus,  in  the  case  of  an  indi- 
vidual, every  trade  or  business  which  the  taxpayer  controls  is  to  be 
aggregated  for  purposes  of  this  test.  In  the  case  of  a  taxpayer  which 
is  a  corporation,  every  trade  and  business  of  all  corporations  under 
common  ov/nership  with  the  taxpayer  is  to  be  aggregated. 

The  bad  debt  deduction  is  to  he  allowed  only  if  the  taxpayer  has 
made  substantial  continuing  efforts  to  collect  on  the  debt.  Thus,  a  tax- 
payer must  make  good  faith  efforts  over  a  period  of  time  to  collect  the 
debt  and  must  be  able  to  document  those  efforts.  However,  it  is  not 
intended  that  a  taxpayer  is  required  in  any  case  to  file  a  lawsuit 
against  the  debtor  in  order  to  be  determined  to  have  made  substantial 
continuing  efforts. 

The  Congress  affirmed  that  the  provision  of  prior  law  was  not  in- 
tended to  apply  to  taxi:)ayers  whose  primary  business  is  to  provide 
goods  or  services  to  political  parties.  The  changes  made  by  the  Act 
thus  reflect  Congress'  original  intent  in  enacting  prior  law. 

Effective  date 
This  provision  is  to  apply  to  taxable  years  beginning  after  Decem- 
ber 31,  1975. 

Revenue  effect 

It  is  anticipated  that  this  provision  will  produce  a  negligible  loss  of 
revenues. 

5.  Tax-Exempt  Bonds  for  Student  Loans  (Sec.  2105  of  the  Act  and 
sec.  103  of  the  Code) 

Prior  law 
Under  section  103(a)  of  the  Code,  interest  paid  on  certain  govern- 
mental obligations  is  exempt  from  Federal  income  tax.  These  obliga- 
tions are  those  of  the  States  and  their  political  subdivisions,  and  of 
certain  corporations  organized  under  an  Act  of  Congress  as  instru- 
mentalities of  the  United  States.  However,  interest  on  such  govern- 
mental obligations  (with  a  minor  exception)  is  not  exempt  from  tax- 
ation if  a  major  portion  of  the  proceeds  can  be  reasonably  expected  to 
be  used,  directly  or  indirectly,  to  purchase  nonexempt  securities  or 
obligations  that  can  reasonably  be  expected  to  produce  a  higher  yield 
over  the  term  of  the  issue  than  the  yield  on  the  governmental  obliga- 
tions. These  governmental  obligations,  which  are  subject  to  Federal 
taxation,  are  called  "arbitrage  bonds."  In  addition,  governmental 
obligations  whose  proceeds  are  expected  to  be  used  to  replace  such 
nonexempt  go.ernmental  obligations  are  themselves  subject  to  tax. 


609 

However,  governmental  obligations  are  not  treated  as  arbitrage 
bonds  merely  because  their  proceeds  are  temporarily  invested  in  ob- 
ligations paying  a  higher  yield  until  those  proceeds  can  be  put  to  their 
intended  purpose.  In  addition,  obligations  are  not  arbitrage  bonds 
simply  because  their  proceeds  are  invested  in  obligations  paying  a 
higher  yield  that  are  a  part  of  a  reasonably  required  reserve  or  re- 
placement fund. 

Reasons  for  change 

Congress  is  a^vare  that  groups  in  at  least  one  State  are  attempting 
to  develop  a  student  loan  program  for  students  dei?iring  a  college 
education.  Since  political  subdivisions  in  the  State  apparently  do  not 
have  the  governmental  authority  to  issue  bonds  to  finance  their  own 
student  loan  programs,  not-for-profit  corporations  in  that  State  are 
being  organized  to  finance  the  needed  student  loan  programs.  These 
corporations,  however,  faced  considerable  obstacles  because  tlie  interest 
on  bonds  tliey  wished  to  issue  to  finance  student  loans  may  have  been 
taxable  under  prioi-  law.  The  corporations  are  not  political  subdi- 
visions of  the  State  and  could  not  be  treated  under  the  Treasury  reg- 
ulatio)is  as  acting  "on  behalf  of"  the  State  or  its  political  subdi- 
visions. Even  if  they  were  described  in  section  103(a),  these  obliga- 
tions might  not  have  been  exempt  because  they  might  have  been 
arbitrage  bonds  under  section  103  (c) . 

Under  the  Emergency  Insured  Student  Loan  Act  of  1969,  the  Com- 
missioner of  Education  (of  the  Department  of  Health,  Education, 
and  "Welfare)  is  authorized  to  provide  incentive  payments  to  institu- 
tions providing  student  loans.  Although  the  maximinn  rate  of  interest 
to  be  paid  by  students  on  their  loans  is  now  set  at  seven  percent,  this 
yield,  together  with  the  incentive  payments  received  by  the  institution 
making  the  loan  from  the  Commissioner  of  Education,  would  consti- 
tute a  yield  that  could  be  higher  than  the  maximum  yield  the  corpora- 
tions believe  they  vv'ould  be  able  to  pay  on  their  bonds  if  they  are  to 
cover  administrative  expenses  and  maintain  a  solvent  loan  program. 
Consequently,  tlieir  bonds,  under  prior  law,  would  be  considered 
arbitrage  bonds  and  not  entitled  to  tax  exemption. 

Congress  believes  it  is  appropriate  to  treat  the  obligations  of  these 
corporations  providing  student  loans  in  the  same  manner  as  if  the 
State  had  issued  the  bonds  directly. 

ExpluTiation  of  provision 

This  proAdsion  adds  to  the  list  of  exempt  obligations  described  in 
section  103(a)  those  obligations  of  not-for-profit  corporations  or- 
ganized by,  or  requested  to  act  by,  a  State  or  a  political  subdivision 
of  a  State  (or  of  a  possession  of  the  United  States),  solely  to  acquire 
student  loan  notes  incurred  under  the  Higher  Education  Act  of  1965, 
The  entire  income  of  these  corporations  (after  payment  of  expenses 
and  provision  for  debt  service  requirements)  must  accrue  to  the  State 
or  political  subdivision,  or  be  reauired  to  be  used  to  purchase  addi- 
tional student  loan  notes.  The  obligations  are  to  lie  called  "Qualified 
Scholarshi])  Fundi nir  Bonds." 

As  a  result  of  this  provision,  organizations  which  v.-ish  to  maintain 
student  loan  programs  will  have  statutory  autliority  to  issue  tax- 
exempt  bonds  to  finance  their  operations. 


610 

In  addition,  a  provision  is  added  to  make  it  clear  that  the  student 
loan  incentive  payments  made  by  the  Commissioner  of  Education 
under  the  Emergency  Insured  Student  Loan  Act  of  1969  are  not  to  be 
taken  into  account  in  determining  whether  the  yield  on  the  student 
loan  notes  is  higher  than  the  yield  on  the  bonds  issued  to  finance  the 
student  loan  program.  As  a  result,  bonds  issued  to  finance  student  loan 
programs  would  be  expected  to  be  able  to  avoid  arbitrage  bond 
classification. 

E-ffective  date 
These  provisions  would  apply  to  obligations  issued  on  or  after 
the  date  of  enactment.  Thus,  the  interest  on  bonds  issued  on  or  after 
the  date  of  enactment  in  order  to  finance  student  loan  programs  to 
enable  students  to  attend  institutions  of  higher  learning  may  be 
exempt  from  Federal  taxation  if  the  requirements  of  the  amendment 
are  met. 

Revenue  ejfect 
It  is  estimated  that  these  provisions  will  reduce  the  revenues  by  less 
than  $5  million  annually. 

6.  Personal  Holding  Company  Amendments  (Sec.  2106  of  the  Act 
and  Sec.  543  of  the  Code) 

Prior  la/w 

A  corporation  which  is  a  personal  holding  company  is  taxed  on  its 
undistributed  personal  holding  company  income  at  a  rate  of  70  per- 
cent (sec.  541).  A  corporation  is  a  personal  holding  company  where 
five  or  fewer  individuals  own  more  than  50  percent  in  value  of  its 
outstanding  stock  and  at  least  60  percent  of  the  corporation's  adjusted 
ordinary  gross  income  comes  from  certain  types  of  income. 

Royalties  (other  than  mineial,  oil  or  gas  royalties  and  copyright 
royalties)  received  by  a  corporation  are  personal  holding  company 
income,  regardless  of  how  much  income  of  other  types  the  corporation 
may  have  (sec.  543(a)  (1)).  "Royalties''  include  amounts  received  for 
a  license  to  use  trade  brands,  secret  processes,  franchises  and  similar 
intangible  property. 

In  general,  rental  income  received  from  persons  other  than  major 
shareholders  is  treated  as  personal  holding  company  income  unless 
such  rent  comprises  50  percent  or  more  of  the  corporation's  adjusted 
ordinary  gross  income  and,  if  the  companj^  has  a  substantial  amount 
of  other  types  of  personal  holding  company  income,  it  distributes  such 
income  (sec.  543(a)  (2)). 

Under  a  separate  rule  of  prior  law  (sec.  543(a)  (6) ),  rents  received 
by  a  corporation  from  leasing  corporate  "property"  to  a  25 -percent  or 
greater  shareholder  were  pei-sonal  holding  company  income,  but  only 
if  over  10  percent  of  the  company's  total  income  came  from  otlier  types 
of  personal  holding  company  income.  In  Rev.  Rul.  71-596, 1971-2  Cum. 
Bull.  242,  the  IRS  ruled  that  a  company's  income  from  licensing  a 
major  shareholder  to  make  and  sell  a  secret  process  was  governed 
by  the  "royalty"  rule  rather  than  by  the  "sliareholder  rent"  rule.  In 
1975  the  U.S.  Court  of  Claims  also  held  in  Montgomery  Coca-Cola 
Bottlmg  Co.  v.  United  States,  75-1  USTC  para.  9291,  35  AFTR  2d 


611 

75-1081  (Ct.  CI.  1975),  that  the  royalty  rule  rather  than  the  share- 
holder rent  rule  applies  to  income  from  a  license  of  intangible  prop- 
erty. Consequently,  the  full  license  payments  of  this  kind  have  been 
held  to  be  personal  holdino-  company  income  in  the  category  of 
"royalties"  (sec.  54:3(a)(l)),  regardless  of  how  much  income  of 
otlier  types  the  corporation  may  have. 

Reasons  for  change 

Broadly  stated,  the  rationale  for  the  treatment  of  rental  income 
generally  under  the  personal  holding  company  rules  is  that  if  the  rents 
received  for  the  use  of  corporate  property  are  over  half  of  the  cor- 
poration's total  income,  the  company  is  engaged  in  an  active  real  estate 
business  and  generally  ought  not  be  treated  as  being  used  merely  to 
deflect  passive  income  away  from  its  shareholders.  Similarly,  rental 
income  received  from  shareholders  has  generally  not  been  treated 
as  personal  holding  company  income  unless  the  income  is  used  to 
shelter  appreciable  amounts  of  other  investment  income.  How^ever. 
the  statute  has  long  treated  income  from  royalties  received  by  a  cor- 
poration for  the  use  of  intangible  property  (except  for  certain  spe- 
cially treated  kinds  of  royalties)  as  personal  holding  company  income 
regardless  of  the  nature  or  source  of  the  company's  other  income. 
Typically,  such  royalties  come  from  third-person  payors  unrelated 
to  the  corporation,  i.e.,  persons  who  are  not  its  shareliolders.  The 
issue  is  whether  more  favorable  treatment  under  sec.  543(a)(6) 
should  be  accorded  to  royalty  income  received  by  a  corporation  from 
one  or  more  of  its  major  shareholders  than  is  accorded  the  same  type 
of  income  when  it  is  received  from  outsiders.  Congress  concluded  that 
no  sound  justification  exists  for  such  a  distinction. 

On  the  other  hand,  it  has  come  to  Congress"  attention  that  in  some 
situations  a  corporation  may  be  given  ownership  of  licenses  and  other 
intangible  property  in  order  to  protect  the  license  through  the 
perpetual  life  of  the  corporation,  although  the  shareholders  still  desire 
to  conduct  a  trade  or  business  in  which  they  use  the  license. 
Consequently,  the  corporation  w  ill  license  the  contract  right  to  one  or 
more  of  its  shareholders  who  will  use  the  contract  right  in  conducting 
his  or  their  sepaiate  business.  In  this  type  of  situation.  Congress  be- 
lieves that  if  tangible  and  intangible  property  are  together  leased  and 
licensed  to  a  25  percent  or  greater  sliareholder  and  used  by  him  in  con- 
ducting an  active  trade  or  business,  the  company's  income  from  the 
license  (although  treated  as  royalty  income  under  section  543  (a)  (1) 
by  reason  of  the  Act)  should  not  count  as  a  type  of  income  which,  un- 
der the  10  percent  test  of  section  543(a)  (6),  could  cause  income  from 
the  tangible  property  to  be  treated  as  personal  holding  company 
income. 

Explanati-on  of  provision 
The  Act  amends  the  shareholder  rent  rule  in  section  543(a)  (6)  to 
apply  that  rule  only  to  tangible  property  leased  by  a  corporation  to 
one  or  more  of  its  major  shaivholders.  Conp-ress  intends,  liowever,  that 
even  if  income  received  bv  the  corporation  from  renting  tansrible  prop- 
erty to  a  maior  shareholder  qualifies  under  the  tests  in  section  543(a) 
(6)  as  nonpersonal  holding  company  income,  such  income  must  also 


612 

be  treated  as  rental  income  for  purposes  of  the  general  rent  rules  in 
section  543(a)(2)  of  present  law  and,  as  such,  must  be  separately 
tested  under  those  rules.  On  the  other  liand,  if  income  from  a  lease 
of  tangible  property  constitutes  personal  holding  company  income 
pursuant  to  the  tests  of  section  543(a)  (6),  it  will  be  personal  holding 
company  income  even  if  it  could  qualify  not  to  be  so  treated  under 
the  general  rent  rules  of  section  543(a)  (2)  (by  reason,  for  example,  of 
satisfying  the  dividend  distribution  requirements  of  that  paragraph). 
In  order  not  to  constitute  personal  holding  company  income,  there- 
fore, rents  from  tangible  property  must  satisfy  the  applicable  rules 
of  both  paragraphs  (2)  and  (6)  of  section  543(a). ^ 

The  Act  also  makes  clear,  in  effect,  that  income  from  the  use  of  secret 
processes,  trade  brands  and  other  intangible  property  (but  not 
including  certain  specially-treated  royalties) ,  are  always  to  be  treated 
as  pereonal  holding  company  income  under  the  general  royalty  rule 
(sec.  543  (a)  ( 1 ) ) ,  regardless  of  whether  they  are  received  from  a  share- 
holder of  the  corporation  or  from  an  unrelated  third  party. 

The  Act  provides,  however,  that  solely  for  purposes  of  determining 
under  section  543(a)(6),  as  amended,  whether  over  10  percent  of 
the  corporation'o  income  consists  of  personal  holding  company  income, 
income  from  a  license  of  intangible  property  to  a  25  percent  or  great- 
er shareholder  is  not  to  be  treated  a^  personal  holding  company  income, 
but  only  if  the  corporation  owns  a  substantial  part  of  the  tangible 
property  used  in  connection  with  the  intangible  property  and  leases 
to  the  shareholder  both  kinds  of  property,  all  of  which  he  uses  to  con- 
duct an  active  trade  or  business.  If  these  conditions  are  not  satisfied, 
compensation  received  for  the  use  of  intangibles  is  included  among  the 
other  types  of  personal  holding  company  income  of  the  company  for 
purposes  of  applying  the  10  percent  test  under  section  643(a)  (6)  to 
determine  whether  income  from  tangible  property  is  to  be  treated 
as  personal  holding  company  income  under  that  paragraph. 

Effective  date 
These  changes  made  in  section  543  of  the  Code  apply  to  taxable  years 
beginning  after  December  31, 1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  not  have  a  significant  effect 
on  tax  revenues. 


1  Rental  Income  received  by  a  corporation  from  the  use  of  tangible  property  by  a  25- 
pereent  or  prrpater  shareholder  may  satisfy  the  requirements  under  section  543(a)(2)  in 
order  to  escape  treatment  as  personal  holding  company  income,  but  such  Income  may  still 
he  treated  as  personal  holding  company  Income  by  reason  of  the  rules  of  section  543(a)  (6). 

Conversely,  rent  received  from  shareholders  can  "pass"  section  543(a)  (6)  but  still  "fail" 
the  tests  in  section  543(a)(2),  with  the  result  that  such  Income  will  constitute  personal 
holding  company  income.  To  illustrate  this  latter  situation,  assume  that  a  corporation 
receives  $100  in  rents  (for  tangible  property)  from  a  major  shareholder  and  $6  in  dividend 
income  from  portfolio  investments  and  that  the  company  expends  $95  In  deductions  for 
depreciation,  interest,  and  property  taxes  relating  to  the  rental  property.  On  these  facts, 
the  rental  Income  is  not  personal  holding  company  income  under  section  543(a)  (6)  because 
less  than  10  percent  ($6/$106)  of  the  company's  ordinary  gross  income  is  derived  from  other 
personal  holding  company  income.  However,  the  rental  Income  must  also  be  tested  under 
the  general  rent  rule  of  section  543(a)(2).  So  tested,  the  rent  income  is  personal  holding 
company  income  because  the  50  percent  safe  haven  test  (in  sec.  543(a)(2)(A)  is  not 
satisfied;  the  adjusted  Income  from  rents  ($5)  is  less  than  50  percent  of  the  company's 
adjusted  ordinary  gross  Income  ($11). 


613 

7.  Work  Incentive  (WIN)  and  Federal  Welfare  Recipient  Employ- 
ment Incentive  Tax  Credits  (sec.  2107  of  the  Act  and  sec 
50  (A)  and  (B)  of  the  Code) 

Prior  law 

Under  prior  law,  a  work  incentive  (WIN)  credit  equal  to  20  percent 
of  the  wages  paid  during  the  first  12  months  of  employment  to  qualified 
AFDC  recipients  was  available  to  employers  engaged  in  a  trade  or 
business  who  hire  such  employees.  Qualified  participants  were  certified 
by  the  local  WIN  agency. 

The  amount  of  the  credit  available  in  any  year  was  limited  to  the 
first  $25,000  of  tax  plus  one-half  of  tax  liability  in  excess  of  $25,000. 
The  credit  was  not  available  in  the  case  of  an  employee  who  ceased  to 
work  for  the  original  employer  unless  the  employee  voluntarily  quit, 
became  disabled,  or  was  fired  for  misconduct  before  two  years  had 
passed. 

Under  the  Federal  welfare  recipient  employment  incentive  tax  credit 
(welfare  recipient  tax  credit),  all  private  employers  including  those 
who  provide  employment  for  private  household  workers  were  eligible 
for  the  credit.  Qualified  employees  were  AFDC  recipients  who  had 
received  benefits  for  90  days.  The  credit  was  essentially  the  same  as  the 
WIN  credit :  20  percent  of  eligible  wages,  except  that  there  was  a  limit 
of  $5,000  a  year  on  the  annual  eligible  wages  for  nonbusiness  em- 
ployees; the  same  overall  credit  limit  of  $25,000  of  tax  plus  one-half 
of  the  excess  also  applied.  The  State  or  local  welfare  agency  certified 
recipients  as  qualified.  This  provision  expired  on  July  1, 1976. 

Reasons  for  change 

WIN  tax  credit. — The  Congress  was  concerned  that  the  WIN  tax 
credit  is  not  being  used  to  the  extent  anticipated.  One  aspect  of  the 
WIN  tax  credit  which  has  been  cited  as  a  major  reason  why  employers 
are  not  using  the  credit  is  the  requirement  for  repayment  of  the  credit 
by  the  employer  if  he  terminates  the  employment  without  cause  before 
the  end  of  the  second  year.  A  significant  percentage  of  the  amounts 
which  have  been  earned  as  tax  credits  have  reportedly  been  recovered 
by  the  IRS  for  this  reason.  It  has  been  suggested  to  the  Congress 
that  the  removal  or  modification  of  this  recapture  provision  would  en- 
courage greater  use  of  the  tax  credit  and  would  make  it  consistent  with 
the  welfare  recipient  tax  credit,  which  has  no  recapture  provision. 

Another  suggestion  for  promoting  greater  use  of  the  credit  has  been 
to  raise  the  dollar  limitations  on  the  amount  which  any  single  em- 
ployer can  claim.  Treasury  statistics  indicate  that  about  63  percent  of 
the  amount  claimed  for  W^IN  is  by  corporations  with  assets  in  excess 
of  $250  million.  These  larger  corporations  might  be  expected  to  make 
greater  use  of  the  credit  by  hiring  more  welfare  recipients  if  there 
were  a  higher  limit  on  the  amount  which  could  be  claimed. 

Welfare  recipient  tax  credit. — The  welfare  tax  credit,  which  became 
effective  March  29,  1975  (as  part  of  the  Tax  Reduction  Act  of  1975) 
and  expired  July  1, 1976,  has  been  in  effect  for  too  brief  a  time  to  judge 
its  effectiveness.  Early  statistics  show,  however,  that  there  has  been  vir- 
tually no  use  made  of  the  provision  thus  far.  Part  of  the  problem  is 


234-120  O  -  77  -  40 


614 

that  it  is  still  unknown  and  employers  have  not  yet  had  any  experience 
with  it.  In  order  to  give  it  a  fairer  test,  it  would  seem  desirable  to  ex- 
tend the  expiration  date  into  the  future.  This  would  assure  not  only 
that  there  would  be  sufficient  opportunity  to  make  employers  aware 
of  its  advantages,  but  also  that  it  could  be  tested  over  time  for  its  use- 
fuhiess  as  a  means  of  getting  welfare  recipients  moved  into  jobs. 

Because  the  welfare  tax  credit  was  originally  passed  with  a  15-month 
limit,  there  was  no  reason  to  provide  for  a  limit  to  the  period  of  time 
for  which  the  credit  could  be  claimed  for  any  one  employee.  However, 
when  the  credit  is  extended  for  several  years  such  a  limit  becomes 
necessary.  It  is  difficult  to  justify  giving  an  employer  a  tax  advantage 
for  an  indefinite  period  into  the  future  for  each  welfare  recipient  he 
may  hire.  One  year  would  seem  to  be  adequate  time  for  the  employer- 
employee  relationship  to  have  become  well  enough  established  to  make 
termination  of  the  credit  with  regard  to  an  employee  justifiable  and 
without  undue  risk  to  tlie  employee.  This  would  be  consistent  with 
the  WIN  tax  credit  provision  which  also  gives  a  credit  only  for  the 
first  12  months  of  employment. 

Explanation  of  provision 

The  Act  makes  several  modifications  to  both  the  WIN  and  welfare 
tax  credits  to  make  them  more  effective. 

The  Act  makes  three  changes  in  the  AVIN  credit.  First,  the  credit 
is  available  from  tlie  date  of  hiring  if  employment  is  not  terminated 
without  cause  before  the  end  of  six  months.  Second,  an  additional 
exemption  is  added  to  the  recaptui-e  rules  so  that  there  would  be 
no  recapture  of  the  credit  if  the  employee  wei-e  laid  off  due  to  a  sub- 
stantial reduction  in  business.  Third,  the  limit  on  the  credit  is  doubled 
from  $25,000  to  $50,000  plus  one-half  of  the  excess  over  $50,000. 

The  Act  also  made  three  changes  in  the  welfare  recipient  tax  credit. 
First,  the  expiration  date  is  extended  from  July  1,  1976,  to  January  1. 
1980.  Second,  a  limit  of  12  months  for  which  the  wages  of  any  one 
employee  would  be  eligible  for  the  credit  is  ])rovided.  Third,  the  WIN 
agencies  can  also  certify  eligibility  for  the  welfare  recipient  tax 
credit. 

Effective  dote 
These  changes  became  effective  upon  the  date  of  enactment  of  this 
Act  (October  4,  1976). 

Revenue  effect 
This  provision  will  reduce  budget  receipts  b}^  $3  million  in  fiscal 
year  1977,  $7  million  in  fiscal  year  1978,  and  $9' million  in  fiscal  year 
1981. 

8.  Excise  Tax  on  Parts  for  Light-Duty  Trucks  (sec.  2108  of  the 
bill  and  sec.  6416(b)  (2)  of  the  Code) 

Prior  Jaiv 
The  Revenue  Act  of  1971  repealed  the  10-percent  excise  tax  on  light- 
duty  trucks  and  buses  (those  with  gross  vehicle  weight  of  10,000  ]:)0unds 
or  less).  As  a  result,  truck  and  bus  parts  and  accessories  sold  by  the 
vehicle  manufacturer  as  part  of  (or  in  connection  with  the  sale 
thereof)  a  light-duty  truck  or  bus  are  not  subject  to  tax — neither  the 
10-percent  tax  that  used  to  be  imposed  on  the  vehicle,  nor  the  8-percent 


615 

tax  on  truck  parts  and  accessories.  (Both  the  10-percent  and  8-percent 
taxes  are  scheduled  to  be  reduced  to  5-percent  for  sales  on  or  after 
October  1,  1979).  Also,  if  a  truck  parts  or  accessories  manufacturer 
sells  parts  or  accessories  to  a  manufacturer  of  light-duty  trucks  for  use 
in  "further  manufacture''  of  those  trucks,  the  parts  and  accessories 
are  not  subject  to  tax.  However,  under  prior  law,  if  the  truck  parts 
manufacturer  sold  parts  separate  from  the  light-duty  trucks  and 
the  installation  of  those  parts  by  a  retail  truck  dealer  technically  was 
not  "further  manufacture"  of  the  trucks,  then  the  manufacturer's 
excise  tax  of  8  percent  applied.  This  was  so  even  though  the  part  or 
accessory  was  sold  to  the  retail  customer  at  the  same  time  he  purchased 
the  tax-exempt  light-duty  truck  or  bus. 

Reasons  for  change 
It  appeal  jd  inequitable  to  the  Congress  to  tax  a  truck  part  or  ac- 
cessory when  purchased  by  a  truck  dealer  as  a  separate  item  where  it 
is  sold  on  or  in  connection  -with  the  retail  sale  of  a  light-duty  truck, 
while  exempting  such  parts  or  accessories  if  they  were  included  with 
the  truck  as  delivered  from  the  manufacturer  to  the  dealer.  The  pro- 
vision removes  the  discriminatory  treatment  of  such  parts  and 
accessories. 

Explanation  of  provision. 
The  Act  provides  that  the  8-percent  manufacturer's  excise  tax  on 
truck  parts  and  accessories  is  to  be  refunded  or  credited  to  the  manu- 
facturer in  the  case  of  any  part  or  accessory  sold  on  or  in  connection 
with  the  first  retail  sale  of  a  light-duty  truck.  Thus,  those  parts  and 
accessories  are  to  be  effectively  treated  the  same  as  the  parts  and  acces- 
sories that  actually  are  a  part  of  the  tax-exempt  truck  as  delivered 
from  the  manufacturer.  Tlie  credit  or  refund  is  not  intended  to  cover 
replacement  parts  even  if  ordered  at  the  time  of  the  purchase  of  the 
truck,  but  only  those  parts  and  accessories  which  are  to  have  original 
use  on  the  purchased  truck  or  bus. 

Effective  date 
The  amendments  made  by  this  section  apply  to  parts  and  accessories 
sold  after  the  date  of  enactment  (after  October  4,  1976). 

Revenue  effect 
This  amendment  is  estimated  to  result  in  annual  revenue  losses  of 
about  $3  million.  This  revenue  would  otherwise  go  into  the  Highway 
Trust  Fund  (througli  September  30, 1979). 

9.  Exclusion  From  Manfacturers'  Excise  Tax  for  Certain  Articles 
Resold  After  Modification  (sec.  2109  of  the  Act  and  sec.  4063 
of  the  Code) 

Prior  law 

A  10 -percent  manufacturers'  excise  tax  is  imposed  on  sales  or  resales 
of  bodies  and  chassis  for  heavy  trucks,  buses  not  used  for  mass  trans- 
port, heavy  trailers  and  semitrailers,  and  highway  tractors  (other 
than  for  light-duty  trucks  or  buses — those  with  gross  vehicle  weight  of 
10,000  pounds  or  less). ^  An  8-percent  tax  is  imposed  on  sales  or  re- 


1  The  rate  of  tax  Is  to  be  reduced  to  5  percent  for  sales  on  or  after  October  1,  1979 
rsec.  4061(a)(1)  of  the  Code). 


616 

sales  of  parts  or  accessories  for  trucks  and  buses  (sec.  40Gl(b) ).-  The 
same  taxes  are  imposed  upon  a  manufacturer,  producer,  or  importer 
of  an  article  who  uses  tliat  article  himself  and  does  not  sell  it  (sec. 
4218). 

Reasons  for  change 
Persons  Avho  obtain  bodies  or  chassis  and  certain  parts  or  accessories 
from  different  manufacturers  and  combine  them  are  considered  "fur- 
ther manufacturers"  and  must  pay  a  10-percent  tax  on  the  resale  of  the 
combined  article,  after  credit  for  tax  previously  paid  by  the  original 
manufacturers.  The  same  additional  tax  must  be  paid  by  the  "further 
manufacturer"  who  uses  the  combined  article  himself  rather  than 
I'esells  it.  On  the  other  hand,  persons  who  buy  the  entire  combination 
from  a  single  manufacturer  do  not  pay  a  manufacturers'  excise  tax  on  a 
resale  or  personal  use  even  if  they  themselves  must  combine  the  articles. 
This  discriminatory  tax  treatment  results  in  a  competitive  disadvan- 
tage to  the  taxpayer  who  combines  the  articles  from  different  manu- 
facturers since  he  must  pay  an  additional  tax  on  his  profit  and  on  his 
cost  of  assembling  the  item  (and,  if  the  article  is  resold,  the  cost  of 
marketing  the  item ) . 

Explanation  of  provision 
Under  the  Act,  a  resale  or  use  of  an  article  subject  to  the  10-percent 
manufacturers'  excise  tax  is  not  to  be  taxed  merely  because  the  tax- 
payer reselling  or  using  the  article  combined  it  with  a  coupling  device, 
wrecker  crane,  loading  and  unloading  equipment,  aerial  ladder  or 
tower,  snow  and  ice  control  equipment,  earthmoving,  excavation  and 
construction  equipment,  spreader,  sleeper  cab,  cab  shield,  or  wood  or 
metal  floor.  This  provision  will  remove  the  discriminatory  tax  treat- 
ment operating  against  the  taxpayer  who  combines  one  of  these  articles 
with  an  article  from  a  different  manufacturer  on  which  the  10-percent 
tax  has  been  paid. 

Effective  date 
This  provision  applies  to  resales  and  uses  on  or  after  the  dat€  of 
enactment  of  the  Act,  October  4. 1976. 

Revenue  effect 
This  provision  is  expected  to  result  in  a  revenue  loss  of  less  than  $5 
million  annually,  which  would  otherwise  go  into  the  Highway  Trust 
Fund  (through  September  30, 1979). 

10.  Franchise  Transfers  (sec.  2110  of  the  Act  and  sec.  751  of  the 
Code) 

Prior  law 
The  Code  (sec.  1253)  provides  generally  that  the  ti-ansfer  of  a 
franchise,  trademark,  or  trade  name  shall  not  be  treated  as  a  sale  or 
exchange  of  a  capital  asset  if  the  transferor  retains  any  significant 
power,  right,  or  continuing  interest  with  respect  to  the  subject  matter 
of  the  franchise,  trademark,  or  trade  name. 


-  This  tax  is  also  scheduled  to  be  reduced  to  5  percent  for  sales  on  or  after  October  1, 
1979    (sec.  4061(b)). 


617 

Under  prior  law,  gain  which  would  be  treated  as  ordinary  income 
pursuant  to  section  1253  (unlike  gain  which  would  be  treated  as  ordi- 
nary income  under  any  other  sections  of  the  Code,  e.g.,  sections  1245, 
1250, 1251,  and  1252)  was  not  treated  as  an  "unrealized  receivable"  of 
a  partnership  which  would  have  the  effect  of  causing  ordinary  income 
upon  certain  partnership  distributions,  payments  in  liauidation  of  a 
partnership  interest,  or  sales  or  other  dispositions  of  partnership 
interests. 

Reasons  for  change 
Congress  believed  that  partnership  transactions  of  the  type  de- 
scribed above  should,  in  situations  where  a  franchise,  trademark  or 
trade  name  is  involved,  be  subject  to  ordinary  income  treatment  as  in 
cases  in  which,  if  a  partnership  were  not  involved,  ordinary  income 
would  be  recognized.  In  general,  failure  to  deal  witli  partnership  trans- 
actions in  this  manner  would  have  allowed  taxpayers  to  avoid  ordinary 
income  treatment  by  restructuring  transactions  to  involve  the  forma- 
tion of  a  partnership  by  the  franchisor  and  the  franchisee  followed  by 
a  sale  or  liquidation  of  the  franchisor's  partnership  interest. 

Explanation  of  provision 
The  Act  provides  that,  with  respect  to  certain  partnership  distribu- 
tions, sales  of  partnership  interests,  and  distributions  in  liquidation  of 
partnership  interests,  the  term  "unrealized  receivable"  is  to  include  the 
ordinary  income  element  which  would  have  been  recognized  had  the 
partnership  directly  transferred  a  franchise,  trademark,  or  trade  name. 

Effective  date 
This  provision  applies  to  transactions  occurring  after  December  31, 
1976,  in  taxable  years  ending  after  that  date. 

Revenue  effect 
It  is  estimated  that  this  provision  will  have  no  significant  revenue 
effect  in  fiscal  year  1977  and  future  years. 

11.  Employer's  Duties  To  Keep  Records  and  To  Report  Tips  (See. 
2111  of  che  Act) 

Prior  law 

The  tax  law  (sec.  6053(a)  of  the  Code)  requires  employees  to  report 
all  tips  received  (including  charge  account  tips)  to  their  employei*s, 
usually  on  a  mo?l^l1ly  basis.  Tlie  tips  required  to  be  reported  to  employ- 
ers are  tips  received  and  retained  after  any  tip-splitting  (such  as  by 
waiters  and  waitresses  with  busboys)  or  tip-pooling  (such  as  by  a 
waiter  with  other  waiters).  Section  6051(a)  requires  employers  to 
report  on  IRS  Forms  (W-2)  as  wa^es  subject  to  income  tax  withliold- 
ing  and  Federal  Insurance  Contributions  Act  (FICA)  withholding 
only  the  tips  actually  reported  to  them  by  their  employees  pursuant  to 
section  6053 (a). 

Section  6041(a)  requires  every  emplover  of  an  employee  earning 
$600  or  more  yearly  to  report  the  total  of  that  employee's  earnings  to 
the  IRS.  As  a  result,  the  regulations  (sec.  1.6041-2(a)  (1) )  specify 
that  earnings  in  addition  to  those  required  to  be  reported  as  subject  to 
withholding  are  required  to  be  reported  separately  to  the  IRS  on  the 
Form  W-2  for  the  employee. 


618 

In  Revenue  Ruling  76-231,  the  IRS  recently  held  that  charge 
account  tips  not  reported  to  the  employer  by  the  employee  must 
nevertheless  be  reported  to  tlie  IKS  by  tlie  em|)loyer.  If.  Ix'cause  of 
tip-splitting  or  tip  pooling,  the  amount  i-epoiteJ  by  tlie  employee 
on  his  income  tux  return  differs  from  the  total  amount  of  tips  reported 
by  the  employer  for  that  employee,  the  employee  is  required  by  the 
ruling  to  attach  an  explanation  of  the  difference  to  his  income  tax 
return. 

Reasons  for  change 

The  requirement  that  employers  report  to  the  IRS  charge  account 
tips  not  reported  to  them  by  their  employees  appears  to  entail  burden- 
some record-keeping  requirements  for  many  employers.  As  a  matter  of 
general  practice,  charge  account  tickets  are  turned  over  by,  for  ex- 
ample, a  waiter  to  the  business  manager,  who  then,  or  shortly  there- 
after, reimburses  the  waiter  from  the  cash  register  or  other  ready 
cash  for  the  amount  shown  on  the  charge  ticket  which  represents  the 
waiters  tip.  However,  at  the  end  of  an  accounting  period,  employers 
may  have  only  a  re<,'ord  of  total  charge  account  tips,  and  such  em- 
ployers would  not  necessarily  have  any  way  of  breaking  down  that 
total  per  employee.  In  order  to  determine  the  amount  of  charge 
account  tips  received  by  each  employee,  such  employers  must  go  back 
to  allocate  each  charge  ticket  to  the  employee  responsible  for  it,  if  that 
employee's  identity  is  identifiable  from  the  charge  ticket. 

Congress  is  concerned  that  the  new  reporting  rules  contained  in 
Revenue  Ruling  76-231  (and  in  its  predecessor.  Revenue  Ruling 
75-400)  may  present  a  new  and  unnecessarily  burdensome  record- 
keeping requirement  for  some  emplovei-s.  Congress  is  also  concerned, 
however,  that  the  income  of  some  highly  compensated  employees,  such 
as  maitres  d'hotel,  head  waiters,  and  waiters  in  expensive  restaurants, 
may  l)e  seriously  underreported  to  the  IRS  if  they  neglect  to  report 
the  full  amount  of  their  charge  account  tips. 

Explanation  of  provision 

This  section  provides  tliat  the  IRS  is  not  to  follow  Revenue  Rulings 
75-400  and  76-231  until  1979,  and  that,  in  the  meantime,  the  IRS 
requirements  with  regard  to  reporting  charge  account  tips  are  to 
be  made  in  accordance  witli  IRS  practice  prior  to  the  issuance  of 
t])ose  rulings.  Congress  contemplates  that,  prior  to  1979,  the  IRS  and 
the  affected  employers  will  explore  the  possibility  of  finding  methods 
of  providing  the  IRS  with  the  information  it  needs  to  avoid  under- 
statements of  tip  income  while  at  the  same  time  avoiding  unduly 
burdensome  record-keeping  requii'ements  for  employers. 

The  passage  of  this  section  of  tlie  Act  is  not  intended  to  affect  the 
Service's  present  power  to  audit  individuals  with  respect  to  tip  income. 

Effective  date 
This  section  is  effective  January  1,  1976.  Under  its  revenue  rulings, 
t\\Q  IRS  did  not  attempt  to  apply  its  new  reporting  requirements  for 
employers  for  calendar  years  prior  to  1976.  As  a  result,  the  effective 
date  of  this  section  eliminates  the  need  to  comply  with  the  revenue 
rulings,  and  it  forgives  any  failure  to  have  acted  in  accordance  with 
the  rulings. 


619 

Revenue  effect 
This  provision  is  expected  to  result  in  a  revenue  loss  of  less  than 
$5  million  annually  through  1978. 

12.  Treatment  of  Certain  Pollution  Control  Facilities  (sec.  2112  of 
the  Act  and  sees.  48  and  169  of  the  Code) 

PHor  law 

Five-year  amortization  initially  was  made  available  to  a  taxpayer 
at  his  election  for  pollution  control  equipment  that  was  placed  in 
service  after  1968  in  a  plant  or  other  property  that  was  in  existence 
before  1969.  The  election  was  available  for  equipment  placed  in  service 
before  January  1, 1976,  at  which  time  the  provision  expired.  The  pro- 
vision was  enacted  as  a  special  incentive  for  the  installation  of  pollu- 
tion control  equipment  in  the  Tax  Reform  Act  of  1969,  because  that 
Act  repealed  the  investment  tax  credit. 

Rapid  amortization  was  available  for  the  installation  of  certified 
pollution  control  equipment  with  a  useful  life  of  up  to  15  years.  For 
equipment  with  a  useful  life  greater  than  15  years,  the  basis  attribut- 
able to  the  fii-st  15  years  could  be  amortized  over  a  5-year  period,  and 
the  remaining  years  could  be  depreciated  under  the  regular  rules  for 
depreciation,  including  use  of  one  of  the  several  alternative  methods 
of  accelerated  depreciation.  Property  that  was  eligible  for  rapid 
amortization  was  not  made  eligible  for  the  investment  tax  credit  when 
it  was  re-enacted  in  1971. 

In  order  to  be  eligible  for  rapid  amortization,  the  pollution  control 
equipment  had  to  be  certified  as  a  new,  identifiable  treatment  facility 
to  be  used  in  an  existing  plant  to  abate  or  control  water  or  atmos- 
pheric pollution  or  contamination  by  removing,  altering,  disposing,  or 
storing  of  pollutants,  contaminants,  wastes  or  heat.  Certification  was 
required  by  appropriate  State  and  Federal  authorities  that  the  equip- 
ment complied  with  the  appropriate  standards. 

In  addition  to  the  rapid  amortization  provision  that  had  been  in 
effect  through  1975,  taxpayers  who  placed  pollution  control  equip- 
ment in  service  might  be  able  to  finance  the  cost  of  acquisition,  in  w^hole 
or  in  part,  through  the  issue  of  industrial  development  bonds.  Several 
conditions  and  limitations  apply  to  the  issue  of  these  bonds  in  section 
103  of  the  Code,  and  all  taxpayers  may  not  be  able  to  qualify  to  issue 
these  tax-exempt  bonds.  Under  the  Revenue  Act  of  1971,  taxpayers 
who  did  not  elect  rapid  amortization  were  able  to  use  accelerated 
depreciation  on  ADR  guideline  lives  and  the  investment  credit.  In 
many  cases,  this  combination  gave  greater  tax  benefits  than  five-year 
amortization. 

Reasons  for  change 

Five-year  amortization  for  certified  pollution  control  equipment 
expired  at  the  end  of  1975  when  a  bill  providing  for  a  one-year 
extension  was  not  enacted  before  adjournment. 

Congress  believes,  however,  that  reenactment  of  this  tax  incentive 
is  necessary  to  encourage  the  installation  of  pollution  control  equip- 
ment. The  equipment  is  placed  in  service  because  public  policy  now 
requires  that  the  cost  of  dealing  with  pollution  be  included  in  the 
prices  of  products  as  a  cost  of  production.  This  transfers  the  cost 


620 

burden  of  removing  pollution  created  by  the  production  process  to  t  he 
consumers  of  the  product  from  the  victims  of  pollution.  The  producers 
must  install  equipment  that  frequently  is  expensive  and  may  not 
increase  productivity.  In  recognition  of  this  addition  to  a  business- 
man's capital  costs  because  of  public  policy,  Congress  believes  that 
continuing  this  assistance  in  reducing  the  cost  burden  is  appropriate. 

After  restoration  of  the  investment  credit  in  1971,  the  amortization 
provision  was  used  infrequently  because  the  investment  credit  plus 
accelerated  depreciation  over  ADR  guideline  lives  provided  greater 
tax  benefits.  Congress  believes  that  the  investment  credit  also  should 
be  made  available  in  combination  with  rapid  amortization  to  restore 
the  viability  of  the  amortization  provision  as  an  incentive. 

Since  enactment  of  the  1969  legislation,  pollution  control  has  been 
considered  to  be  a  process  that  takes  place  at  the  end  of  the  production 
line.  Congress  believes  that  perspective  has  been  excessively  narrow 
and  that  a  broader  definition  of  pollution  control  is  appropriate. 

Explanation  of  the  provision 

The  Act  restores  the  five-year  amortization  provision  as  of  Janu- 
ary 1,  1976,  as  a  permanent  provision.  The  provision  applies  to  a  new, 
identifiable,  certified  pollution  control  facility  installed  in  a  plant 
in  operation  before  January  1,  1976,  The  Act  amends  the  prior  law 
definition  to  cover  pollution  control  equipment  that  prevents  the  crea- 
tion of  pollutants,  as  well  their  emission,  which  formerly  had  been 
the  limit  of  the  provision.  In  addition,  the  Act  provides  that  a  facil- 
ity or  equipment  for  which  the  taxpayer  elects  five-year  amortiza- 
tion will  be  eligible  for  a  one-half  investment  tax  credit.  The  limited 
investment  credit  will  not  be  allowed,  however,  where  the  useful  life 
of  the  facility  or  equipment  would  be  less  than  5  years,  as  the  useful 
life  would  be  determined  without  regard  to  this  amortization  pro- 
vision. 

Under  the  Act,  the  election  of  fiA'e-year  amortization  applies  to  fa- 
cilities that  will  prevent  the  creation  or  emission  of  pollutants  when 
installed  at  the  site  of  a  plant  or  other  property  in  existence  before 
January  1,  1976,  which  do  not  lead  to  a  significant  increase  in  output 
or  capacity,  a  significant  extension  of  useful  life,  or  a  significant 
reduction  in  total  operating  costs  for  such  plant  or  other  property  (or 
any  unit  thereof) ,  or  a  significant  alteration  in  the  nature  of  a  manu- 
facturing production  process  or  facility.  For  purposes  of  this  provi- 
sion, significant  means  a  change  of  more  than  5  percent.  In  determin- 
ing how  significant  is  the  effect  of  a  pollution  control  facility  upon 
output,  capacity,  costs  or  useful  life  of  property,  the  relevant  area  for 
examination  is  to  be  the  operating  unit  most  directly  associated  with 
the  pollution  control  facility. 

The  expanded  definition  of  pollution  control  facility  includes,  for 
example,  a  facility  located  at  a  plant  site,  which  prevents  the  creation 
of  a  pollutant  bv  removing  sulphur  from  fuel  before  it  is  burned  at 
the  plant.  The  definition  also  includes  a  facility,  such  as  a  recovery 
boiler,  that  removes  pollutants  from  material  at  some  point  in  the 
otherwise  unchanged  ]:)rodu('tion  process  at  tlie  plant.  The  Act  does 
not  include  as  a  qualified  pollution  control  facility  a  facilitv  that  func- 
tions as  a  new,  or  makes  a  significant  change  in  a,  manufacturing  or 


621 

production  process  or  facility.  For  example,  where  a  plant  that  has 
employed  heat  to  process  a  material  changes  to  an  electrolytic  process, 
the  latter  is  not  a  qualified  pollution  control  facility  because  it  is  also 
a  new  manufacturing  or  production  process  even  though  it  may  pre- 
vent the  creation  and  emission  of  pollutants. 

Congress  also  made  clear,  in  its  approval  of  the  conference  agree- 
ment, that  the  broader  definition  of  a  pollution  control  facility  which 
is  eligible  for  the  amortization  election  does  not  apply  in  determining 
whether  a  facility  is  a  pollution  control  facility  eligible  for  tax-exempt 
industrial  development  bond  financing. 

The  Act  also  makes  available  an  investment  credit  equal  to  one-half 
of  a  full  credit  for  qualified  pollution  control  facilities  having  a  use- 
ful life  of  5  years  or  more. 

Effective  date 
Eestoration  of  the  election  for  five-year  amortization  is  effective 
with  respect  to  certified  pollution  control  equipment  which  is  placed 
in  service  after  December  31, 1975.  The  investment  credit  will  generally 
be  available  for  such  equipment  placed  in  service  after  December  31, 
1976. 

Revenue  effect 
This  provision  will  increase  tax  receipts  by  $59  million  in  fiscal  year 
1977  and  by  $102  million  in  fiscal  year  1978.  There  will  be  a  decrease  in 
tax  receipts  of  $160  million  in  fiscal  year  1981. 

13.  Clarification  of  Status  of  Certain  Fishermen's  Organizations 
(Sec.  2113  of  the  Act  and  sec.  501  of  the  Code) 

Prior  law 

Agricultural  organizations  are  exempt  from  Federal  income  tax 
under  section  501(c)(5)  of  the  Code.  Organizations  devoted  to  pro- 
moting or  improving  fishing  or  such  related  occupations  as  taking 
shrimp  or  lobsters,  however,  were  not  treated  as  agricultural  organiza- 
tions by  the  Internal  Revenue  Service.^  Organizations  devoted  to  pro- 
moting or  improving  fishing  and  related  pursuits  could  qualify,  on 
the  other  hand,  for  tax  exemption  under  section  501(c)  (6)  as  business 
leagues.^ 

Pursuant  to  statute  and  implementing  regulations  of  the  U.S. 
Postal  Service,^  agricultural  organizations  qualify  as  tax-exempt  or- 
ganizations and  accordingly  enjoy  special  lower  second-  and  third- 
class  mail  rates.  The  U.S.  Postal  Service  has  followed  the  Internal 
Revenue  Code  in  refusing  to  classify  fishing  organizations  as  agricul- 
tural organizations,  and,  as  a  result,  fishing  organizations  did  not 
enjoy  the  lower  postal  rates  given  to  organizations  classified  as  agri- 
cultural organizations. 


1  The  provisions  of  prior  law  defining  aerieultural  pursuits  or  farming  did  not  encompass 
fishing  and  similar  pursuits.  (See  sees.  3121  fg)  and  6420(c).) 

2  Payments  to  section  501(c)(5)  organizations  or  to  section  501(c)(6)  organizations 
are  not  definctihie  as  fhirltable  contributions.  However,  in  most  cases  payments  to  these 
organizations  are  riefl'intjhip  is  hni^inps'  pynenooc. 

3  .S9  U.R.C.  5  4452(d)  as  reaffirmed  bv  the  Postal  Reorganization  Act  of  1970  and  pur- 
suant to  the  Domestic  Mail  Classification  Schedule  adopted  by  the  Board  of  Governors  of 
the  U.S.  Postal  Service  under  the  authority  of  the  Postal  Reorganization  Act. 


622 

Reasons  for  change 
Conoress  believes  that  tliere  is  no  valid  reason  for  differential ing 
under  section  501(c)(5)  between  occupations  devoted  to  i)roducing 
foodstutls  from  the  earth  and  occupations  devoted  to  ))rodiicing  food- 
stutfs  from  water.  In  addition  to  tlie  specific  i)rac(ical  consequence  of 
influencing  the  U.S.  Postal  Sei-vice  to  refuse  to  give  organizations  oi- 
leagues  devoted  to  fishing  and  i-elated  i)ursuits  tlu»  reduced  postal  rates 
granted  to  agricultuial  organizations,  this  distinction  may  have  had 
further  practical  and  undesirable  consequences  in  the  future  had  it 
not  been  eliminated. 

Exflanation  of  provision 

This  section  adds  a  new  provision  (neAv  subsection  (g)  of  sectioi\ 
501  of  the  Code)  to  explain  the  uieaning  of  the  word  "agriculturar'  in 
section  501(c)(5).  The  amendment  provides  tliat  "agriculniral"  in- 
cludes "the  art  or  science  of  cultivating  land,  liarvesting  crops  or 
aquatic  i-esources.  oi-  raising  livestock." 

The  term  "harvesting  *  *  *  aquatic  resources"  includes  fishing  and 
related  pursuits  (such  as  the  taking  of  lobsters  and  shrimps).  Both 
fresh  water  and  salt  water  occupations  are  to  qualify  as  "agri<-ultural" 
under  the  new  definition.  In  addition,  the  cultivation  of  undei-water 
vegetation,  such  as  edible  sea  plants,  qualifies  as  agi'icultui-al  in  na- 
ture,"* as  does  the  cultivation  or  growth  of  any  edible  organism.  Also, 
the  operation  of  "'fish  farms"  is  to  be  considei-ed  agricultuiv  under  the 
new  definition.  However,  aquatic  resources  aie  only  to  include  animal 
or  vegetable  life,  not  mineral  resources. 

Congress  does  not  intend  the  definition  of  "agriculturaF'  to  be  all 
encompassing.  The  term  is  not  necessarily  to  be  limited  to  "the  art  or 
science  of  cultivating  land,  hai'vesting  crops  or  accpiatic  resources,  or 
raising  livestock." 

Effective  date 
This  provision  applies  to  taxable  vears  ending  after  December  31, 
1975. 

Revenue  effect 
This  provision  is  expected  to  result  in  a  j'evenue  loss  of  less  than  $5 
million  annually. 

14.  Innocent  Spouse  (sec.  2114  of  the  Act  and  sec.  6013(e)  of  the 
Code) 

Prior  J.iw 

Ordinarily  under  section  0013 (e),  an  innocent  spouse  may  be  re- 
lieved of  the  generally  ai)plicable  rule  of  joint  and  several  liability  on 
a  joint  return  if  the  liability  is  attributable  to  omissions  of  income 
for  Mliich  the  spouse  seeking  relief  is  not  responsible. 

lender  prior  law,  relief  could  have  been  sought  for  all  taxable  years 
which  were  still  open  when  that  provision  was  enacted  (January  12, 

■•  No  infprenct'S  are  to  bo  drawn  from  tliis  provision  as  to  whother  any  pursuit  tliat  may 
qualify  under  the  new  term  did  or  did  not  qualify  under  prior  law. 


623 

1971),  but  could  not  be  granted  for  a  year  which  was  already  closed 
by  the  statute  of  limitations,  res  judicata,  or  otherwise. 

If  certain  conditions  are  met,  relief  may  be  granted  to  an  innocent 
spouse  who  filed  a  joint  return  whicli  omitted  income  in  excess  of  25 
percent  of  the  income  actually  reported.  The  spouse  seeking  relief 
must  establish  that  he  or  she  did  not  know  of  and  had  no  reason  to 
know  of  the  omission.  Also,  it  must  be  concluded  that  it  is  inequitable 
to  hold  the  innocent  spouse  liable  for  the  tax  deficiency.  A  determina- 
tion about  whether  it  is  inequitable  to  hold  an  innocent  spouse  liable 
must  be  based  on  all  the  farts  and  circumstances  and  must  consider 
whether  the  innocent  spouse  benefitted  significantly  from  the  omitted 
income. 

Relief  under  this  provision  covers  liability  for  tax,  interest,  penal- 
ties and  other  amounts.  Although  Congress  was  especially  concerned 
with  granting  relief  to  innocent  spouses  of  embezzlers  who  fail  to  re- 
port income  fully,  the  relief  may  cover  any  type  of  omission. 

Reaso7is  for  change 
The  Congress  believed  that  relief  should  be  granted  in  certain  cases 
where  an  innocent  spouse  was  unable  to  obtain  relief  under  prior  law 
solely  because  a  judicial  decision  had  rendered  an  issue  res  judicata. 
The  Congress  believed  it  appropriate  to  alleviate  the  undue  hardship 
imposed  on  an  innocent  spouse  (1 )  who  became  liable  for  tax  because  of 
the  res  judicata  effect  of  a  judicial  decision  prior  to  the  enactment  of 
this  provision  and  (2)  who  could  have  benefitted  from  the  pi-ovision  if 
he  or  she  had  kept  the  taxable  year  in  question  open  within  the  tax 
administrative  process  and  had  not  sought  judicial  relief. 

EvflanatJon  of  frovision 

The  Act  grants  lelief  under  the  innocent  spouse  pi-ovision  to  certain 
taxiJayers.  who  but  for  the  res  judicata  effect  of  adverse  judicial 
decisions  prior  to  the  provision's  enactment,  would  have  been  relieved 
of  liability  for  unreported  income. 

Except  for  the  application  of  the  section  to  certain  closed  years, 
the  substance  of  the  provision  under  pi-ior  law  and  as  amended  by  this 
Act  is  the  same. 

Tender  the  Act,  a  taxpayer  may  apply  under  section  6013(c)  for  re- 
determination of  his  or  her  tax  liability  for  taxable  years  beginning 
within  ten  years  prior  to  the  enactment  of  section  G013(e)  and  ending 
on  or  before  January  12. 1971,  the  date  of  enactment  of  that  provision, 
if  such  relief  has  been  barred  solely  by  operation  of  res  judicata.  A 
redetermination  sought  under  the  Act  is  to  be  made  without  regard  to 
the  res  judicata  effect  of  a  judicial  decision.  Taxpayers  found  to  have 
overpaid  their  taxes  are  to  be  entitled  to  refunds. 

Effecfive  date 

The  application  permitted  bv  the  Act  must  be  made  before  the  end  of 
the  first  calendar  year  beginning  after  the  date  of  enactment  of  this 
Act. 

Revenue,  effect 

It  is  estimated  that  this  provision  involves  a  negligible  revenue  loss. 


624 

15.  Rules  Relating  to  Limitations  on  Percentage  Depletion  in 
Case  of  Oil  and  Gas  Wells  (see.  2115  of  the  Act  and  sec. 
613A  of  the  Code) 

PHor  law 

Prior  to  tlie  Tax  Keduction  Act  of  1975  any  taxpayer  was  entitled 
to  a  deduction  for  the  oTeater  of  the  percentage  depletion  allowance 
or  the  cost  depletion  allowance  on  oross  income  from  an  oil  and  ^as 
property.  The  percentage  allowance  was  equal  to  22  percent  of  such 
gross  income,  but  not  more  than  50  percent  of  the  taxable  income  from 
such  property. 

The  Tax  Reduction  Act  of  1975  repealed  the  percentage  depletion 
allowance  for  oil  and  gas  with  two  excei)tions.  Under  the  first  excep- 
tion, natural  gas  sold  under  a  fixed  contract  or  subject  to  federal  jn-ice 
regulation  is  still  e]igil)lo  for  peirentage  de})letion  comi)uted  without 
regard  to  the  limitations  on  ])ercentage  depletion  contained  in  the  Tax 
Reduction  Act  of  1975.  Under  the  other  exception  (the  "small  pro- 
ducer exemption"),  percentage  depletion  is  allowed  for  a  limited 
amount  of  production  fiom  wells  located  within  the  United  States. 
The  amount  of  ])roduction  eligible  for  percentage  depletion  is  an 
average  of  2000  barrels  ]jer  day  (or  its  equivalent  in  cubic  feet  of  gas) 
for  1975  and  phases  down  to  an  average  of  1000  barrels  per  day  (or  its 
equivalent  in  cubic  feet  of  gas)  for  1980  and  thereafter.  The  percent- 
age de])letion  rate  for  eligible  ])roduction  remains  at  22  percent  through 
1980  and  then  is  gradually  reduced  annually  to  15  percent  for  1984 
and  years  thereafter.  However,  production  resulting  from  secondary 
and  tertiary  recovery  processes  remains  eligible  for  the  22  percent 
rate  through  1983. 

For  any  taxpayei-  eligible  for  the  small  producer  exemption,  the 
deduction  for  any  year  attributable  to  such  small  ]iroducer  exemption 
may  not  exceed  65  percent  of  the  taxi)ayer's  taxable  income.  If  a 
taxpayer  acquired  an  interest  in  an  oil  and  gas  jiroperty  after  1974 
and  the  pro|)erty  is  "proven"  at  the  time  of  transfer,  the  taxpayer  is 
generally  not  allowed  ])ercentage  de])letion  on  ]^roduction  from  that 
property  under  the  small  producer  exem})tion.  Also,  a  taxpayer  is  not 
eligible  for  the  small  jiroducer  exemption  on  anv  oil  or  gas  i)roduction 
dui-ing  any  period  for  which  such  taxpayer  is  classified  as  a  "retailer" 
of  oil  or  gas,  or  products  derived  from  oil  or  gas.  Finally,  a  taxpayer 
is  ineligible  for  the  small  producer  exem])tion  for  any  taxable  year 
for  which  the  taxpayer  (or  a  related  pej-son)  enirages  in  refining  of 
crude  oil  if.  on  anv  day  during  the  year,  he  has  refinery  runs  exceeding 
50,000  barrels. 

Generally,  a  taxpaver  is  subject  to  the  "retailei-"'  exclusion  for  any 
taxable  year  in  which  the  tax|»ayer  either  directlv.  or  through  a  re- 
lated person,  sells  oil  or  gas  (oi-  any  ]>roduct  derived  from  oil  or  gas) 
either  (a)  through  a  retail  outlet  operated  bv  the  taxpayer  or  a  re- 
lated person,  or  (b)  to  any  ])evson  who  is  obligaled  under  a  contract 
with  the  taxpayer  (or  a  related  person)  to  use  the  trademark,  etc.  of 
the  taxpayer  (or  a  related  person)  in  marketing  oil  and  gas  (or  de- 
rivatiA'e  products),  or  who  is  o-iven  au<^hority  under  a  contract  to 
occupy  a  retail  outlet  controlled  by  the  taxpayer. 

Reaso'ns  for  change 
Certain  provisions  of  the  Tax  Reduction  Act  of  1975  relating  to  per- 
centage depletion  have  been  or  might  have  been  inteipreted  in  a  man- 


625 

ner  whicli  is  inconsistont  with  wliat  the  Congress  believes  to  have  been 
its  intent  in  enaetinc;  that  h'oishition.  In  some  cases,  the  literal  lan- 
gua<2:e  of  the  statute  requires  unintended  results.  In  other  cases,  the 
statutoi-y  lanouaoe  is  ambiguous. 

First,  the  i-etailer  exclusion  could  have  been  construed  to  apply  in 
many  cases  Avhere  it  Avas  not  intended  to  apply.  Foi-  example,  the  re- 
tailer exclusion  could  have  been  inter[)reted  to  deny  the  small  pro- 
(hicer  exemption  to  a  royalty  interest  holder  who  also  holds  a  mere  5- 
percent  interest  in  a  partnei'ship  that  operates  a  corner  drujjstore 
which  sells  petroleum  jelly.  The  ron<>ress  believes  that  the  retailer 
exclusion  should  apply  only  where  the  taxpayer  has  substantial  retail 
operations  and  not  to  cases  where  a  taxpayers  retail  operations  are 
essentially  de  miniiius.  In  addition,  the  Cong:ress  believes  that  the  re- 
tailer exclusion  should  be  applied  only  in  the  case  of  retail  sales  as  that 
term  is  commonly  used.  Thus,  bulk  sales  of  oil  or  natural  gas  directly 
to  industrial  or  commercial  users  should  not  be  treated  as  retail  sales 
through  a  retail  outlet.  Nor  should  retail  sales  be  taken  into  account  if 
they  take  )>lace  outside  the  United  States,  provided  the  taxpayer  is 
not  exporting  oil,  gas,  or  derivative  products. 

The  I'ule  ])roh.ibiting  the  percentage  depletion  deduction  on  proven 
propei-ty  which  has  been  transferred  was  intended  to  pi-event  a  prolif- 
eration of  the  amount  of  proven  oil  and  gas  reserves  that  might  be 
eligible  for  percentage  depletion  when  produced.  The  Congress  believes 
that  the  rule  was  not  intended  to  apply  to  some  cases  of  transfers 
which  occur  by  operation  of  law.  Foi'  example,  where  a  property  is  held 
in  trust  and  the  beneficiaries  are  entitled  to  percentage  depletion  with 
I'espect  to  the  property,  the  birth  or  death  of  a  beneficiai-y  may  con- 
stitute a  ti-ansfei'.  This  kind  of  a  transfer  was  not  intended  to  give  rise 
to  the  denial  of  percentage  depletion.  Also,  the  Congress  believes  that 
transfers  within  a  connnonly  controlled  grou})  should  not  I'esult  in  the 
loss  of  percentage  depletion,  so  long  as  the  transferor  and  transferee 
both  remain  part  of  the  commonly  controlled  group  subject  to  a  single 
limitation  on  their  depletable  oil. 

Finally,  it  came  to  the  attention  of  the  Congress  that  the  Treasury 
Department  has  encountered  administrative  difficulties  as  a  result  of 
certain  technical  problems  in  the  new  depletion  rules.  To  correct  any 
possible  defects,  the  Congress  adopted  certain  technical  amendments 
for  clarification. 

Explaimtion  of  •provisions 
The  Act  makes  several  changes  in  the  retailer  exclusion.  First,  bulk 
sales  of  oil  or  natuj-al  <r{is  directly  to  industrial  or  commercial  users  are 
treated  as  not  constituting  retail  sales.  Second,  where  gross  receipts 
from  the  sale  of  oil  or  gas,  or  products  derived  therefrom,  by  all  retail 
outlets  of  the  taxpayer  (or  related  persons)  do  not  exceed  $5  million 
for  the  taxable  year,  that  taxpayer  will  not  \yv  treated  as  a  retailei*  for 
that  year.  Thus,  if  the  taxpayer  and  related  persons  operate  a  total  of 
five  outlets,  the  taxpayer  Avill  be  subject  to  the  retailer  exclusion  only  if 
the  aggiegate  aross  receipts  from  the  sale  of  oil,  gas,  or  theii'  deriva- 
tive iiroducts  l>v  these  outlets  exceed  $5  million  for  the  year.  This 
de  minhniH  exception  applies  to  retail  outlets  occupying  land  owned, 
leased  or  controlled  by  the  taxpayer  as  well  as  those  outlets  owned 


626 

directly  by  him.^  Also,  a  taxpayei-  will  not  he  subject  to  the  retailer 
exclusion  for  any  taxable  year  i'oi-  which  all  retail  sales  of  oil,  tras,  or 
their  cleri\ative  ]>roducts  by  retail  outlets  are  made  outside  the  United 
States,  provided  that  no  domestic  pi'oduction  of  the  taxpayer  or  a 
related  i)erson  is  exported  duiin^  the  year  in  (piestion  or  the  immedi- 
ately precedinji^  taxable  year. 

The  Act  also  adds  an  additional  excej)tion  to  the  transfer  rule.  Under 
this  exception,  no  change  of  beneficiaries  of  a  trust  shall  be  (considered 
a  "transfer"  if  the  chanoe  occurs  solely  by  reason  of  the  death,  birth, 
or  adoption  of  any  beneficiary  if  the  transferee  was  a  beneficiary  under 
the  trust  prior  to  the  triggering-  event  or  is  a  lineal  descendant  of  the 
grantor  or  any  other  beneficiary.^ 

Under  the  trust  laws  of  certain  States,  as  well  as  the  provisions  of 
some  existing  trust  instruments,  part  or  all  of  the  depletion  allowance  is 
required  to  be  allocated  to  the  trustee,  even  though  income  distributions 
are  made  to  beneficiaries.  Such  distributions  reduce  the  taxable  income 
of  the  trust  and,  because  of  the  65  percent  limitation,  jeopardize  the 
deduction  under  the  small  producer  exemption.  The  Congress  believes 
that  this  result  was  not  intended.  Thus,  to  correct  this  situation,  the 
Act  provides,  for  purposes  of  the  65-percent-of-taxable-income  limi- 
tation, that  a  trust's  taxable  income  shall  be  computed  without  a 
deduction  for  distributions  to  beneficiaries  during  the  taxable  year. 
In  addition,  the  language  of  prior  law"  was  changed  to  make  clear 
that  in  computing  taxable  income  for  purposes  of  the  ()5-percent-of- 
taxable-income  liinitation,  percentage  depletion  under  the  small  pro- 
ducer exemption  is  not  treated  as  a  deduction  from  taxable  income. 
(Otherwise,  tliere  would  be  a  circle,  with  pei-centage  de])letion  reduc- 
ing the  base  of  taxable  income  against  whicli  the  BH-percent  linvitation 
is  measured.)  However,  if  a  property  is  exempted  from  the  provisions 
of  these  limitations  on  percentage  depletion  (because  it  produces  a 
regulated  natural  gas,  etc.).  then  taxable  income  would  be  reduced  by 
the  depletion  taken.  Also,  if  the  cost  depletion  deduction  allowable 
on  one  or  more  of  the  taxpayer's  oil  or  gas  ])ro))erties  is  greater  than 
the  percentage  depletion  cleduction  allowed  under  tliis  section  (with- 
out regard  to  the  limitation  based  on  taxable  income)  then  the  entire 
amount  of  allowable  cost  depletion  must  be  deducted  in  computing 
taxable  income  for  purposes  of  the  6r)-percent  limitation. 

Under  the  tax  law%  percentage  depletion  is  to  be  computed  by  each 
partner  in  the  case  of  an  oil  or  gas  property  held  by  a  partnershi]). 
Some  partners  may  be  limited  to  cost  depletion  bv  reason  of  the  A'ari- 
ous  limitations  and  exclusions,  while  other  partners  will  be  entitled 
to  percentage  depletion.  Whatever  depletion  allowance  is  deducted  by 
the  partners  reduces  the  basis  of  the  partnership  ])roperty.  The  basis 
affects  the  amount  of  the  cost  depletion  allowance  for  any  year,  as  well 
as  the  amount  of  gain  or  loss  recognized  vtpon  a  sale  or  exchange  of 
such  property. 

In  the  case  of  partnerships  having  numerous  partneis.  difficulty 
arises  if  the  pai-tnei'shi])  is  required  to  maintain  the  basis  account  for 


1  For  purposes  of  thp  r^^tnilor  exclusion,  bulk  sales  by  Ihe  produoer  of  oil  or  natural 
pas  (lirertlv  to  commercial  or  Industrial  users  are  not  to  be  taken  into  account.  Therefore, 
this  type  of  sale  is  also  not  to  be  taken  into  account  for  purposes  of  tbe  fie  minimis  rule. 

2  For  this  purpose,  an  individual  adopted  by  a  beneficiary  is  a  lineal  descendant  of  that 
beneficiary. 


627 

partnership  oil  or  fjas  property.  The  partnership  would  have  to  ask 
that  each  partnei-  inform  the  partnership  annually  of  the  amount 
of  depletion  deducted  with  respect  to  each  property.  This  practice 
would  be  burdensome  and  unreliable.  Moreover,  if  the  basis  of  the 
property  were  maintained  at  the  partnership  level,  deductions  by  part- 
ners entitled  to  percentao^e  depletion  would  reduce  the  basis  and  jeop- 
ardize the  cost  depletion  allowance  for  those  partners  not  entitled  to 
percentao:e  depletion.  Also,  on  a  subsequent  sale  of  the  property,  part- 
ners limited  to  cost  depletio)i  would  recognize  the  same  portion  of  fjain 
or  loss  as  those  partners  entitled  to  percentage  depletion.  These  results 
were  not  intended  under  the  Tax  Keduction  Act  of  1975  which  pro- 
vided that  percentage  depletion  under  the  small  producer  exemption 
is  to  be  complied  at  the  partner  level.  Accordingly,  the  Act  clarifies 
existing  rules  so  that  the  partnerehip  basis  in  oil  or  gas  properties  is 
allocated  to  partners  proportionately.  Thereafter,  each  partner  main- 
tains an  individual  basis  account  and  computes  his  own  allowance  for 
either  percentage  depletion  or  cost  depletion  on  all  his  oil  and  gas 
properties.^ 

As  noted  above,  under  the  tax  law  a  retailer  (or  a  refiner)  is  not 
eligible  for  the  small  producer  exemption  if  he  directly,  or  through  a 
i-elated  person,  sells  oil,  natural  gas,  or  products  derived  therefrom 
through  a  retail  outlet  (or  annually  refines  a  certain  amount  of  crude 
oil) .  The  definition  of  a  related  person  is  based  on  a  significant  owner- 
ship test.  However,  the  definition  under  prior  law  did  not  specify 
that  a  significant  ownershi])  interest  is  held  when  a  person  indirectly 
holds  a  significant  ownership  interest  in  another  person.  In  order  to 
prevent  taxpayers  from  avoiding  the  retailer  and  refinei-  exclusions 
by  the  use  of  intermediate  entities,  the  Act  clarifies  the  law  by  specifi- 
cally providing  that  in  determining  whether  a  significant  OAvnership 
interest  is  held,  an  interest  owned  by  or  for  a  corporation,  partnership, 
trust,  or  estate  shall  be  treated  as  owned  directly  both  by  itself  and 
proportionately  by  its  shareholders,  partners,  or  beneficiaries,  as  the 
case  may  be. 

Tlie  Act  also  permits  percentage  depletion  to  be  retained  on  })rop- 
'^rty  which  is  transferred  by  individuals,  corporations  and  other  en- 
tities, all  of  which  are  part  of  the  same  controlled  group  after  the 
transfer  (and  thus  must  continue  to  combine  oil  production  to  deter- 
mine the  maximum  number  of  barrels  of  oil  eligible  for  percentage 
depletion).  However,  if  any  transferee  ceases  to  be  part  of  the  same 
controlled  group  as  the  transferor  at  some  later  time,  percentage 
depletion  is  to  be  disallowed  with  respect  to  the  transferred  property 
as  of  that  date  (in  order  to  prevent  a  proliferation  of  the  limited 
exemption  from  the  repeal  of  percentage  depletion). 

For  example,  under  the  Act,  the  wife  and  minor  children  of  a  pro- 
ducer could  receive  part,  ownership  in  a  pi'oven  property  without  loss 
of  depletion  because  they  are  all  treated  as  one  taxj^ayer  for  percent- 
age depletion  purposes.  Other  examples  would  include  transfers 
between  business  entities  under  common  control,  within  the  same  con- 
trolled group  of  corporations,  and  to  a  tiust  to  the  extent  the  benefici- 
aries of  the  trust  are  members  of  the  family  of  the  grantoi-  of  the  ti  urt. 


"  For  this  purpose,  the  partner  adjusts  his  basis  for  his  Individual  deductions  for  depletion 
and  he  separately  computes  gain  or  loss  on  the  proceeds  from  the  sale  or  exchange  of 
an  oil  or  gas  property. 


628 

Elective  date 
Those  provisions  are  offectiA'e  on  Jannuiv  1,  1075.  for  taxable  years 
endin<2:  after  Decemlx^r  31,  1974  (the  efl'ective  date  of  the  provisions 
rehitino;  to  the  percentage  depletion  deduction  in  the  Tax  Reduction 
Act  of  1975). 

Revenue  effect 
This  provision  will  reduce  budoet  receipts  by  $24  million  in  fiscal 
year  1977,  $10  million  in  fiscal  year  1978,  and  $10  million  in  fiscal  year 
1981. 

16.  Federal  Collection  of  State  Individual  Income  Taxes  (sec.  2116 
of  the  Act  and  sees.  6361  and  6.362  of  the  Code) 

Pnor  law 

A  State  may  elect  to  have  the  Internal  Revenue  Service  collect  the 
State's  individual  income  tax  if  the  State  enters  into  an  agreement 
Avith  the  Internal  Revenue  Service,  and  if  the  State  individual  income 
tax  is  a  qualified  tax.  However,  nnder  ])rior  law  the  piggyback  sys- 
tem was  "triggered"'  only  when  two  States,  representing  at  least  5 
percent  of  Federal  individual  tax  returns,  entei-  into  an  agreement 
with  the  Treasuiy  to  have  their  taxes  collected  by  the  Treasury. 

Three  types  of  State  taxes  are  qualified :  taxes  on  residents'  income 
based  on  Federal  taxable  income  at  rates  determined  by  the  States; 
taxes  on  residents'  income  which  are  a  percentage  of  the  Federal  liabil- 
ity ;  and  taxes  on  nonresidents'  wage  and  other  Ijusiness  income. 

Generally,  for  a  tax  based  on  taxable  income  to  qualify  for  Federal 
collection,  the  State  tax  must  be  imposed  on  an  amount  equal  to  an  in- 
dividual's taxable  income  for  the  taxable  j'ear.  as  such  income  is  defined 
from  time  to  time  in  the  Internal  Revenue  Code  of  1954.  Three  adjust- 
ments must  be  made  to  the  tax  base  in  order  for  the  tax  to  qualify 
for  Federal  collection:  (1)  subti-act  from  Federal  taxable  income  any 
interest  received  on  U.S.  obligations  received  by  a  taxpayer  and  in- 
cluded in  Federal  gross  income,  (2)  add  to  Federal  taxable  incojue  any 
deductions  claimed  by  a  taxpayer  for  net  State  and  local  taxes,  and  (3) 
add  to  Federal  taxal^le  income  the  interest  from  ol)ligations  of  States 
or  political  subdivisions  which  is  exempt  from  Federal  income  tax. 
Also  a  State  may  impose  a  ''minimum  tax''  on  tax  preferences  and 
allow  a  credit  for  income  taxes  paid  to  another  State  or  a  political  sub- 
division of  another  State. 

A  qualified  resident  tax  computed  as  a  percentage  of  Federal  tax 
is  defined  as  one  imi>osed  on  the  excess  of  the  taxes  imposed  by  chapter 
1  of  the  Internal  Revenue  Code  over  the  sum  of  the  nonrefundable 
credits  allowable  against  these  taxes.  This  includes  in  the  base  the 
Federal  liability  for  the  mininnnn  tax.  As  Avith  the  tax  l)ased  on  Fed- 
eral taxable  income,  certain  adjustments  are  provided  by  the  Act 
for  the  tax  based  on  a  percentage  of  the  Federal  tax,  as  follows:  (1) 
decrease  liability  on  account  of  interest  on  U.S.  obligations  included 
in  Federal  taxable  income,  (2)  increase  liability  by  including  net  tax- 
exempt  income,  (3)  increase  liability  by  adding  back  net  State  income 
tax  deduction,  and  (4)  allow  a  credit  for  income  tax  paid  to  another 
State  (or  political  subdivision). 


629 

Finally,  a  nonresident  tax  will  not  be  qualified  unless  the  amount 
of  tax  imposed  by  a  State  on  the  income  of  a  nonresident  does  not 
exceed  the  tax  that  would  be  imposed  by  the  State  if  he  were  a  resident 
and  if  his  taxable  income  were  an  amount  equal  to  the  excess  of  his 
wage  and  other  business  income  derived  from  sources  within  the  State, 
over  that  portion  of  the  nonbusiness  deductions  allowable  under  the 
State's  qualified  resident  tax  which  bears  the  same  ratio  to  the  total 
of  such  deductions  that  the  wage  and  other  business  income  derived 
from  sources  within  the  State  bears  to  the  taxpayer's  adjusted  gross 
income. 

Reasons  for  change 

To  date,  the  requisite  two  States  with  5  percent  or  more  of  1972 
Federal  individual  incouie  tax  returns  liave  not  "triggered"  the  piggj'- 
back  system.  This  reluctance  on  tlie  part  of  tlie  States  stems  from  ap- 
parent uncertainty  about  whether  or  not  the  Federal  Government 
would  bear  the  costs  of  administering  the  collection  of  State  taxes,  even 
though  the  1972  legislation  contemplated  that  the  Federal  Govern- 
ment and  not  the  States,  would  bear  those  costs.  Also,  there  was  con- 
cern that  certain  progressive  features  of  current  State  individual  in- 
come taxes  would  be  eliminated  were  a  State  to  elect  to  piggyback, 
and  there  may  have  been  coordination  problems  among  several  States 
to  jointly  elect  and  therefore  trigger  the  pigij^back  system. 

To  remove  those  impediments,  the  Act  (1)  makes  it  clear  that  the 
Federal  government  Avill  bear  the  costs  of  pigg^-backing,  (2)  permits 
States  to  provide  sales  tax  credits,  and  (eS)  eliminates  the  5-percent- 
of-returns  rule  and  lowers  the  trigger  to  one  State. 

Explanation  of  frovlswn 

The  Act  makes  explicit  Congress'  intent  that  the  Federal  GoA'ern- 
ment  will  not  charge  any  State,  directly  or  indirectly,  for  Federal  ad- 
ministration of  the  State's  income  taxes  under  the  piggj^'backing 
provisions. 

The  Act  also  reduces  to  one  State  the  number  of  States  needed  to  set 
off  this  trigger,  and  removes  the  requirement  of  prior  law  that  the 
initially-electing  State  or  States  must  represent,  in  the  aggregate,  5 
percent  or  more  of  the  Federal  individual  income  tax  returns  filed 
during  1972.^  This  has  the  effect  of  permitting  a  State  to  make  its 
decision  whether  to  elect  piggybacking  based  on  its  own  needs,  without 
having  to  predict  whether  that  State  will  be  joined  by  other  States  of 
any  given  size. 

Finally,  the  Act  permits  a  State  to  provide  a  credit  for  State 
sales  tax  against  State  income  tax.  Such  credits  are  increasingly  being 
made  available  under  existing  State  laws  and  are  generally  designed  to 
reduce  the  regressive  efl'ects  of  flat-rate  State  sales  taxes,  especially 
when  such  taxes  are  imposed  on  food. 

Effective  date 
This  provision  is  to  take  effect  on  the  date  of  enactuient  (October  -f. 
1976). 


1  While  the  trigger  is  reduced  to  one  Stale,  piggybacking  becomes  effective  within  the 
notification  process  of  prior  law,  i.e.,  the  first  January  1  which  is  more  than  one  year  after 
the  date  of  notification. 


234-120  O  -  77  -  41 


630 

Revenues  e-ffect 
This  provision  is  not  expected  to  liave  any  eflFect  on  Federal  revenues. 

17.  Cancellation  of  Certain  Student  Loans  (sec.  2117  of  the  Act 
and  sec.  117  of  the  Code) 

Prior  law 

Gross  income  means  all  income,  from  whatever  source  derived, 
including  income  from  discharge  of  indebtedness,  unless  otherwise 
provided  by  law  (sec.  61).  However,  subject  to  certain  limitations, 
gross  income  does  not  include  any  amount  received  as  a  scholarship 
at  an  educational  institution  or  as  a  fellowship  grant  (sec.  117(a) ),  An 
amount  paid  to  an  individual  to  enable  him  to  pursue  studies  or  re- 
search does  not  qualify  as  a  scholarship  or  fellowship  grant  if  such 
amount  represents  compensation  for  past,  present  or  future  employ- 
ment services  or  if  such  studies  or  research  are  primarily  for  the  bene- 
fit of  the  grantor  (Regs.  §  1.117-4 (c) ). 

Under  certain  student  loan  programs  established  by  the  TTnited 
States  and  various  State  and  local  governments,  all  or  a  portion  of 
the  loan  indebtedness  may  be  discharged  if  the  student  performs 
certain  services  for  a  period  of  time  in  a  certain  geographical  area 
pursuant  to  conditions  in  the  loan  agreement.  In  1973,  the  Internal 
Revenue  Service  ruled  on  a  situation  in  which  a  State  medical  educa- 
tion loan  scholarship  program  provided  that  portions  of  the  loan  in- 
debtedness are  discharged  on  the  condition  that  the  recipient  practices 
medicine  in  a  rural  area  of  the  State.  The  condition  that  services  be  per- 
formed in  an  area  selected  by  the  grantor  imposes  a  substantial  quid 
pro  guo,  so  that  the  services  are  primarily  for  the  benefit  of  the  grantor. 
Therefore,  the  Service  determined  that  amounts  received  from  such  a 
loan  program  were  included  in  the  gross  income  of  the  recipient  to  the 
extent  that  repayment  of  a  portion  of  the  loan  is  no  longer  required 
(Rev.  Rul.  78-2.56,  1973-1  C.B.  56).  On  November  4,  1974,  the  Service 
determined  that  this  ruling  would  be  applied  only  to  loans  made  after 
June  11,  1973,  the  date  of  the  above  ruling  (Rev.  Rul.  74-540,  1974-2 
C.B.  38). 

Reasons  for  change 
Many  States  and  cities  have  experienced  difficulty  in  attracting 
doctors,  nurses  and  teachers  to  serve  certain  areas,  including  both 
rural  communities  and  low-income  urban  areas.  A  provision  in  stu- 
dent loan  programs  for  loan  cancellation  in  certain  circumstances  is 
intended  to  encourage  the  recipients,  upon  graduation,  to  perform 
needed  services  in  such  areas.  Proponents  of  these  programs  believe 
that  the  loan  cancellation  is  not  primarily  for  the  benefit  of  grantor, 
as  the  Service  has  ruled,  but  for  the  benefit  of  the  entire  community 
and  that  the  exclusion  from  income  of  the  amount  of  indebtedness 
discharged  in  exchange  for  these  services  would  further  the  purpose 
of  the  programs.  In  addition,  proponents  believe  the  exclusion 
would  be  consistent  with  the  treatment  of  scholarships  and  fellow- 
ship grants  which  ai-e  not  contingent  upon  the  performance  of  needed 
services  by  the  recipient. 

Explanation  of  proinsion 
The  Act  provides  that  no  amount  shall  be  included  in  gross  income 
by  reason  of  the  discharge  of  all  or  part  of  the  indebtedness  of  the  in- 


631 

dividual  under  certain  student  loan  programs  if  the  discharge  was 
pursuant  to  a  provision  of  tlie  loan  agreement  under  which  all  or  part 
of  the  indebtedness  of  tlie  individual  would  be  discharged  if  the  in- 
dividual works  for  a  certain  period  of  time  in  certain  professions  in 
certain  geographical  areas  or  for  certain  classes  of  employers.  This 
provision  applies  to  student  loans  made  to  an  individual  to  assist  him 
in  attending  an  educational  institution  only  if  the  loan  was  made  by 
the  United  States  or  an  instrumentality  or  agency  thereof  or  by  a 
State  or  local  government,  either  directly  or  pursuant  to  an  agreement 
with  an  educational  institution. 

The  House  Ways  and  JNIeans  Committee  has  indicated  tliat  it  plans, 
witli  the  assistance  of  the  Internal  Revenue  Service,  to  study  the  treat- 
ment of  scholarships  and  fellowships,  including  student  loans  that 
are  forgiven.^  To  allow  further  study  in  this  area,  the  provisions  of 
this  section  are  eflFective  through  Deceuiber  31, 1978. 

Effective  date 
The  amendment  made  by  this  section  shall  apply  with  respect  to 
loans  forgiven  prior  to  January  1, 1979. 

Revenue  effect 
It  is  estimated  that  this  provision  will  have  only  a  negligible  revenue 
loss. 

18.  Simultaneous  Liquidation  of  Parent  and  Subsidiary  Corpo- 
rations (sec.  2118  of  the  Act  and  sec.  337  of  the  Code) 

Prior  law 

A  corpoi-ation  which  adopts  a  plan  of  complete  liquidation  and, 
Avithin  12  months  thereafter,  sells  or  exchanges  some  or  all  of  its 
assets  and  liquidates  completely  generally  does  not  recognize  gain  or 
loss  from  the  sale  or  exchange  (sec.  337).  Its  shareholders  will  ordi- 
narily be  taxable,  however,  on  the  sale  proceeds  which  they  receive  as 
part  of  the  liquidating  distributions  made  to  them  (sec.  331) . 

Under  prior  law  this  corporate  nonrecognition  rule  did  not  apply, 
however,  if  the  corporation  making  the  sale  or  exchange  was  an  80 
percent  or  gi-eater  controlled  subsidiary  of  a  parent  corporation  and  if 
the  parent  took  a  carryover  basis  in  the  assets  of  the  subsidiary  when 
it  liquidated  the  subsidiary  (former  sec.  337(c)  (2) ). 

Reasons  for  change 

The  purpose  of  the  general  rule  fi-eeing  the  coi'poration  from  tax 
on  a  gain  from  a  sale  of  its  assets  followed  by  a  complete  liquidation  is 
to  eliminate  the  need  for  determining  whether  a  corporation  in  the 
])rocess  of  completely  liquidating,  which  distributes  some  of  its  assets 
to  its  own  shareholders  who  then  complete  a  sale  of  the  asset  to  a  third 
party,  should  be  treated  for  tax  purposes  as  remaining  taxable  on  the 
sale  or  whether  the  shareholders  receiving  the  assets  should  be  treated 
as  taxable  on  the  sale. 

Plowever,  if  a  corporate  shareholder  of  a  company  wliich  sells  its 
assets  is  not  taxable  when  it  liquidates  the  subsidiary  (as  occurs  under 
sec.  332),  and  if  the  subsidiary  were  not  taxable  on  a  gain  from  selling 


1  Report  of  the  Committee  on  Ways  and  Means  (H.  Rept.  94-658;  November  12,  1975), 
p.  427. 


632 

its  assets,  no  tax  at  all  would  be  paid  on  the  gain  represented  by  the 
sale  proceeds.  Hence,  prior  law  (sec.  337(c)(2))  required  that  a 
controlled  subsidiary  must  recognize  gain  or  loss  where  it  sells  its 
assets  and  then  liquidates  into  its  parent. 

In  some  situations,  however,  where  both  the  parent  and  the  sub- 
sidiary plan  to  liquidate  after  a  sale  of  property  by  the  subsidiary  (and 
sometimes  after  the  parent  also  sells  some  or  all  of  its  assets  at  the  same 
time),  it  is  less  important  to  tax  the  subsidiary  on  its  gain  from  a  sale 
of  assets.  In  fact,  two  taxes  w^ere  often  required  by  prior  law  in  this  sit- 
uation :  a  sale  of  assets  by  the  subsidiary  was  subject  to  tax  (in  light  of 
former  section  337  (c)  (2) ) ,  and  the  shareholders  of  the  parent  corpora- 
tion also  recognized  gain  when  the  parent  liquidated  (sec.  331).  The 
Internal  Kevenue  Service  had  held,  however,  that  this  tax  result 
could  be  avoided  if  the  parent  first  liquidated  the  subsidiary  into 
itself  (without  recognizing  gain  or  loss  by  reason  of  sec.  332)  after 
which  the  parent  adopts  its  own  plan  of  liquidation  (under  sec.  337) 
and  then  sells  the  assets  formerly  owned  by  the  subsidiary.  Under  that 
sequence,  neither  the  parent  nor  its  subsidiary  would  recognize  gain  or 
loss  and  the  parent's  shareholders  alone  would  recognize  gain  or  loss 
on  the  liquidation  of  the  parent.^ 

Alternatively,  the  parent  could  distribute  its  subsidiary's  stock  to  the 
parent's  own  shareholders  who  would  be  taxable  on  the  value  of  the 
subsidiary  at  that  time,  but  if  the  shareholders  then  caused  the  sub- 
sidiary to  sell  its  assets  under  the  rules  of  section  337,  the  exception 
in  former  section  337(c)(2)  would  be  avoided,  and  no  second  tax 
would  be  required  (because  of  basis  adjustments  at  the  shareholder 
level)  on  the  asset  sale  or  on  liquidation  of  the  subsidiary. ^ 

Congress  believes  that,  consistent  \v'ith  the  underlying  purpose 
of  section  337,  the  sequence  of  formal  steps  taken  by  the  parties  in  this 
type  of  situation  should  not  determine  what  tax  results  occur. 

Explanation  of  provision 

The  Act  permits  the  general  nonrecognition  rule  of  section  337(a) 
to  apply  to  a  controlled  subsidiary  which  sells  property  and  then 
liquidates  completely,  provided  that  the  parent  corporation  also  liqui- 
dates completely  in  the  same  transaction.  In  order  to  obtain  non- 
recognition  of  gain  or  loss,  all  other  generally  applicable  requirements 
of  section  337  would  have  to  be  satisfied  (such  as  the  rule  that  the  sale 
or  exchange  of  property  must  occur  within  12  months  after  the  sub- 
sidiary adopts  a  plan  of  complete  liquidation).  In  this  situation,  not 
only  must  the  selling  subsidiary  make  a  liquidating  distribution  of  all 
of  its  remaining  assets  (less  assets  retained  to  meet  claims)  within  12 
months  after  its  plan  of  liquidation  is  adopted,  but,  in  addition,  during 
the  same  12-month  period,  the  parent  corporation  must  also  distribute 
all  of  its  assets  in  its  own  complete  liquidation.  (The  parent  will  be 
regarded  as  having  liquidated  completely  for  purposes  of  this  rule 
even  though  it  retains  assets  to  meet  claims.) 

Because  sec.  337(a)  will  be  applicable  to  the  selling  subsidiary  in 
this  situation,  gain  on  a  sale  of  the  subsidiary's  assets  will  not  be  rec- 

1  See  Rev.  Rul.  69-172.  1969-1  Cum.  Bull.  99. 

-  Under  prior  law,  the  Tax  Court  had  held  that  the  statutory  intent  behind  former  sec. 
.'?37(c)(2)  was  not  to  deny  a  selling  subsidiary  the  benefit  of  section  337  where  both  the 
subsidiary  and  its  parent  simultaneously  sold  their  assets  to  a  third  party  and  completely 
liquidated.  Kamis  Engineering  Company,  60  T.C.  763  (1973). 


633 

oganized  by  the  subsidiary  if  the  subsidiary  makes  the  sale  or  if,  under 
the  so-called  "Court  Holding  Company  principle,"  a  sale  by  the  parent 
can  be  treated  for  tax  purposes  as  having  been  made  by  the  subsidiary.^ 
A  realized  loss  on  a  sale  by  the  subsidiary  of  property  which  has  de- 
clined in  value  will  similarly  not  be  recognized. 

If  the  selling  subsidiary  is  a  member  of  a  group  of  controlled  sub- 
sidiaries having  a  common  parent  corporation,  the  new  rule  requires 
in  effect  that  all  other  subsidiaries  in  the  direct  line  of  stock  owner- 
ship above  the  level  of  the  selling  subsidiary  must  also  liquidate  com- 
pletely. These  other  subsidiaries  must  distribute  their  assets  (less  assets 
retained  to  meet  claims)  in  complete  liquidation  within  the  12  month 
period  beginning  on  the  date  of  adoption  of  the  selling  subsidiary's 
plan  of  liquidation.*  The  effect  of  requiring  the  liquidation  of  all  sub- 
sidiaries in  a  chain  above  the  selling  subsidiary  is  to  eliminate  a  "Court 
Holding  Company"  problem  which  could  otherwise  continue  to  exist 
in  this  type  of  situation.  For  example,  assume  that  a  parent  corpora- 
tion, P,  owms  all  the  stock  of  subsidiary  S-1,  which  in  turn  ow^ns  all 
the  stock  of  subsidiary  S-2,  and  that  S-2  sells  its  assets  after  adopting 
a  section  337  plan.  The  effect  of  not  requiring  S-1  to  liquidate  would 
be  to  leave  a  possible  continuing  fact  question  in  some  cases  as  to  who 
should  be  treated  for  tax  purposes  as  having  made  a  sale  of  property. 
If  S-2  were  treated  as  the  seller  of  its  assets  for  tax  purposes,  section 
337  would  protect  S-2  against  recognition  of  gain  or  loss ;  however,  if 
on  the  facts  the  Commissioner  could  successfully  contend  that  S-1 
negotiated  the  sale  and  therefore  S-2  should  be  treated  as  having  made 
a  liquidating  distribution  of  the  property  in  kind  of  S-1,  w^hich  then 
completed  the  sale,  S-1  could  be  required  to  recognize  gain  or  loss  as 
if  it  had  actually  sold  the  assets.  Tlie  Act  eliminates  the  possibility  of 
this  kind  of  continuing  factual  difficulty  by  extei)ding  section  337  to 
an  asset  sale  by  S-2  on  coadition  that  both  S-i  and  P  also  liquidate 
completely.  Then,  even  if  S-1  could  be  treated  as  the  seller  for  tax  pur- 
poses, section  337  would  apply  at  the  level  of  S-1  to  provide  nonrec- 
ognition  of  its  gain  or  loss. 

Effective  date 
This  provision  is  effective  for  sales  or  exchanges  made  ]Dursuant  to 
a  plan  of  liquidation  adopted  on  or  after  January  1,  1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  not  have  any  significant 
effect  on  tax  revenues. 

19.  Prepublication  Expenses  (sec.  2119  of  the  Act  and  sees.  61, 
162,  174,  263  and  471  of  the  Code) 

Prior  law 
The  Internal  Revenue  Code  (sec.  174(a)  (1) )  pennits,  under  certain 
circumstances,  an  itemized  deduction  for  research  and  experimental 

3  See  Commissioner  v.  Court  Holding  Co.,  324  U.S.  331  (1945)  and  United  States  v. 
Cumberland  Public  Service  Co..  338  TJ.S. 'iSl  (1950). 

*  For  purposes  of  this  rule,  the  group  of  corporations  to  which  this  rule  applies  must 
constitute  an  "affiliated  group"  as  defined  in  section  1504(a).  An  affiliated  sroup  will 
qualify  under  this  provision  regardless  whether  the  group  elects  (under  sec.  15<Jl'„to  nle 
a  consolidated  tax  return.  Also  for  purposes  of  this  rule,  the  exceptions  to  the  definition 
of  "includible  corporation"  contained  in  section  1504(b)  are  not  to  apply.  Therefore,  the 
members  of  the  affiliated  group  are  to  be  determined  as  if  the  corporations  referred  to 
in  section  1504(b)  were  members  of  the  group. 


634 

expenditures  otherwise  chargeable  to  a  taxpayer's  capital  account.  The 
regulations  under  this  provision  define  research  and  experimental 
expenditures  as  expenditures  incurred  in  connection  with  a  taxpayer's 
trade  or  business  which  represent  research  and  development  costs  in 
the  experimental  or  laboratory  sense.  The  regulations  specifically  ex- 
clude expenditures  for  research  in  connection  with  literary,  historical, 
or  similar  projects. 

Prior  to  the  enactment  of  this  Act,  the  Internal  Revenue  Service 
held  in  Revenue  Ruling  73-395  ^  that  the  costs  incurred  by  an  accrual 
basis  taxpayer  in  the  writing,  editing,  design  and  art  work  directly 
attributable  to  the  development  of  textbooks  and  visual  aids  did  not 
constitute  research  and  experimental  expenditures  under  section  174. 
The  Service  further  held  that  these  costs  could  not  be  inventoried 
(under  sec.  471)  but  instead  represented  expenditures  that  must  be 
capitalized  (under  sec.  263)  and  may  be  depreciated  (under  sec. 
167(a)). 

The  ruling  also  stated  that  expenditures  incurred  in  the  actual  print- 
ing and  publishing  of  textbooks  and  visual  aids  should  be  inventoried 
(under  sec.  471)  with  a  part  of  the  costs  being  apportioned  to  books 
and  visual  aids  still  on  hand  at  the  end  of  the  taxable  year.  Also, 
expenditures  for  manuscripts  and  visual  aids  which  were  abandoned 
would  be  deductible  as  losses  (under  sec.  165). 

Reasons  for  change 
The  Congress  was  made  aware  of  the  concerns  of  the  publishing 
industry  as  to  whether  Revenue  Ruling  73-395,  as  described  above,  cor- 
rectly interpreted  the  law  under  section  174  as  it  applies  to  the  publish- 
ing industry.  The  Congress  understood  that  historically  tax  accounting 
practices  in  the  publishing  industry  have  varied  greatly  and  no  stand- 
ard procedures  have  been  developed.  Industry  members  apparently 
have  followed  their  own  interpretations,  particularly  with  regard  to 
the  treatment  of  publishers'  prepublication  expenditures.  The  Con- 
gress further  was  informed  that  in  the  case  of  these  expenses,  some 
publishers  deducted  them  currently  while  other  publishers  capitalized 
them.  The  Congress  believed  that  in  view  of  the  uncertainty  with 
respect  to  the  treatment  of  prepublication  expenditures,  the  Internal 
Revenue  Service  should  review  this  treatment  and  issue  regulations 
to  establish  a  uniform  treatment  of  such  expenditures  for  the  entire 
publishing  industry.  This  would  allow  interested  taxpayers  an  oppor- 
tunity to  advise  the  Service  about  the  practices  and  problems  within 
the  industry  with  respect  to  this  matter.  Since  the  Congress  was  con- 
cerned about  the  retroactive  application  of  Revenue  Ruling  73-395 
which  would  affect  practices  consistently  followed  by  many  taxpayers 
for  years,  the  Congress  believed  that  any  new  rules  applicable  under 
regulations  promulgated  after  the  enactment  of  this  Act  should  only 
have  prospective  application. 

Explanation  of  provision 
The  provision  generally  allows  publishers  to  continue  their  cus- 
tomary treatment  of  prepublication  expenditures  without  regard  to 
Revenue  Ruling  73-395.  The  prepublication  expenditures  affected  by 

1 1973-2  CB  87. 


635 

the  provision  are  those  paid  or  incurred  in  connection  with  the  taxpay- 
er's trade  or  business  of  publishing  for  the  writing,  editing,  compiling, 
illustrating,  designing  or  other  development  or  improvement  of  a  book, 
teaching  aid,  or  similar  product. 

The  provision  allows  taxpayers  to  treat  their  prepublication  ex- 
penditures in  the  manner  in  which  they  have  been  treated  consistently 
by  the  taxpayer  in  the  past  until  new  regulations  are  issued  with  regard 
to  these  expenditures  after  the  date  of  enactment  of  this  Act  (Octo- 
ber 4, 1976). 

Any  regulations  issued  by  the  Internal  Revenue  Service  after  the 
date  of  enactment  of  this  Act  are  to  apply  prospectively  only  to 
taxable  years  beginning  after  their  issuance.  Until  these  regiilations 
are  issued,  the  Internal  Revenue  Service  is  to  administer  the  applica- 
tion of  sections  61  (as  it  relates  to  cost  of  goods  sold),  162.  174, 
263  and  471  to  the  prepublication  expenditures  of  publishers  without 
regard  to  Revenue  Ruling  73-395.  In  addition,  as  indicated  above,  the 
Service  is  to  administer  these  sections  in  the  same  manner  as  they  were 
consistently  applied  by  taxpayers  prior  to  the  issuance  of  Revenue  Rul- 
ing 73-395.  If  a  taxpayer  did  not  consistently  follow  a  specific  tax  ac- 
counting method,  his  returns  will  be  treated  by  the  Service  in  accord 
with  usual  administrative  procedures. 

Effective  date 
This  provision  is  effective  on  the  date  of  enactment  of  this  Act. 

Revenue  effect 
The  provision  will  have  little  or  no  revenue  effect  because  publishers 
would  have  benefitted  by  an  IRS  suspension  of  Revenue  Ruling  73-395  ^ 
and  would  have  neither  reported  nor  paid  the  past  tax  liabilities  as- 
sessed by  the  Service  pursuant  to  its  interpretation  of  the  law  as  stated 
in  that  ruling.  However,  if  the  Service  had  not  suspended  audit  and 
appellate  activitiy  in  cases  arising  from  its  legal  interpretation  as  evi- 
denced in  Revenue  Ruling  73-395,  and  if  no  legislative  bar  on  enforce- 
ment were  enacted,  publishers'  past  due  tax  liabilities  could  amount  to 
several  hundred  million  dollars. 

20.  Contributions  to  Capital  of  Regulated  Public  Utilities  in  Aid 
of  Construction  (sec.  2120  of  the  Act  and  sees.  118  and  362 
of  the  Code) 

Prior  law 

Generally,  contributions  to  the  capital  of  a  corporation,  whether  or 
not  contributed  by  a  shareholder,  are  not  includible  in  the  gross  in- 
come of  the  corporation  (sec.  118).  Nonshareholder  contributions  of 
property  to  the  capital  of  a  corporation  take  a  zero  basis  in  the  hands 
of  the  corporation.  If  money  is  contributed  by  a  nonshareholder,  the 
basis  of  any  property  acquired  with  srich  n  one>'  during  the  12-month 
period  beginning  on  the  day  the  contr  :vatJOfi  i  received  or  of  certain 
other  property  is  reduced  by  the  amount  of  such  contribution  (sec. 
362(c)). 

Certain  regulated  public  utilities  (water  and  sewage  disposal)  have 
traditionally  obtained  a  substantial  portion  of  their  capital  needed  for 

2  Press  release  IR-1575,  March  17,  1976. 


636 

the  construction  of  facilities  through  contributions  in  aid  of  construc- 
tion. The  concept  of  contributions  in  aid  of  construction  originates 
from  a  line  of  early  Board  of  Tax  Appeals  decisions  dealing  with 
amounts  contributed  by  customers  to  public  utilities  to  pay  for  exten- 
sions of  service  lines  necessary  to  enable  them  to  be  serviced  by  the 
public  utility.  The  decisions  treated  such  amounts  as  not  giving  rise  to 
taxable  income  to  the  public  utilities. 

In  a  1958  ruling,  the  Internal  Revenue  Service  aimounced  that  it 
would  continue  to  follow  the  early  case  law  with  respect  to  contribu- 
tions in  aid  of  construction,  but  only  with  respect  to  regulated  utilities. 
The  iiding  also  indicated  that  any  change  of  position  would  be  given 
nonretroactive  effect  (Rev.  Rul.  58-535,  1958-2  CB  25).  In  1975,  the 
Service  issued  Revenue  Ruling  75^557  (1975-2  CB  38)  which  revoked 
the  1958  ruling,  withdrew  the  IRS's  acquiescence  in  the  early  line  of 
cases,  and  held  that  amounts  paid  by  the  purchaser  of  a  home  in  a  new 
subdivision  as  a  connection  fee  to  obtain  water  service  were  includible 
in  the  utility's  income.  The  ruling  was  made  prospective  for  transac- 
tions entered  into  on  or  after  February  1,  1976. 

Reasons  for  change 

The  effect  of  the  recent  IRS  ruling  was  to  increase  substantially  the 
taxes  of  those  utilities  which  had  previously  treated  all  contributions 
in  aid  of  construction  as  nontaxable  contributions  to  capital.  These  in- 
creased taxes  would  have  ultimately  resulted  in  higher  charges  to  util- 
ity customers.  Since  such  increased  charges  must  be  approved  by  pub- 
lic utility  commissions,  the  working  capital  of  the  utilities  could  have 
been  substantially  reduced  resulting  in  delays  in  furnishing  service  and 
curtailment  of  expansion  of  service.  Further,  the  immediate  inclusion 
of  such  contributions  in  income  would  cause  a  mismatching  of  income 
and  related  expense  since  the  utility  must  increase  income  in  the  year 
in  which  the  contributions  are  received,  even  though  most  of  the  ex- 
penses attributable  to  those  facilities  would  not  arise  until  subsequent 
years. 

The  Congress  believed  that  the  treatment  of  contributions  in  aid  of 
construction  by  water  and  sewage  disposal  utilities  should  be  con- 
tinued by  providing  that  contributions  in  aid  of  construction  received 
by  such  utilities  from  an  existing  or  potential  customer,  a  builder  or 
developer,  a  governmental  body,  or  any  other  person  will  constitute 
a  contribution  to  capital.  However,  the  Congress  also  believed  that 
nontaxable  treatment  should  not  be  accorded  to  customer  connection 
fees  and  to  contributions  to  utilities  which  are  not  required  to  serve 
the  general  public. 

Explanation  of  provisions 
This  provision  amends  the  current  rules  concerning  nonshareholder 
contributions  to  capital  by  specifying  that  amounts  received  as  con- 
tributions in  aid  of  construction  by  a  water  or  sewage  disposal  utility 
(described  in  section  7701(a)  (33)  (A)  (i) )  which  are  used  for  quali- 
fied expenditures  and  which  are  not  included  in  the  rate  base  for  rate 
making  purposes  by  the  regulatory  body  having  rate-making  juris- 
diction are  to  be  treated  as  nontaxable  contributions  to  the  capital  of 
the  utility. 


637 

For  this  purpose,  the  Secretary  is  to  prescribe  rules  defining  what 
items  and  amounts  constitute  a  contribution  in  aid  of  construction. 
The  following  are  examples  of  facilities  which  the  Congress  considers 
to  be  contributions  in  aid  of  construction. 

(1)  A  builder  or  developer  constructs  water  lines  and/or  support 
facilities  such  as  water  filtration  plants,  water  towers,  etc.,  and  turns 
such  facilities  over  to  a  regulated  water  or  sewage  disposal  utility. 

(2)  A  builder  or  developer  furnishes  the  necessary  funds  to  a  regu- 
lated water  or  sewage  disposal  utility  which  uses  those  funds  to  build 
certain  water  or  sewage  disposal  facilities. 

(3)  A  builder  or  developer  pays  for  the  water  or  sewage  disposal 
facility  (commonly  referred  to  as  an  "advance")  in  return  for  the 
qualifying  utility  agreeing  to  pay  the  developer  a  percentage  of  the 
receipts  from  the  facilities  over  a  fixed  period.  Where  the  total  pay- 
ments made  to  the  developer  are  less  than  the  cost  of  the  facilities 
Avhich  are  transferred  to  the  utility,  any  difference  is  to  be  treated  as  a 
contribution  in  aid  of  construction. 

(4)  Governmental  units  furnish  regulated  water  or  sewage  disposal 
utilities  with  relocation  fee  payments  where  the  local  jurisdiction 
requires  that  certain  construction  be  done  by  the  utility  in  order  to 
achieve  a  desired  purpose  of  the  goverrment  unit.  e.g..  tearing  up  an 
old  road  to  be  replaced  by  a  new  one  mav  I'equire  replacement  of  cer- 
tain underground  pipies  and  lines,  providing  additional  sewage  dis- 
posal facilities  as  a  result  of  drainage  proiects,  etc. 

Under  the  Act,  nontaxable  treatment  is  not  accorded  to  customer 
connection  fees.  Customer  connection  fees  include  any  payments  made 
by  a  customer  to  the  utility  for  the  cost  of  installing  the  connection 
between  the  customer's  property  and  the  utilitv's  main  water  or  sewer 
lines  (including  the  cost  of  meters  and  piping)  and  any  amounts  paid 
as  sprvice  charges  for  stopping  or  starting  service. 

Where  a  utility  receives  a  lump-sum  amount  as  a  payment  for  items 
which  aualifv  for  nontaxable  treatment  under  this  provision  and  for 
items  which  do  not  so  qualifv  (such  as  customer  connection  fees),  then 
the  portion  which  qualifies  for  nontaxable  treatment  under  this  provi- 
sion is  to  be  determined  on  a  case  by  case  basis  under  the  facts  and 
circumstances  of  each  case.  In  addition,  the  mere  fact  that  the  appli- 
cable rate-making  authority  classifies  an  amount  received  by  a  utility 
as  an  amount  for  which  nontaxable  treatment  is  permitted  is  not  con- 
clusive of  nontaxable  treatment  if  such  amounts  actually  are  for  items 
for  which  nontaxable  treatment  is  not  permitted. 

In  addition,  a  requirement  is  added  to  insure  that  nontaxable  treat- 
ment is  accorded  to  only  those  utilities  that  are  required  to  serve  the 
public. 

A  qualified  expenditure  is  an  amount  which  is  expended  for  the 
acquisition  or  construction  of  tangible  property  described  in  section 
1231  (b),^  where  the  acquisition  or  construction  of  the  facilitv  was  the 
purpose  motivating  the  contribution  {i.e..  the  purpose  for  which  such 
amounts  were  received).  Such  capital  assets  must  be  used  predomi- 
nantly {i.e..  80%  or  more)  in  a  trade  or  business  of  furnishing  Avater  or 
sewerage  services  to  the  utility's  customers.  Such  expenditure  must 

1  For  this  purpose,  a  capital  asset  includes  all  expenditures  which  must  be  capitalized 
for  such  facilities  under  the  normal  rules  of  tax  accounting  (sec.  263). 


638 

occur  by  the  end  of  the  second  taxable  year  after  the  year  in  which  the 
money  was  received.-  For  this  purpose,  the  Congress  intends  that 
amounts  received  by  the  utility  which  are  subject  to  being  returned  to 
the  payer,  if  the  cost  of  the  facility  is  less  than  projected,  are  not  sub- 
jected to  these  rules  so  long  as  the  repayment  occure  Avithin  the  2-year 
period  during  which  qualified  expenditures  can  be  made.  Any  amounts 
not  so  expended  must  be  included  in  income  for  the  taxable  year  in 
which  such  amounts  were  received.  In  addition,  accurate  records  must 
be  kept  of  the  amounts  contributed  on  the  basis  of  the  project  for  which 
the  contribution  was  made  and  by  year  of  contribution. 

No  depreciation  may  be  claimed  and  no  investment  credit  may  be 
taken  \yith  respect  to  any  property  acquired  as  a  result  of  a  qualified 
expenditure.^  If  a  taxpayer  wishes  to  change  its  present  practice  of 
treating  contributions  in  aid  of  construction  to  a  practice  which  is 
consistent  with  this  provision,  such  change  constitutes  a  change  in 
method  of  accounting. 

In  providing  these  special  rules  for  water  and  sewage  disposal 
companies,  the  Congress  intends  that  no  inference  should  be  drawn 
as  to  the  proper  treatment  of  such  items  by  companies  which  are  not 
water  or  sewage  disposal  utilities. 

Effective  date 

This  provision  is  to  be  effective  for  contributions  made  on  or  after 
February  1, 1976. 

Revenue  effect 
This  provision  will  reduce  budget  receipts  by  $16  million  in  fiscal 
year  19T7,  $11  million  in  fiscal  year  1978,  and  $11  million  in  fiscal  vear 
1981. 

21.  Prohibition  of  Discriminatory  State  Taxes  On  Production  and 
Consumption  of  Electricity  (sec.  2121  of  the  Act) 

Prior  lato 

Federal  statutes  provide  few  limitations  on  the  power  of  States  to 
tax  nondomiciliaries  or  to  impose  special  taxes  on  goods  or  services 
produced  in  the  taxing  State  for  nondomiciliary  use  outside  the  tax- 
ing State. 

However,  Public  Law  86-272  ^  established  certain  minimum  stand- 
ards upon  the  power  of  a  State  to  tax  nondomiciliaries  selling  in 
the  taxing  State  in  interstate  commerce.  That  Act  did  not  affect  the 
powers  of  States  to  tax  goods  or  services  produced  within  its  boun- 
daries for  consumption  outside  its  boundaries.  Title  II  of  the  Act, 
however,  also  provided  for  further  "studies  of  all  matters  pertaining 
to  the  taxation  of  interstate  commerce.  .  .  ." 


-  The  expenditure  also  can  occur  anytime  before  the  contribution  In  aid  of  construc- 
tion is  received.  For  example,  If  the  utility  Installed  a  water  main  for  a  customer  in 
1977,  amounts  received  as  contributions  in  aid  of  construction  in  years  after  1977  from 
the  customer  are  not  taxable  to  the  extent  that  the  utility  had  made  previous  qualifying 
expenditures  or  makes  qualifying  expenditures  within  the  2-year  period. 

3  However,  in  the  case  of  an  "advance"  (described  in  Item  number  3,  above),  the  pay- 
ments made  by  the  utility  to  the  developer  would  be  considered  as  a  capital  expenditure 
In  the  year  of  payment.  In  such  a  case,  the  pavments  should  be  allocated  proportionately 
to  the  basis  of  each  of  the  various  assets  acquired  with  the  original  contribution.  Where 
such  assets  are  depreciable,  the  allocated  payments  would  be  depreciable  over  the  remaining 
useful  life  of  that  asset. 

1  86th  Cong.,  1st  Sess.,  73  Stat.  555  (1959). 


639 

Reasons  for  change 

Congress  has  learned  that  one  State  places  a  discriminatory  tax  upon 
the  production  of  electricity  within  its  boundaries  for  consumption 
outside  its  boundaries.  Wliile  the  rate  of  the  tax  itself  is  identical  for 
electricity  that  is  ultimately  consumed  outside  the  State  and  electricity 
whicli  is  consumed  inside  the  State,  discrimination  results  because  the 
State  allows  the  amount  of  the  tax  to  be  credited  against  its  gross  re- 
ceipts tax  if  the  electricity  is  consumed  within  its  boundaries.  This 
credit  normally  benefits  only  domiciliaries  of  the  taxing  State  since  no 
credit  is  allowed  for  electricity  produced  within  the  State  and  con- 
sumed outside  the  State.^  As  a  result,  the  cost  of  the  electricity  to  non- 
domiciliaries  is  normally  increased  by  the  cost  the  producer  of  the 
electricity  must  l^ear  in  paying  the  tax.  However,  the  cost  to  domicil- 
iaries of  the  taxing  State  does  not  include  the  amount  of  the  tax. 

Congress  believes  that  this  is  an  example  of  discriminatory  State 
taxation  which  is  properly  within  the  ability  of  Congress  to  prohibit 
tlirough  its  power  to  regulate  interstate  commerce. 

Explanation  of  provision 

This  provision  prohibits  any  State,  or  political  subdivision  of  a 
State,  from  imposing  a  tax  on  or  with  respect  to  the  generation  or 
transmission  of  electricity  if  the  tax  discriminates  against  out-of-State 
manufacturers,  producers,  wholesalers,  retailers,  or  consumers  of  that 
electricity.  A  tax  is  considered  discriminatory  if  it  directly  or  indirectly 
results  in  a  greater  tax  burden  on  electricity  which  is  generated  and 
transmitted  in  interstate  commerce  than  on  electricity  which  is  gen- 
erated and  transmitted  in  intrastate  commerce. 

This  provision  is  not  intended  to  prohibit,  restrain,  or  burden  any 
other  State  which  currently  imposes  a  nondiscriminatory  tax  on  the 
generation  of  electricity. 

This  provision  re]5laces  the  current  Title  II  of  Public  Law  86-272, 
which  is  the  title  calling  for  further  congressional  studies.  A  number 
of  studies  of  the  problem  of  multistate  taxation  of  interstate  commerce 
have  already  been  made  by  congressional  committees,  and  the  present 
Title  II  is  not  needed  to  authorize  any  additional  studies  that  may  be 
needed. 

Effective  date 
The  prohibition  of  discriminatory  taxes  made  by  this  amendment 
is  effective  beginning  June  30, 1974. 

Revenue  effect 
This  provision  will  have  no  impact  upon  Federal  revenues. 

22.  Deduction  for  Cost  of  Removing  Architectural  and  Transpor- 
tation Barriers  for  Handicapped  and  Elderly  Persons  (sec. 
2122  of  the  Act  and  sec.  190  of  the  Code) 

Prior  law 
Under  prior  law.  there  were  no  special  provisions  for  the  tax  treat- 
ment of  expenditures  to  remove  architectural  and  transportational 
barriers  to  the  handicapped  and  elderly. 

2  However,  a  credit  for  the  amount  of  a  tax  on  the  production  of  electricity  imposed  by 
a  second  State  is  allowed  against  the  first  State's  gross  receipts  tax  if  the  electricity  is 
consumed  in  the  first  State. 


640 

However,  generally  costs  incurred  for  the  improvement  of  property 
used  in  a  trade  or  business  must  be  capitalized.  Such  improvements 
may  be  depreciated  over  their  useful  life,  if  the  period  is  determinable. 

Reasons  for  change 
In  spite  of  previous  Federal  legislation  to  contend  with  the  problem 
of  architectural  and  transportation  barriers  to  the  handicapped  and 
elderly,  such  barriers  remain  widespread  in  business  and  industry.  The 
Congress  believes  that  creating  a  tax  incentive  for  a  limited  period 
could  promote  more  rapid  modification  of  business  facilities  and  vehi- 
cles. In  addition,  the  removal  of  barriers  to  the  handicapped  and 
elderly  would  increase  their  involvement  in  economic,  social  and  cul- 
tural activities. 

Explanation  of  provision 

The  Act  provides  electing  taxpayers  with  a  tax  incentive  for  the 
removal  of  architectural  and  transportation  barriers  to  the  handi- 
capped and  elderly.  A.n  electing  taxpayer  may  treat  certain  expenses 
for  the  removal  of  architectural  and  transportation  barriers  as  deduc- 
tible expenses  in  the  year  paid  or  incurred  instead  of  capitalizing  them. 
Deductible  expenses  are  those  paid  or  incurred  in  order  to  make  more 
accessible  to  and  usable  by  the  handicapped  and  elderly  any  facility 
or  public  transportation  vehicle  owned  or  leased  by  the  taxpayer  for 
use  in  his  trade  or  business.  The  maximum  deduction  for  a  taxpayer, 
including  a  controlled  group  of  corporations  filing  a  consolidated 
return,  for  a  return  for  any  taxable  year  is  $25,000. 

In  order  to  qualify  for  the  deduction,  the  expenses  must  be  for  bar- 
rier removal  in  business  facilities  which  the  taxpayer  establishes  to  the 
satisfaction  of  the  Secretary  meet  standards  set  by  the  Secretary  of  the 
Treasury  with  the  concurrence  of  the  Architectural  and  Transporta- 
tion Barriers  Compliance  Board  and  as  established  by  1968  legislation.^ 

The  definition  of  an  elderly  person  under  this  provision  is  age  65  or 
over.  Handicapped  individuals  include,  but  are  not  limited  to,  the 
blind  and  deaf. 

The  deduction  is  limited  to  a  3-year  period  in  order  that  the  Con- 
gress may  re\'iew  its  cost  effectiveness. 

Effective  date 
This  provision  applies  to  taxable  yeare  beginning  after  December  31, 
1976,  and  before  January  1, 1980. 

Revenue  effect 
This  provision  will  result  in  a  revenue  loss  of  %i  million  in  fiscal 
1977  and  $10  million  in  fiscal  1978. 

23.  Reports  on  High-Income  Taxpayers  (sec.  2123  of  the  Act) 

Prior  law 
The  Secretary  of  the  Treasury  is  directed  (under  sec.  6108  of  the 
Code)  to  publish  annually  statistics  compiled  from  tax  returns,  in- 
cluding classifications   of  taxpayers   and   of  income,   the   amounts 

1  "An  Act  to  insure  that  certain  buildings  financed  with  Federal  funds  are  so  designed 
and  constructed  as  to  be  accessible  to  the  physically  handicapped,"  approved  August  12, 
1968  (82  Stat.  718;  42  U.S.C.  4151). 


641 

allowed  as  deductions,  exemptions  and  credits  and  any  other  facts 
deemed  pertinent  and  valuable. 

Reasons  for  change 

The  statistics  published  by  the  Internal  Revenue  Service  are  an 
extremely  valuable  source  of  information  for  the  analysis  of  tax 
policy.  Generally,  the  Service  has  done  an  excellent  job  in  comput- 
ing and  publisliing  their  statistics. 

In  one  respect,  however,  these  statistics  are  iriisleading.  They  use 
"adjusted  gross  income"  as  the  definition  of  an  individual's  income. 
This  is  a  concept  that  is  useful  for  purposes  of  computing  the  appro- 
])riate  amount  of  income  tax  but  is  not  a  very  good  analytical  measure 
of  total  income  for  purposes  of  determining  a  person's  ability  to  pay 
income  tax.  This  has  led  to  considerable  confusion  about  the  extent 
to  which  high-incouie  people  are  able  to  avoid  paying  income  tax. 

Adjusted  gross  income  equals  all  gross  income  that  is  not  specifi- 
cally excluded  from  gross  income  minus  (1)  trade  or  business  deduc- 
tions (other  than  most  such  deductions  by  emploj^ees),  (2)  the  deduc- 
tion for  alimony  (which  is  made  a  deduction  from  gross  income  in  this 
Act),  (3)  the  deduction  for  one-half  of  long-term  capital  gains,  (4) 
deductions  for  losses  from  the  sale  or  exchange  of  property,  (5)  deduc- 
tions attributable  to  rents  and  royalties,  (6)  the  moving  expense 
deduction,  (T)  deductions  for  contributions  to  individual  retirement 
accounts,  (8)  deductions  for  contributions  to  H.R.  10  plans,  and  (9) 
certain  other  deductions. 

Taxable  income  equals  adjusted  gross  income  minus  itemized  deduc- 
tions (or,  if  the  taxpayer  so  elects,  the  standard  deduction)  and  the 
deduction  for  personal  exemptions. 

In  recent  years,  the  Internal  Revenue  Service  has  published  statis- 
tics on  the  number  of  people  with  high  adjusted  gross  incomes  who 
paid  no  individual  income  tax.  In  1974,  for  example,  there  were  244 
people  with  adjusted  gross  income  above  $200,000  who  paid  no  Fed- 
eral income  tax.  There  were  5  tax  returns  with  adjusted  gross  income 
over  $1  million  and  no  Federal  income  tax  liability. 

The  Congress  believed  that  it  is  important  to  publish  statistics 
on  the  extent  of  tax  avoidance  by  high-income  people,  but  that  the 
statistics  currently  being  published  are  deficient  in  several  respects. 

First,  while  most  itemized  deductions  are  for  personal  expenses 
and  should  not,  therefore,  be  deducted  in  measuring  total  income  for 
statistical  purposes,  some  of  them  are  business  or  investment  expenses 
that  should  be  deducted  in  properly  measuring  total  income.  The  use 
of  adjusted  gross  income  as  a  statistical  measure  of  total  income  means 
that  no  itemized  deductions  are  allowed.  One  example  of  such  a  deduc- 
tion that  should  be  allowed  is  investment  interest  and  expense,  at  least 
to  the  extent  it  offsets  investment  income.  Another  example  is  the 
deduction  for  employee  business  expenses. 

Second,  some  of  the  types  of  income  that  are  specifically  excluded 
from  gross  income  should  be  included  in  a  proper  statistical  measure- 
ment of  total  income.  These  include,  for  example,  interest  on  State  and 
local  government  bonds  and  the  first  $100  of  dividend  income,  both 
of  which  are  tax  exempt. 

Third,  some  of  the  deductions  allowed  in  arriving  at  adjusted  gross 
income  should  not  be  deducted  in  defining  a  proper  measure  of  total 


642 

income.  These  include  such  items  as  the  capital  grains  deduction  and  the 
deductions  for  contributions  to  individual  retirement  accounts  and 
H.R.  10  plans. 

Congress  believed  that  the  Internal  Revenue  Service  should  use  the 
available  data  to  obtain  a  more  accurate  estimate  of  how  many  high- 
income  individuals  are  able  to  avoid  paying  income  tax,  what  is  the 
effective  tax  rate  on  the  high-income  group,  and  precisely  what  deduc- 
tions are  used  by  hi.qfh-income  people  in  avoiding  tax.  The  Act,  there- 
fore, instructs  the  Secretary  of  the  Treasury  to  publish  statistics  on 
tax  liability  of  high-income  individuals,  using  a  definition  of  income 
that  corresponds  to  a  proper  analytical  measure  of  total  income  more 
closley  than  does  adjusted  gross  income. 

Explanation  of  j)ro  vision 

The  Act  instructs  the  Secretary  of  the  Treasury  to  publish  statistics 
on  the  tax  liability  of  people  with  total  incomes  of  $200,000  or  more. 
These  statistics  should  include  the  number  and  average  income  of 
high-income  people  with  no  income  tax  liability  (after  credits)  ;  the 
specific  deductions,  exclusions  and  credits  used  by  these  people  to  avoid 
tax;  the  number  of  high-income  individuals;  and  the  total  income  and 
tax  liability  of  the  high-income  group. 

For  this  purpose,  income  should  be  defined  in  a  way  that  more  closely 
approximates  a  proper  analytical  measure  of  total  income  than  does 
adjusted  gross  income.  This  new  concept  of  income  should  be  derived 
from  information  that  is  now  required  to  be  listed  on  the  tax  return ; 
Congress  does  not  intend  to  complicate  further  the  income  tax  return 
by  adding  new  lines  that  are  unnecessary  for  tax  collection  and  are 
only  designed  to  serve  a  statistical  purpose.  Being  derived  only  from 
items  already  appearing  on  the  tax  return,  this  new  measure  of  income 
will  not  itself  be  a  comprehensive  measure ;  but  it  will  be  better  than 
adjusted  gross  income. 

The  new  measure  of  income  should  include  the  following  two  adjust- 
ments :  First,  adjusted  gross  income  should  be  reduced  by  investment 
interest  and  expense  to  the  extent  that  it  does  not  exceed  investment 
income.  Second,  the  items  of  tax  preference  under  the  minimum  tax 
that  are  exclusions  from  gross  income  or  deductions  in  arriving  at 
adjusted  gross  income  should  be  added  back  to  adjusted  gross  income. 
The  Secretary  may  also  adjust  for  other  items  of  tax  preference  for 
which  data  are  available.  These  two  adjustments  are  to  be  made 
separately,  as  Avell  as  together,  so  that  the  Act  mandates  statistics  using 
three  new  definitions  of  income. 

Congress  does  not  intend  that  this  provision  add  substantial  cost  to 
the  Statistics  of  Income  program.  When  data  are  not  available  to 
generate  precise  statistics,  the  Secretary  should  come  as  close  as  pos- 
sible to  making  precise  estimates  of  the  relevant  numbers. 

Effective  date 
This  provision  is  eifectiA^e  for  Statistics  of  Income  for  1975  and  sub- 
sequent years.  If  data  collection  problems  prevent  full  compliance 
for  1975  without  substantial  additional  cost,  the  Secretary  may  make 
cruder  estimates  for  1975  than  is  intended  for  subsequent  years. 

Revenue  effect 
This  provision  will  have  no  impact  upon  Federal  revenues. 


643 

24.  Tax  Treatment  of  Certified  Historic  Structures  (sec.  2124  of 
the  Act  and  sec.  191  of  the  Code) 

Prior  law 

The  original  users  of  depreciable  real  property  constructed  after 
July  24,  1969,  are  allowed  to  depreciate  the  property  using  accelerated 
methods  of  depreciation,  including  the  150  percent  declining  balance 
method  (200  percent  in  the  case  of  residential  rental  property).  Ac- 
celerated depreciation  methods  are  generally  not  allowable  with  re- 
spect to  used  property  acquired  after  July  24,  1969.  A  125  percent  de- 
clining-balance method  may  be  employed  to  depreciate  used  residential 
property  with  a  useful  life  of  20  yeai-s  or  more  at  the  time  of  acquisi- 
tion. Ordinarily,  the  costs  of  rehabilitating  an  existing  structure  must 
be  capitalized  and  depreciated  according  to  the  method  used  to  depreci- 
ate the  structure. 

Generally,  the  expenses  of  demolishing  an  old  building,  and  the  re- 
maining undepreciated  basis  of  the  demolished  building,  are  deductible 
unless  the  building  was  acquired  with  a  view  toAvarcl  its  demolition. 

Under  prior  law,  a  charitable  deduction  was  not  allowed  for  a  contri- 
bution to  charity  (not  in  trust)  of  less  than  the  taxpayer's  entire  in- 
terest in  the  property  unless  it  was  a  contribution  of  an  undivided 
interest  in  the  property,  a  contribution  which  would  have  been  entitled 
to  a  charitable  deduction  if  it  had  been  made  in  trust,  or  a  contribu- 
tion of  a  remainder  interest  in  real  property  consisting  of  personal 
residences  or  farms. 

Reasons  for  change 
Congress  believes  that  the  rehabilitation  and  preservation  of  historic 
structures  and  neighborhoods  is  an  important  national  goal.  Congress 
believes  that  the  acliievement  of  this  goal  is  largely  dependent  upon 
whether  private  funds  can  be  enlisted  in  the  preservation  movement. 
Tax  considerations  have  an  important  bearing  on  whether  i)rivate 
interests  are  willing  to  maintain  and  rehabilitate  historic  structures 
rather  than  allow  them  to  deteriorate  or  replace  them  with  new  build- 
ings. It  has  been  argued  that  certain  tax  provisions  of  prior  law  en- 
couraged the  demolition  and  replacement  of  old  buildings  instead  of 
their  rehabilitation.  In  particular,  it  has  been  argued  that  discrimina- 
tion against  preservation  efforts  existed  under  prior  law  l^ecause  (1) 
the  expenses  of  demolishing  an  old  building  and  the  remaining  un- 
depreciated basis  of  the  demolished  building  were  deductible  unless 
the  building  had  been  acquired  with  a  view  towards  its  demolition  and 
(2)  more  favorable  depreciation  methods  were  allowed  with  respect  to 
expenditures  incurred  in  the  construction  of  new  structures  than  those 
incurred  in  the  rehabilitation  of  existing  structures.  Because  of  the 
adverse  effect  that  these  provisions  of  prior  law  may  have  had  on  the 
preservation  of  historic  structures.  Congress  decided  that  the  tax  ad- 
vantages of  demolishing  historic  structures  and  of  building  replace- 
ment structures  should  be  reduced.  In  addition.  Congress  decided  to 
create  an  incentive  for  historic  presei-vation  by  providing  accelerated 
depreciation  and  rapid  amortization  for  expenses  incurred  in  the 
rehabilitation  of  historic  structures. 

Explanation  of  provisions 
The  Act  allows  taxpayers  an  election,  in  lieu  of  claiming  the  depre- 
ciation deductions  otherwise  allowable,  to  amortize  over  a  60-month 


644 

period  the  capital  expenditures  incurred  in  a  certified  rehabilitation 
of  a  certified  historic  structure.  Amortization  is  to  be  recaptured  as 
ordinary  income  on  a  sale  of  the  property.  A  "certified  historic  struc- 
ture" is  defined  as  a  building  or  structure  on  which  depreciation  is  al- 
lowable and  which  is  (a)  listed  in  the  National  Register,  (b)  located  in 
a  Registered  Historic  District  and  is  certified  by  the  Secretary  of  the 
Interior  as  being  of  historic  significance  to  the  district,  or  (c)  located 
in  a  historic  district  designated  under  a  State  or  local  statute  con- 
taining criteria  satisfactory  to  the  Secretary  of  the  Interior.  A  "certi- 
fied rehabilitation"  is  defined  to  be  any  rehabilitation  of  a  certified 
historic  structure  which  the  Secretary  of  the  Interior  has  certified  as 
being  consistent  with  the  historic  character  of  such  property  or  district. 

Alternatively,  the  Act  allows  taxpayers  an  election  to  be  treated 
for  depreciation  purposes  as  if  they  were  the  original  users  of  a  "sub- 
stantially rehabilitated  historic  property"  (with  the  result  that  they 
would  be  allowed  to  use  the  150  percent  (or  200  percent  in  the  case  of 
residential  rental  property)  declining-balance  method  of  depreciation 
with  respect  to  the  entire  basis  of  any  such  rehabilitated  property  on 
which  depreciation  was  allowable).  A  "substantially  rehabilitated 
historic  property"  is  defined  to  be  any  certified  historic  property  if  the 
capital  expenditures  incurred  in  the  certified  rehabilitation  of  the  prop- 
erty during  the  24-month  period  ending  on  the  last  day  of  the  taxable 
year  exceed  the  greater  of  (1)  the  taxpayer's  adjusted  basis  in  the 
structure  on  the  first  day  of  the  24-month  period  or  (2)  $5,000.  This 
election  to  use  accelerated  depreciation  must  be  made  with  respect  to 
the  entire  structure.  A  taxpayer  cannot  elect  5-year  amortization  with 
respect  to  certain  components  of  a  structure  and  accelerated  deprecia- 
tion with  respect  to  others. 

The  Act  provides  that  in  case  of  the  demolition  of  a  certified 
historic  structure,  or  of  any  other  structure  in  a  Registered  Historic 
District  unless  certified  by  the  Secretary  of  the  Interior  prior  to  its 
demolition  not  to  be  of  historic  significance  to  the  district,  no  deduction 
is  to  be  allowed  for  (1)  the  amount  expended  for  its  demolition  or 
(2)  any  loss  sustained  on  account  of  the  demolition.  Deductions  dis- 
allowed under  this  provision  are  to  be  treated  as  chargeable  to  the 
capital  account  with  respect  to  the  land  on  which  the  demolished 
structure  was  located,  and  thus  are  not  to  be  includible  in  the  depre- 
ciable basis  of  any  replacement  structure. 

The  Act  also  provides  that  accelerated  depreciation  methods  are  not 
allowed  with  respect  to  real  property  constructed  on  a  site  which  had 
been  occupied  by  a  certified  historic  structure  which  was  demolished 
or  substantially  altered  (other  than  by  virtue  of  a  certified  rehabilita- 
tion). 

Under  the  Act,  a  deduction  is  allowed  for  the  contribution  to 
a  charitable  organization  exclusively  for  "conservation  purposes" 
of  (1)  a  lease  on.  option  to  purchase,  or  easement  with  respect  to  real 
property  of  not  less  than  30  years'  duration  or  (2)  a  remainder  interest 
in  real  property.  For  this  purpose,  a  charitable  •contribution  includes 
a  contribution  to  a  governmental  unit.  The  term  "conservation 
purposes"  is  defined  to  mean  the  preservation  of  land  areas  for  public 
outdoor  recreation  or  education,  or  for  scenic  enjoyment,  the  preserva- 
tion of  historically  important  land  areas  or  structures,  or  the  preserva- 


645 

tion  of  natural  environmental  systems.  Such  contributions  also  qualify 
as  charitable  contributions  for  estate  and  gift  tax  purposes. 

Effective  date 
The  five-year  amortization  of  certified  rehabilitation  expenses 
applies  to  additions  to  capital  account  after  June  14,  1976,  and  before 
June  15,  1981.  Accelerated  depreciation  of  substantially  rehabilitated 
historic  property  applies  to  additions  to  the  capital  account  after 
.Tune  30, 1976,  and  before  July  1, 1981.  The  disallowance  of  deductions 
with  respect  to  demolitions  of  historic  structures  applies  to  demolitions 
commencing  after  June  80,  1976,  and  before  January  1,  1981.  The 
required  use  of  straight  line  depreciation  on  replacement  structures 
applies  to  additions  to  the  capital  account  after  December  31,  1975, 
and  before  June  15,  1981.  The  deductions  are  allowable  for  charitable 
contributions  and  transfers  for  conservation  purposes  made  after 
June  13,  1976,  and  before  June  14,  1977. 

Revenue  effect 
It  is  estimated  that  these  provisions  will  result  in  a  revenue  loss  of 
$1  million  in  fiscal  1977,  $3  million  in  fiscal  1978,  and  $16  million  in 
fiscal  1981. 

25.  Supplemental  Security  Income  for  Victims  of  Certain  Natural 

Disasters  (sec.  2125  of  the  Act) 

Prior  law 
In  general  a  recipient  of  supplemental  security  income  living  in 
someone  else's  household  has  his  benefits  reduced  by  one-third  to 
reflect  a  lower  level  of  need.  However,  Public  Law  94-331  eliminates 
for  up  to  6  months  the  one-third  reduction  in  the  case  of  individuals 
displaced  as  a  result  of  a  major  disaster  occurring  between  June  1, 
1976  and  December  31, 1976. 

Reasons  for  change 
The  6-month  period  provided  for  in  prior  law  proved  to  be  an 
adequate  period  of  time  for  victims  of  the  flood  disasters  occurring  in 
the  last  half  of  1976  to  relocate.  Consequently,  many  of  these  victims 
faced  a  reduction  in  SSI  benefits  as  of  the  end  of  1976. 

Explanation  of  provision 
The  Act  extends  the  period  during  which  the  one-third  reduction  in 
SSI  benefits  may  be  suspended  for  these  disaster  victims  from  6 
months  to  18  months. 

Effective  date 
The  provision  is  effective  upon  enactment. 

Revenvs  effect 
This  provision  has  no  effect  on  budget  receipts. 

26.  Net   Operating  Loss   Carryovers  for   Cuban   Expropriation 

Losses  (sec.  2126  of  the  Act  and  sec.  172(b)  of  the  Code) 

Prior  law 
L'nder  prior  law,  a  taxpayer  could  carry  over  a  net  operating  loss 
attributable  to  Cuban  expropriation  to  each  of  15  taxable  years  follow- 
ing the  taxable  year  of  the  loss. 


234-120  O  -  77  -  42 


646 

Reasons  joi'  change 

An  original  10-year  carryover  period  for  Cuban  expropriations  was 
extended  5  years  in  1971  by  Public  Law  91-677.  This  alleviated  but  did 
not  correct  the  inequity  for  people  who  sustained  losses  but  could  not 
offset  them  because  they  were  generating  small  annual  incomes.  The 
Internal  Revenue  Service  estimates  that  there  are  a  few  hundred  claims 
with  losses  remaining  to  be  carried  forward.  These  Cuban  expropria- 
tion losses  had  to  be  claimed  prior  to  December  31,  1965.  They  have 
been  investigated  and  accepted  by  the  Internal  Revenue  Service  as 
actual  losses. 

The  period  was  first  extended  to  permit  the  use  of  the  losses  sus- 
tained. Since  there  are  still  some  who  have  not  had  that  chance,  par- 
ticularly those  people  least  able  to  reestablish  themselves,  the  Congress 
believes  it  is  appropriate  that  an  additional  extension  be  provided. 

The  provision  as  amended  applies  to  a  decreasing  number  of  persons, 
and  their  losses  are  not  among  the  largest  Cuban  losses.  These  business- 
men are,  in  many  cases,  finally  generating  income  that  will  allow  them 
to  carry  forward  their  losses. 

Explanation  of  "provision 
The  Act  extends  the  carryover  period  for  five  years  to  20  taxable 
years  following  the  loss.  The  Congress  intends  this  to  be  the  final  exten- 
sion of  the  provision. 

Effective  date 
This  amendment  is  effective  upon  enactment. 

Revenue  effect 
The  revenue  effect  of  this  amendment  is  expected  to  be  negligible. 

27.  Outdoor  Advertising  Displays  (sec.  2127  of  the  bill  and  sec.  1033 
(g)  of  the  Code) 

Prior  law 

Statutory  rules  provide  that  gains  from  involuntary  conversions  of 
property  (including  casualties  and  condemnations)  are,  in  general, 
allowed  nonrecognition  treatment  where  money  realized  from  the 
involuntary  conversion  is  reinvested,  within  a  limited  period  of  time, 
in  property  which  is  similar  or  related  in  serv*  or  use  to  the  prop- 
erty converted  (sec.  1033).  A  special  rule  has  also  been  provided  for 
condemnations  of  business  or  investment  real  estate  (other  than  in- 
ventory property)  under  which  more  liberal  rules  are  adopted  for 
purposes  of  determining  whether  a  purchase  of  replacement  real 
estate  qualifies  as  similar  or  related  in  service  or  use  to  the  property 
converted  (sec.  1033(g)). 

The  Internal  Revenue  Service  has  ruled  that  outdoor  advertising 
billboards  and  displays  are  real  property  for  purposes  of  the  invest- 
ment credit  and  depreciation  recapture.^  However,  this  administrative 
interpretation  has  been  successfully  challenged  in  several  court  cases 
which  hold  that  billboards  are  tangible  personal  property  (and  not 
real  property)  for  purposes  of  the  investment  credit.^ 

1  Rev.  Rul.  68-62,  1968-1  C.B.  365. 

2  See,  e.g.,  Alabama  Displays,  Inc.  et  al.  v.  United  States,  507  F.2(i  844  (Ct.  Cls.  1974i  : 
Whiteco  Industries,  Inc.,  65  T.C.  664  (1975). 


647 

Reasons  for  change 
The  Federal  Highway  Beautification  Act  of  1965  and  State  high- 
way beautification  statutes  authorize  the  government  to  condemn  and 
purchase  privately  owned  highway  billboards.  Because  of  continuing 
restrictions  on  where  highway  billboards  may  be  located,  the  former 
owners  of  condemned  billboards  (particularly  small  companies)  are 
prevented  from  using  their  condemnation  awards  to  build  and  situate 
replacement  billboards;  these  taxpayers  have  been  forced  instead  to 
reinvest  their  awards  in  other  types  of  property.  At  the  time  the  Con- 
gress enacted  the  highway  beautification  legislation  it  was  anticipated 
that  the  IRS  would  permit  taxpayers  whose  billboards  were  con- 
demned to  invest  in  other  types  of  real  property  without  payment  of 
tax.  However,  the  recent  court  decisions  involving  the  classification 
of  billboards  as  tangible  personal  property  for  investment  credit  pur- 
poses have  put  that  determination  in  jeopardy.  Thus,  in  order  to 
permit  reinvestments  of  billboard  condenniation  proceeds  to  qualify 
for  tax-free  treatment  under  the  involuntary  conversion  rules  in  ap- 
propriate circumstances,  while  still  not  affecting  the  recent  court  de- 
cisions. Congress  decided  to  allow  taxpayei-s  an  election  to  treat  out- 
door adv'crtising  displays  as  real  property. 

Explanation  of  provisions 

Under  these  provisions,  an  election  is  provided  for  taxpayers  to 
treat  outdoor  advertising  displays  as  real  property.  This  election,  once 
made,  is  irrevocable  without  the  permission  of  the  Secretary  to  change 
it  and  applies  to  all  qualifying  outdoor  advertising  displays  of  the 
taxpayer.  The  availability  of  this  election  should  not  be  interpreted 
to  prevent  owners  of  outdoor  advertising  displays  Avho  do  not  make 
an  election  from  claiming  treatment  for  them  as  personal  property. 

Outdoor  advertising  displays  do  not  qualify  for  the  election  where 
the  taxpayer  has  previously  treated  the  property  as  tangible  personal 
property  (by  claiming  either  the  investment  credit  or  additional  first- 
year  depreciation).  This  limitation  is  necessary  to  prevent  a  taxpayer 
from  treating  the  same  property  as  tangible  personal  property  for 
purposes  of  the  investment  credit  and  as  real  property  for  purposes 
of  the  involuntary  conversion  replacement  property  and  depreciation 
recaptui-e  rules. 

The  term  "outdoor  advertising  display"  includes  rigidly  assembled 
outdoor  signs  and  displays  which  are  attached  to  the  ground,  a  build- 
ing, or  other  permanent  structure  for  purposes  of  displaying  advertis- 
ing messages  to  the  public.  This  term  includes  highway  billboards 
attached  to  the  ground  with  wood  or  metal  poles,  pipes  or  beams, 
with  or  without  concrete  footings. 

The  Act  also  provides  that  replacement  real  property  will  be  con- 
sidered "like  kind"'  property  even  though  a  taxpayer's  interest  in  the 
replacement  property  is  different  from  the  real  property  interest  held 
in  a  qualified  outdoor  advertising  display  which  was  involuntarily 
converted.  This  is  to  enable,  for  example,  purchases  of  replacement 
property  to  qualify  under  section  1033(g)  even  though  a  fee  simple 
interest  in  real  estate  is  acquired  to  replace  in  part  a  billboard  owner's 
leasehold  interest  in  real  property  on  which  the  billboard  was  located. 


648 

Effective  date 
These  provisions  apply  to  taxable  years  beginning  after  Decem- 
ber 31, 1970.  It  is  contemplated  that  the  Secretary  will  allow  taxpayers 
who  have  previously  made  replacements  of  qualified  outdoor  advertis- 
ing displays  during  closed  taxable  years  a  sufficient  period  of  time 
to  make  an  election  for  these  closed  years. 

Revenue  effect 

It  is  estimated  that  this  provision  will  have  no  appreciable  effect  on 
budget  receipts. 

28.  Tax  Treatment  of  Large  Cigars  (sec.  2128  of  the  Act  and  sees. 
5701(a),  5702,  and  5741  of  the  Code) 

Prior  law 
Under  prior  law  (sec.  5701(a)(2)),  the  manufacturers  excise  tax 
on  large  cigars  (those  weighing  more  than  3  pounds  per  thousand 
cigars)  was  imposed  on  the  basis  of  a  bracket  system  with  the  rate  of 
tax  dependent  on  the  retail  price  of  the  cigar.  The  brackets  were  as 
follows : 


Intended  retail  price  per  cigar  (in  cents) 

Tax  per 


Over—  Not  over—  thousand 

0... - 2J^  $2.50 

IM — - 4  3  00 

4 6  4.00 

6 8  7.00 

8 15  10.00 

15 20  15.00 

20 20.00 

The  retail  price  of  a  cigar  was  defined  for  Federal  tax  purposes  as 
"the  ordinary  retail  price  of  a  single  cigar  in  its  principal  market."  The 
law  provided  that  any  State  or  local  tax  imposed  on  cigars  as  a  com- 
modity was  to  be  excluded  when  determining  the  ordinary  retail  price. 

Beasotis  for  change 
The  prior  bracket  system  was  arbitrary  in  that  it  produced  widely 
varying  effective  rates  of  tax  depending  on  the  retail  price  of  the  cigar. 
For  cigars  intended  to  retail  for  20  cents  each  or  less,  the  effective  rate 
of  tax  depended  on  a  combination  of  the  rate  of  tax  for  the  given 
bracket  in  which  they  fall  and  the  price  of  the  cigar.  Thus,  in  the  wide 
bracket  covering  cigars  intended  to  retail  for  over  8  cents  and  not  over 
15  cents,  the  tax  rate  of  $10  per  thousand  varied  from  a  maximum  of 
12  percent  of  the  intended  retail  price  (including  the  tax)  for  cigars 
priced  at  three  for  25  cents  to  a  minimum  of  6.7  percent  for  cigars  in- 
tended to  retail  for  15  cents  each.  This  6.7-percent  minimum  effective 
rate  also  applied  to  cigars  at  the  top  of  the  over  4  cents  and  not  over  6 
cents  bracket.  However,  in  the  over  6  cents  and  not  oA^er  8  cents 
bracket,  the  minimum  effective  rate  was  8.8  percent.  At  the  very  bottom 
of  the  tax  scale  (namely,  in  the  case  of  cigars  intended  to  retail  for  not 
more  than  2V2  cents  each),  the  tax  of  $2.50  per  thousand  imposed  an 
effective  rate  of  10  percent  of  the  retail  price  for  cigare  intended  to 
retail  at  two  for  5  cents. 


649 

A  corollary  of  the  variability  of  the  effective  rates  of  tax  was  the 
fact  that  a  shift  in  the  price  of  a  cigar  from  the  top  of  one  bracket  to 
the  bottom  of  the  next  tax  bracket  could  result  in  a  tax  increase  dis- 
proportionate to  the  price  increase.  An  example  of  this  was  the  in- 
crease in  tax  from  $4  to  $7  per  thousand  between  cigars  intended  to 
retail  for  6  cents  and  those  intended  to  retail  for  more  than  6  cents 
and  not  over  8  cents.  At  the  6-cent  level,  the  tax  was  6.7  percent  of  the 
retail  price  and  10.4  percent  of  the  manufacturer's  net  price  (exclusive 
of  tax).^  If  the  manufacturer  of  a  6-cent  cigar  raised  the  stated  retail 
price  to  three  for  20  cents,  the  effective  rate  of  tax  would  have  increased 
to  10.5  percent  of  the  retail  price  and  17.5  percent  of  the  manufacturer's 
net  price.  The  manufacturer  would  have  netted  only  $1.70  more  per 
thousand  cigars  although  consumers  would  pay  $6.67  additional.  This 
bracket  system  not  only  discriminated  among  producers  depending  on 
the  price  at  which  they  sold  their  cigars  within  a  bracket  but  also  pre- 
vented manufacturers  from  freely  adjusting  prices  to  meet  cost 
changes. 

There  is  no  way  to  determine  precisely  how  the  burden  of  the  cigar 
tax  is  distributed  between  consumers  and  owners  of  manufacturing 
firms.  In  either  event,  however,  the  prior  tax  was  discriminatory.  To 
the  extent  it  is  borne  by  consumei'S,  the  burden  imposed  by  the  tax 
varied  erratically  depending  on  the  intended  retail  price  of  the  cigars 
purchased.  To  the  extent  it  is  borne  by  manufacturers,  the  burden  of 
the  tax  varied  depending  on  the  particular  price  lines  produced  by  each 
manufacturer.  As  a  percent  of  sales,  the  tax  paid  was  least  for  those 
manufacturers  whose  production  is  concentrated  in  price  classes  where 
the  effective  rate  of  tax  is  at  a  minimum. 

These  problems  of  the  bracket  system  have  been  recognized  for  a 
long  time  by  the  cigar  industry,  the  Treasury  Department,  and  the 
Congress.  When  the  tax  on  cigars  was  collected  by  means  of  the  pur- 
chase of  stamps,  practical  consideration  favored  the  use  of  some  type 
of  bracket  system  in  order  to  keep  to  a  reasonable  level  the  number 
and  denomination  of  stamps  that  had  to  be  printed.  However,  the  use 
of  stamps  as  evidence  of  payment  of  tax  was  discontinued  in  June 
1959.  As  a  result,  there  was  no  reason  why  the  bracket  system  should 
not  be  eliminated. 

A  change  from  a  tax  base  of  the  intended  retail  price  to  a  base  of 
the  intended  wholesale  price  makes  administration  of  the  tax  easier 
and  avoids  many  of  the  problems  associated  w^ith  the  prior  tax  base 
of  the  intended  retail  price  in  the  cigar's  principal  market.  Admin- 
istration of  the  tax  will  be  facilitated  because  wholesalers  traditionally 
sell  a  given  cigar  at  the  same  price  to  different  retailers.  Retail  prices 
do  not  have  this  consistency.  In  addition,  verification  that  sales  actually 
take  place  at  the  list  price  will  be  easier  than  in  the  case  of  the  intended 
retail  price  because  there  are  far  fewer  wholesalers  than  retailers. 

With  a  tax  based  on  the  wholesale  price  rather  than  the  retail  price, 
a  rate  of  10  percent  is  required  in  order  to  produce  the  same  tax  yield 
as  is  produced  under  prior  law.  However,  if  a  substantial  tax  increase 
is  not  to  result  for  many  cigars,  a  rate  which  is  lower  than  this  is  re- 
quired. Substitution  of  an  ad  valorem  rate  of  tax  for  the  prior  bracket 

^  This  assumes  the  usual  standard  markup  In  determining  the  retail  price. 


650 

system,  of  necessity,  has  a  differing  impact  on  individual  firms  within 
the  cigar  manufacturing  industry. 

An  ad  valorem  rate  set  at  10  percent  of  the  wholesale  price  would 
mean  that  those  firms  which  have  produced  cigars  which  sold  at  prices 
where  the  tax  rate  was  relatively  low  under  the  bracket  system  would 
be  faced  with  a  tax  increase  with  such  a  rate.  Firms  producing  cigars  at 
prices  where  the  tax  rate  has  been  relatively  high  under  tlie  bracket 
system,  of  course,  would  obtain  some  benefit  under  a  10-percent  rate 
structure.  In  a  transition  of  this  type,  however,  in  order  to  prevent  a 
tax  increase  for  a  large  number  of  lines  of  cigars,  a  reduction  in  the 
average  rate  of  tax  is  necessary. 

In  addition  to  the  need  for  a  tax  rate  decrease  because  of  a  shift 
to  an  ad  valorem  system,  a  decrease  in  the  rate  of  tax  for  cigars  also  is 
justified  for  other  reasons  as  well,  First,  when  many  excise  taxes  were 
reduced  or  eliminated  in  1965,  the  tax  on  cigars  was  nevertheless  main- 
tained at  preexisting  rates.  Second,  the  cigar  industry  in  recent  years 
lias  been  experiencing  considerable  financial  difficidty.  Sales  have 
dropped  dramatically  from  9  billion  cigars  in  1964  to  about  6  billion 
in  1975 — a  period  of  rising  costs. 

Explanation  of  provision 

The  Act  changes  the  prior  law  tax  on  large  cigars  (those  weighing 
more  than  3  pounds  per  thousand  2)  to  a  tax  of  814  percent  of  the 
wholesale  price,  but  not  more  than  $20  per  thousand  cigars. 

Wholesale  price,  as  defined  in  the  Act.  means  the  manufacturer's 
or  importer's  suggested  delivered  price  of  the  cigar  to  retailers  (in- 
cluding in  this  price  this  Federal  cigar  tax).  This  price  is  to  be  de- 
termined before  any  trade,  cash,  or  other  discounts,  or  any  promotion, 
advertising,  display,  or  similar  allowances.  Generally,  this  wholesale 
price  is  the  traditional  manufacturer's  or  importer's  declared  intended 
catalog  or  list  delivered  bulk  price  to  retailers.  Where  the  manufac- 
turer or  importer  has  no  suggested  delivered  price  to  retailers  for  the 
particular  cigar  in  question  (as  may  happen,  for  example,  if  he  sells 
only  at  retail,  or  where  the  suggested  delivered  price  to  retailers  is  not 
adequately  supported  by  bona  fide  arm's  length  sales),  the  Act  pro- 
vides that  the  wholesale  price  is  to  be  determined  by  the  Treasury 
Department  on  the  basis  of  the  price  for  which  cigars  of  comparable 
retail  price  are  sold  to  retailers  in  the  ordinary  course  of  trade. 

In  most  cases  the  wholesale  price  will  be  adequately  supported  by 
sales  by  the  wholesalers  to  retailers.  In  only  a  few  situations  will  it  be 
necessary  for  the  Treasury  Department  to  determine  the  wholesale 
price  on  the  basis  of  the  price  for  which  cigars  of  the  same  or  com- 
parable retail  price  are  sold  to  retailers  in  the  ordinary  course  of 
trade. 

The  use  of  the  intended  wholesale  price  as  the  tax  base  will  elimi- 
nate the  troublesome  determination  of  the  retail  price  of  a  single  cigar 
in  its  principal  market. 

The  wholesale  price  does  not  include  State  or  local  taxes  imposed  on 
cigars  as  a  commodity.  The  prior  law  exclusion  of  such  taxes  from 
the  tax  base  is  continued  by  this  provision.  If  a  manufacturer  nor- 
mally includes  State  or  local  taxes  in  his  "wholesale  price,"  he  must 

2  Small  cigars  are  not  taxed  on  the  basis  of  price.  Their  tax  rate  is  75  cents  per  thousand. 


651 

show  the  price  net  of  any  such  taxes  in  a  manner  satisfactory  to  the 
Treasury  Department  for  the  purpose  of  imposing  the  tax  provided 
by  the  Act. 

The  Act  also  amends  the  Code  (sec.  5741)  to  include  importers 
among  those  persons  required  to  keep  records  prescribed  by  the  Treas- 
ury Department  and  to  provide  that  the  required  records  be  available 
for  inspection  by  internal  revenue  officers  during  business  hours.  The 
existing  statutory  requirement  is  extended  to  importers  in  order  to 
avoid  any  doubt  that  appropriately  prescribed  regulations  may  re- 
quire them  to  keep  records  which  are  needed.  This  is  particularly 
relevant  with  the  change  in  manner  of  imposition  of  the  tax  on  large 
cigars  and  the  added  definition  of  "wholesale  price"  which  will  likely 
result  in  a  requirement  that  records  be  kept  by  importers. 

Effective  date 
The  new  ad  valorem  tax  becomes  effective  on  the  first  day  of  the  first 
month  which  begins  more  than  90  days  after  the  date  of  enactment 
of  the  Act  (i.e.,  February  1, 1977) . 

Revenue  effect 
This  provision  will  reduce  budget  receipts  by  $7  million  in  fiscal 
year  1977,  $7  million  in  fiscal  year  1978,  and  $7  million  in  fiscal  year 
1981. 

29.  Treatment  of  Gain  from  Sales  or  Exchanges  Between  Related 
Parties  (sec.  2129  of  the  Act  and  sec.  1239  of  the  Code) 

Prior  law 

Under  prior  law,  recognized  gains  from  a  sale  or  exchange  of  depre- 
ciable property  were  denied  capital  gain  treatment  (and  taxed  as 
ordinary  income)  if  the  transaction  was  between  a  husband  and  wife, 
or  between  an  individual  and  a  corporation  over  80  percent  of  the 
value  of  whose  stock  was  owned  by  the  individual,  his  spouse,  and  his 
minor  children  or  grandchildren  (sec.  1239).  This  rule  applied  where 
the  shareholder  sold  property  to  his  controlled  corporation,  or  vice 
versa. 

Altliough  the  statute  covered  a  sale  or  exchange  "directly  or  in- 
directly" between  an  individual  and  a  controlled  corporation,  several 
courts  had  held  that  this  language  does  not  reach  gain  on  a  sale  of 
depreciable  property  between  two  corporations  each  of  which  is  more 
than  80  percent  controlled  by  the  same  individual  and  his  family. 
These  courts  refused  to  follow  a  ruling  by  the  Internal  Revenue  Serv- 
ice that  a  sale  between  two  such  commonly  controlled  corporations  is 
(for  purposes  of  this  provision)  "indirectly"  a  sale  between  the  indi- 
vidual and  the  corporation.^ 

Reasons  for  change 
In  enacting  section  1239  (and  its  predecessors  in  the  1939  Code), 
Congress  sought  to  prevent  the  practice  of  selling  a  low  basis-high 
value  deoreciable  asset  to  a  controlled  corporation  in  order  to  "step 
up"  the  basis  of  the  asset  for  depreciation  purposes  in  the  hands  of 
the  corporation  at  the  cost  of  a  capital  gain  tax  to  the  selling  share- 


1  Rev.  Rul.  69-109,  1969-1  C.B.  202. 


652 

liolcler.=^  The  corporation's  basis  would  be  its  cost  for  the  property, 
which  in  turn  would  reflect  appreciation  in  value  in  the  hands  of  the 
shareholder. 

In  refusing  to  interpret  "indirectly"  to  cover  commonly  controlled 
corporations,  the  courts  did  not  disagree  that  corporations  under  com- 
mon control  can  and  do  engage  in  sales  or  exchanges  with  each  other 
to  obtain  tax  benefits  which  Congress  wanted  to  deny  if  the  sale 
were  made  directly  between  the  shareholder  and  the  corporation.  The 
courts,  however,  generally  based  their  decisions  on  technical  factors 
involving  the  language  of  the  statute  and  ambiguity  in  the  legislative 
history  of  the  provision. 

The  potential  for  abuse  is  as  evident  in  such  cases,  however,  as  in 
direct  sales  between  a  shareholder  and  his  controlled  corporation.  In 
both  situations,  the  shareholder  (or  his  family)  maintains  control  over 
the  asset  while  the  corporation  obtains  a  higher  depreciable  basis  in 
the  property.  Congress  sees  no  reason  why  a  sale  between  corporations 
controlled  by  the  same  individual  should  be  treated  differently  from  a 
sale  between  an  individual  and  his  controlled  corporation.^ 

No  rules  of  constructive  ownership  were  formerly  provided  in  sec- 
tion 1239  for  purposes  of  determining  the  ownership  of  stock  under 
that  provision.  As  a  result,  a  taxpayer  could  structure  a  transaction 
to  circumvent  the  section.  For  example,  a  taxpayer  desiring  to  sell 
depreciable  property  to  a  corporation  which  he  wholly  owned  could 
avoid  section  1239  by  (prior  to  the  sale)  contributing  his  stock  in  the 
corporation  to  a  holding  company  or  by  transferring  20  percent  of  his 
stock  to  a  trust  for  the  benefit  of  members  of  his  family.  Although  it 
could  be  argued  that  the  taxpayer  continued  to  own  the  stock  "in- 
directly" and  section  1239  therefore  should  come  into  play,  the  courts 
(a;;  indicated)  were  reluctant  to  give  a  broad  interpretation  to  the 
term  "indirectly." 

Explanation  of  proinsion 

The  Act  strengthens  section  1239  in  several  ways.  First,  a  new  rule 
brings  within  the  scope  of  this  provision  a  sale  or  exchange  of  depre- 
ciable property  between  commonly-controlled  coiporations.  Another 
new  rule  makes  the  rules  of  constructive  ownership  ap])licable  in  deter- 
mining stock  ownership  under  this  provision  generally.  For  this  pur- 
pose, the  present  rules  which  apply  under  section  318  are  incorporated 
by  reference.  Third,  the  Act  changes  the  control  requirement  which 
brings  section  1239  into  effect  from  over  80  percent  to  80  percent  or 
more  in  value  of  a  corporation's  stock. 

Under  the  first  of  these  changes,  the  treatment  of  gain  as  ordinary 
income  in  the  case  of  a  sale  between  commonly  controlled  corpora- 
tions occurs  at  the  level  of  the  transferor  (seller)  corporation 
rather  than  at  the  level  of  the  shareholder.  The  constructive  owner- 


2H.  Kept.  586,  82d  Cong.,  1st  Sess.  (1951),  1951-1  C.B.  357,  376.  The  committee  report 
states  that  this  type  of  transaction  may  be  highly  advantageous  "when  the  sale  may  be 
carried  out  without  loss  of  control  over  the  asset  because  the  corporation  to  which  the 
as^et  is  sold  Is  controlled  by  the  individuals  who  make  the  sale." 

•'  The  depreciation  recapture  rules  of  sections  1245  and  1250  would  have  a  limited  use 
to  prevent  this  abuse  where  sales  are  made  (between  controlled  corporations)  of  property 
which  has  a  low  basis  but  a  high  value.  In  such  cases,  sections  1245  and  1250  would  In 
many  cases  recapture  as  ordinary  income  only  a  relatively  small  portion  of  the  seller's  gain. 


653 

ship  rules  are  to  be  used  to  determine  whether  the  80  percent  stock 
ownership  requirement  has  been  met,  but  (in  the  commonly  controlled 
corporation  situation)  the  actual  tax  effect  of  recharacterizing  gain 
as  ordinary  income  will  occur  at  the  corporate  level.* 

Congress  does  not  intend,  however,  to  prevent  section  1239  from 
being  invoked  to  produce  ordinary  income  to  a  shareholder  where  a 
corporation  is  used  as  a  conduit  to  make  a  sale  to  another  controlled 
corporation,  or  where  the  entity  of  a  corporate  transferor  can  prop- 
erly be  disregarded  for  tax  purposes.  These  situations  will  result  in 
ordinary  income  to  the  shareholders.^ 

The  incorporation  of  constructive  ownership  rules  into  section  1239 
applies  generally  to  this  section.  In  light  of  the  section  318  rules,  the 
80-percent  requirement  of  section  1239  will  continue  to  be  measured 
by  reference  to  the  value  of  the  company's  outstanding  stock;  how- 
ever, the  stock  which  will  be  grouped  together  in  measuring  control 
will  include  stock  considered  owned  by  an  individual  under  the  con- 
structive ownership  rules.  Thus,  the  Act  broadens  the  constructive 
ownership  rules  which  trigger  the  restrictions  under  this  provision  to 
include  stock  owned  by  the  taxpayer's  parents,  his  adult  children, 
and  by  any  trust,  estate  or  partnership  of  which  the  taxpayer  is  a  bene- 
ficiary or  partner.  For  example,  if  a  father-owns  outright  79  percent 
of  the  stock  (by  value)  of  a  closely  held  corporation  and  a  trust  for  his 
children  owns  the  remaining  21  percent  of  the  stock,  the  children  will 
be  deemed  to  own  the  stock  owned  for  their  benefit  by  the  trust  in  pro- 
portion to  their  actuarial  interests  in  the  trust  (sec.  318(a)  (2)  (B) ). 
The  father  will,  in  turn,  constructively  own  the  stock  so  deemed  to  be 
owned  by  his  children  (sec.  318(a)(1)  (A)(ii)).  The  result  will  be 
that  the  father  will  be  treated  as  owning  all  the  stock  of  the  corpora- 
tion, and  any  gain  he  would  otherwise  have  to  recognize  from  selling 
depreciable  property  to  the  corporation  will  be  treated  by  section 
1239  (as  amended)  as  ordinary  income. 

Another  effect  of  the  constructive  ownership  rules  is  that  in  some 
cases  section  1239  can  now  produce  ordinary  income  to  a  parent 
corporation  which  sells  depreciable  property  at  a  gain  to  an  80  percent 
or  greater  controlled  subsidiary.  If  one  or  more  related  individuals 
own  at  least  80  percent  of  the  value  of  the  parent  company's  stock,  the 
same  shareholders  will  now  also  own  constructively  the  stock  in  the 
subsidiary  owned  by  the  parent;  as  a  result,  the  same  individual  or 
individuals  will  own  80  percent  or  more  in  value  of  the  stock  of  two 
or  more  corporations  and  a  sale  between  the  two  corporations  will  be 
governed  by  section  1239. 

The  constructive  ownership  rules  also  mean,  among  other  things, 
that  if  a  shareholder  holds  an  option  to  acquire  stock  (such  as  from 


*  If  the  transferor  corporation  Is  a  subchapter  S  corporation  (I.e.,  a  corporation  which 
has  made  an  election  under  sections  1371-1379),  gain  which  Is  denied  capital  gain  treat- 
ment by  reason  of  the  Act  will  be  Included  in  the  corporation's  undistributed  taxable  Income 
which  is  taxed  to  its  shareholders  (pursuant  to  sec.  1373  of  the  Code). 

'•  The  new  rule  bringing  sales  between  certain  controlled  corporations  within  section 
1239  also  Is  not  intended  to  make  such  sales  less  subject  than  they  were  under  prior  law 
to  allocations  of  Income  between  or  among  the  corporations  or  their  shareholders  under 
section  482.  Nor  is  the  new  rule  Intended  to  make  such  sales  no  longer  subject  to  con- 
structive dividend  treatment  to  the  controlling  shareholder  (as  may  occur  In  appropriate 
cases  under  present  law). 


654 

another  shareholder),  he  will  be  treated  as  owning  the  stock  which 
he  could  acquire  by  exercising  the  option  (sec.  318  (a)  (4) ) .® 

Effective  date 
These  new  rules  apply  to  gain  recognized  on  a  sale  or  exchange  made 
after  the  date  of  enactment  of  the  Act  (October  4,  1976).  A  transition 
rule  provides  that  the  new  rules  will  not  apply  to  a  sale  or  exchange 
made  after  the  date  of  enactment  but  occurring  pursuant  to  a  binding 
contract  entered  into  before  the  date  of  enactment. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  an  increase  in  budget 
receipts  of  less  than  S5  million  annually. 

30.  Application  of  Section  117  to  Certain  Education  Programs  for 
Members  of  the  Uniformed  Services  (sec.  2130  of  the  Act) 

Prior  laiD 

Amounts  received  by  an  individual  as  a  scholarship  at  a  qualified 
educational  institution  (as  defined  in  sec.  151(e)  (4) )  or  as  a  fellowship 
grant  for  study,  research,  etc.,  are  generally  excluded  from  gross 
income  (sec.  117(a) ).  However,  such  amounts  are  not  excludible  from 
gross  income  if  they  represent  compensation  for  past,  present,  or  fu- 
ture employment  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  (Treas.  Regs.  §  1.117^  (c) ). 

However,  prior  law  contained  a  special  exclusion  for  amounts  re- 
ceived under  the  Ai-med  Forces  Health  Professions  Scholarship  Pro- 
gram. During  calendar  years  1973,  1974,  and  1975,  amounts  received 
from  appropriated  funds  as  a  scholarship  (including  the  value  of 
contributed  services  and  accommodations)  by  a  member  of  a  uni- 
formed service  ^  who  was  receiving  training  under  the  Armed  Forces 
Health  Professions  Scholarship  Program  ^  (or  any  other  similar  pro- 
gram, as  determined  by  the  Secretary  of  the  Treasury)  were  specifi- 
cally excluded  from  gross  income  by  congressional  action.^  This  exclu- 
sion was  available  whether  the  member  was  receiving  training  while 
on  active  duty  or  in  an  off-duty  or  inactive  status,  and  without  regard 
to  whether  a  period  of  active  duty  was  required  of  the  member  as  a 
condition  of  receiving  those  payments. 

Reasons  for  change 
The  Internal  Revenue  Service  had  ruled  (Rev.  Rul.  76-99,  1976- 
1  C.B.  40)  tliat  without  further  legislation,  all  amounts  received  under 


8  As  another  example  of  the  effect  of  the  stock  attribution  rules,  assume  that  a  share- 
hoiaer  owns  80  percent  of  corporations  A  and  B.  The  shareholder  attempts  to  plan  around 
the  rule  in  the  Act  bringing  sales  between  controlled  corporations  within  section  1239  by 
contributing  his  stock  in  corporation  B  to  newly  formed  holding  company  C,  which  the 
shareholder  wholly  owns,  and  then  having  A  sell  depreciable  property  to  B  at  a  gain.  With- 
out attribution,  this  sale  micht  be  found  not  to  be  covered  by  section  1239.  However,  the 
attribution  rules  incorporated  by  the  Act  will  treat  the  shareholder  as  owning  the  B  stock 
owned  by  holding  company  C.  so  that  A's  eain  on  the  snle  will  be  ordinary  income. 

For  purposes  of  section  1239,  attribution  to  a  shareholder  of  stock  owned  by  a  cor- 
poration, or  vice  versa,  is  to  occur  without  regard  to  the  50-percent  limitations  contained 
In  sections  318(a)(2)(C)   and  318(a)(3)(C). 

1  As  defined  under  37  U.S.C.  101  (3). 

-  Authorized  by  the  Uniformed  Services  Health  Professions  Revitallzation  Act  of  1972 
(10  TT.S.C.  2120-2127). 

3  Public  Law  93-483  (H.R.  12035;  93rd  Congress,  1st  Sess.),  October  24,  1974. 


655 

the  Armed  Forces  Health  Professions  Scholarship  Program  would  be 
treated  as  compensation  and  therefore  includible  in  gross  income  for 
calendar  year  1976  and  thei-eafter.  In  view  of  the  congressional  and 
executive  branches'  concern  regarding  the  need  for  these  health  pro- 
fessions scholarships  for  the  uniformed  services,  the  Congress  con- 
cluded that  those  scholarsliips  would  continue  to  be  excluded  from 
gross  income  pending  a  thorough  staff  review  of  the  appropriate  tax 
treatment  of  the  grants  in  view  of  the  overall  national  policy  toward 
the  military  (and  other  uniformed  services)  health  professions 
programs,^ 

Explanation  of  provision 
The  Act  excludes  from  income  in  1976, 1977, 1978,  and  1979  amounts 
received  under  the  Armed  Forces  Health  Professions  Scholarship 
Program  (and  similar  programs)  by  a  member  of  a  uniformed  serv- 
ices ^  participating  in  a  program  in  1976. 

Effective  date 
This  provision  is  effective  for  amounts  received  during  calendar 
years  1976,  1977,  1978  and  1979  by  persons  participating  in  the  pro- 
grams in  1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  decrease  budget  receipts  by 
$10  million  in  fiscal  year  1977  and  $8  million  in  both  fiscal  1978  and 
fiscal  1979. 

31.  Exchange  Funds  (sec.  2131  of  the  Act  and  sees.  368,  584,  683 
and  721  of  the  Code) 

Prior  laio 

An  exchange  fund  is  an  investment  entity  through  which  large 
numbers  of  investors  pool  stocks  or  debt  securities,  w^hich  usually  are 
liighly  appreciated,  in  exchange  for  shares  of  the  fund.  These  arrange- 
ments allow  investors  to  divei-sify  their  concentrated  ownership  of 
one  or  a  few  securities  into  a  broader  variety  of  other  stocks  and 
securities  (usually  publicly-traded  interests  in  listed  companies) 
without  paying  taxes  on  the  apj^reciation  which  they  realize  at  the 
time  the  different  stocks  are  exchanged  with  the  fund. 

Present  law  does  not  permit  tax-free  formation  of  an  exchange  fund 
as  a  corporation  where  the  result  is  a  diversification  of  the  investor's 
portfolio.^  This  restriction  was  added  in  1966  after  a  period  in  the 
early  1960's  when  investment  management  firms  publicly  solicited 
individuals  owning  highly  appreciated  stocks  or  securities  to  pool 
their  stocks  tax-free  in  a  newly  formed  corporation  which  would  then 
manage  the  combined  portfolio. 

The  1966  legislation  dealt  only  with  swap  funds  in  corporate  form 
and  did  not  deal  with  partnerehips  because,  at  that  time,  such  funds 
could  not  operate  in  partnership  form  (largely  because  of  securities 


1  The  Hoiisp  Committee  on  Ways  and  Means  has  indicated  that  it  plans  to  study,  with 
the  Internal  Revenue  Service,  the  appropriate  tax  treatment  of  scholarships  and  fellow- 
ships (H.  Kept.  94-658  ;  November  12,  1975,  p.  427). 

2  As  defined  under  37  IJ.S.C.  Sec.  101(3). 

1  This  restriction  now  appears  as  section  351(d)  of  the  Code.  See  also  Regulations 
S  1.351-l(c). 


656 

restrictions  and  state  partnership  problems).  Recently,  however,  these 
difficulties  were  resolved  and  a  number  of  public  syndications  were 
organized  to  sell  exchange  funds  as  partnerships.  In  April,  1975, 
the  Internal  Revenue  Service  granted  a  private  ruling  to  the  Vance, 
Sanders  Exchange  Fund  which  proposed  to  operate  as  a  limited  part- 
nership, allowing  investors  to  transfer  appreciated  stocks  or  securities 
to  the  fund  without  a  current  tax  to  the  investor-limited  partners. 
This  ruling  prompted  the  formation  of  other  similar  partnerships, 
including  some  which  proposed  to  offer  interests  to  investors  privately 
(rather  than  by  broad  public  solicitation).  Several  of  these  funds 
filed  private  ruling  requests  with  the  Service,  which  then  suspended 
issuance  of  favorable  rulings  pending  the  outcome  of  legislation  intro- 
duced to  change  the  tax  treatment  of  partnership  exchange  funds. 

Under  prior  law,  the  transfer  of  property  to  a  partnership  by  one 
or  more  persons  in  exchange  for  an  interest  in  the  partnership  did 
not  result  in  recognition  of  gain  or  loss  (sec.  721)."  This  rule  parallels 
the  general  corporate  rule  (sec.  351).  except  that  a  partner  does  not 
have  to  control  the  partnership  immediately  after  the  transfer.  There 
was,  however,  no  exception  requiring  recognition  of  gain  on  transfers 
of  property  to  a  partnership  exchange  fund. 

Reasons  for  change 

Congress  concluded  that  the  creation  of  exchange  funds  through 
partnerships  (or  through  trusts  or  corporate  reorganizations)  should 
not  receive  taxfree  gain  treatment  where  the. principal  effect  is  to 
diversify  a  taxpayer's  investment  without  current  payment  of  tax. 
It  appears  to  the  Congress  that  the  principal  purpose  of  an  exchange 
fund  is  to  diversify  the  depositors'  portfolios  of  highly  appreciated 
stocks  or  securities  without  current  payment  of  tax.  If  a  depositor  had 
instead  liquidated  his  appreciated  portfolio  and  invested  the  proceds 
in  a  mutual  fund  or  other  diversified  portfolio,  a  capital  gain  tax 
would  be  imposed  on  the  gains  in  his  own  stocks.  Even  after  joining 
an  exchange  fund,  the  investors  also  generally  do  not  want  the  mana- 
gers to  sell  off  either  their  own  or  other  stocks  so  as  to  trigger  a  large 
capital  gain  tax  at  an  earlier  time  than  would  have  occurred  had  the 
investors  retained  their  own  shares.  This  conclusion  seems  justified 
by  the  importance  in  a  partnership  "swap"  fund  of  a  mutually  satis- 
factory selection  and  rejection  of  stocks  bv  the  managers  and  investors 
before  the  fund  even  begins  operating.  The  partnership  funds  them- 
selves advertise  that  they  will  have  a  low  or  minimal  portfolio  turn- 
over rate. 

This  type  of  arrangement  differs  from  a  conventional  partnership 
or  corporation  in  which  the  owners  of  different  assets  pool  them  tax- 
free  in  order  to  share  the  risks  of  conducting  an  ongoing  business.  In 
substance,  a  swap  fund  does  not  conduct  an  ordinarv  investment  busi- 
ness :  instead,  it  "provides  an  investment  medium  consisting  of  a  diver- 
sified and  supervised  portfolio  of  equity  securities  to  investors  holding 
blocks  of  individual  equity  securities  with  large  unrealized  apprecia- 
tion, *  *  *."  ^  In  this  light.  Congress  concluded  that  the  original  ex- 

2  The  partner's  basis  in  the  property  he  contributes  to  the  partnership  becomes  both  his 
basis  for  his  partnership  interest  (sec.  722)  and  the  partnership's  basis  in  the  property 
it  receives  (sec.  723). 

*  Prospectus  of  Vance,  Sanders  Exchange  Fund  (January  5,  1976),  p.  1. 


657 

change  of  appreciated  stocks  for  shares  of  an  exchange  fund  should 
properly  be  viewed  as  a  taxable  sale  or  exchange  with  other  investors 
made  through  the  fund. 

Explamation  of  'provision 

Partnership  exchange  funds 

The  Act  makes  a  specific  exception  to  the  general  rule  in  section  721 
of  the  Code  relating  to  nonrecognition  of  gain  or  loss  on  a  contribution 
of  property  to  a  partnership  in  exchange  for  an  interest  in  the  part- 
nership. The  exception  operates  where  a  partner  transfers  property 
to  a  partnership  which  is  an  "investment  company."  If  the  partner- 
ship is  an  investment  company  after  the  exchange,  the  contributing 
partner  must  recognize  gain  (if  any)  which  he  realizes  on  the  ex- 
change,* The  Act  thus  requires  the  current  taxation  of  gains  realized 
by  investors  who  transfer  appreciated  stocks  or  securities  (or  other 
property)  to  an  exchange  fund  operated  as  a  partnership. 

The  Act  does  not  change  the  law  with  regard  to  losses,  so  that 
a  loss  realized  on  a  contribution  of  stock  or  securities  (or  other  prop- 
erty) to  a  partnership  cannot  be  recognized  at  that  time. 

A  partnership  will  be  treated  as  an  "investment  company,"  for 
purposes  of  this  provision,  if  it  satisfies  the  definition  of  an  investment 
company  under  the  present  rules  relating  to  corporate  exchange  funds 
(sec.  351).  The  latter  rules  are  set  forth  in  detail  in  the  regulations 
under  section  351.  In  light  of  these  regulations,  a  partnership  will  be 
treated  as  an  investment  company  if,  after  the  exchange,  over  80  per- 
cent of  the  value  of  its  assets  (excluding  cash  and  nonconvertible  debt 
obligations)  are  held  for  investment  and  are  readily  marketable  stock 
or  securities  (or  are  interests  in  regulated  investment  companies  or 
real  estate  investment  trusts).  The  diversification  rules  of  the  section 
351  regulations  are  also  intended  to  be  incorporated  under  section  721 
as  an  integral  part  of  the  definition  of  an  investment  company.  There- 
fore, in  order  for  the  new  special  rule  in  section  721  to  become  opera- 
tion, property  transfers  to  a  partnership  must  result  in  diversify- 
ing the  transferors'  interests  in  light  of  all  the  assets  obtained  by 
the  partnei-ship  on  the  transfers.  The  determination  of  whether  a  part- 
nership is  an  investment  company  under  this  test  will  ordinarily  be 
made  immediately  after  the  transfers  of  property  under  the  same  plan 
or  as  part  of  the  same  transaction.^  The  amount  and  character  of  the 
gain  which  a  partner  must  recognize  under  the  Act  are  to  be  deter- 
mined under  the  general  provisions  of  present  law. 

These  rules  apply  both  to  limited  partnerships  and  general 
partnerships,  regardless  whether  the  partnership  is  privately  formed 

*  Consistent  with  this  rule,  a  partner's  basis  for  his  partnership  interest  (under  sec. 
722)  is  to  be  increased  by  the  amount  of  gain  recognized  on  his  transfer  of  property  to 
the  partnership.  The  partnership's  basis  in  the  property  contributed  to  it  (sec.  723)  is 
also  to  he  increased  by  the  amount  of  gain  which  the  contributing  partner  must  recognize. 

^  Since  nonrecognition  under'  section  721  does  not  require  that  the  transferor  (either 
alone  or  as  part  of  a  group  of  transferors)  control  the  partnership  inimidately  after  the 
exchange,  gain  on  appreciated  property  will  be  taxable  whether  the  property  is  trans- 
ferred to  a  partnership  investment  company  already  in  operation  or  one  which  is  newly 
formed. 

This  amendment  is  not  intended  to  change  existing  rules  which  permit  the  Service  in 
appropriate  situations  to  treat  related  contributions  and  distributions  by  a  partnership 
having  two  or  more  partners  as  a  direct  taxable  exchange  among  the  partners  (regulations 
gl.731-l(c)(3)). 


658 

or  publicly  syndicated.  They  also  require  recognition  of  gain  by  a 
person  who  transfers  nonpublicly-traded  stocks  or  securities  to  a  part- 
nership which,  after  the  transfer,  meets  the  tests  of  an  investment 
company. 

As  under  the  corporate  rule,  the  property  on  which  gain  will  be  rec- 
ognized is  not  limited  to  appreciated  stocks  or  securities,  but  includes 
other  types  of  property  (such  as  real  estate  or  other  assets)  if  the 
partnership  which  receives  the  property  is  an  investment  company 
after  the  exchange. 

Under  the  new  provision,  and  except  as  provided  below,  a  partner- 
ship may  still  be  an  investment  company  despite  the  existence  of  a 
special  allocation  among  the  partners  as  to  income,  gain,  loss,  or  deduc- 
tion items  (sec.  704).  In  some  situations,  however,  it  might  be  proper 
to  find  that  no  diversification  has  occurred  if  the  partnership  agree- 
ment allocates  income  and  gains  (or  losses)  from  specific  property  to 
the  contributing  partner  and  requires  that  a  withdrawing  partner  be 
returned  the  property  which  he  contributed  originally.'' 

These  provisions  will  not  affect  the  tax  treatment  of  an  investment 
partnership  as  a  partnership  for  tax  purposes ;  that  is,  whether  it  will 
be  taxable  as  a  partnership  or  as  a  corporate-type  entity.  That  classi- 
fication question  will  continue  to  be  determined  under  section  7701  of 
the  Code. 

Effective  date. — The  provisions  for  partnership  exchange  funds 
^PP^y  generally  to  transfers  made  to  a  partnership  after  February  17, 
1976.  This  general  rule  applies  where  the  final  binding  exchange  of 
deposited  securities  for  interests  in  the  fund  is  consummated  after 
February  17,  1976,  and  the  partnership  becomes  the  owner  of  the 
deposited  stocks  and  securities.  Except  as  indicated  below,  this  general 
rule  applies  in  a  situation  where  stocks  or  securities  were  deposited 
with  a  depository  bank  on  or  before  February  17,  1976,  but  where  the 
actual  exchange  with  the  fund  occurs  after  that  date. 

''^Grandfather'''  rides. — Congress  was  informed  that  several  partner- 
ship exchange  funds  were  in  various  stages  of  being  organized  or 
completed  when  legislation  in  this  area  was  introduced  in  the  House. 
One  fund,  the  Vance  Sanders  Exchange  Fund,  had  already  obtained  a 
private  ruling  from  the  Internal  Revenue  Service  approving  its  for- 
mation as  an  exchange  fund.  By  February  17,  1976  (when  legislation 
was  first  introduced),  other  partnerships  had  taken  substantial  steps 
toward  establishing  an  exchange  fund  by  applying  for  a  tax  ruling, 
registering  their  proposed  offering  with  the  Securities  and  Exchange 
Commission,  lining  up  brokers  and  dealer-managers,  or  soliciting  ex- 
pressions of  interest  from  potential  depositors. 

The  Act  contains  "grandfather"  rules  for  these  other  funds  under 
which  the  general  effective  date  does  not  apply  to  completed  transfers 
of  property  to  a  partnership  after  February  17.  1976.  if,  on  or  before 
March  26,  1976,  the  partnership  filed  for  (or  received)  a  private  rul- 
ing from  the  Internal  Kevenue  Service  relating  to  its  character  as  an 


8  The  Treasury  should  provide  by  reeulation  that  the  members  of  a  partnership  which 
would  be  treated  as  an  investment  company  are  not  eligible  to  make  the  election  under 
section  761(a)  not  to  be  proverened  by  the  partnership  tax  rules.  Where  a  partnership 
would  not  be  treated  as  an  investment  company  under  the  new  rules,  however,  because  the 
transfers  do  not  result  in  diversifying  the  transferors'  interests,  the  partners  should  be 
entitled  to  make  the  election  under  section  761(a)  to  the  extent  the  election  would  other- 
wise be  available. 


659 

exchange  fund/  or  the  partnership  filed  a  registration  statement  (if 
required  by  the  securities  laws  to  do  so)  with  the  Securities  and  Ex- 
change Commission.® 

A  partnership  qualifying  for  grandfather  treatment  must  also  sat- 
isfy certain  other  limitations.  First,  there  is  a  limit  on  the  time  period 
for  the  exchange.  The  final  binding  exchanges  of  deposited  stocks  or 
securities  for  interests  in  the  partnership  must  occur  on  or  before 
the  90th  day  after  the  date  on  which  the  Act  becomes  law.  (The  Act 
was  signed  by  the  President  on  October  4,  1976.)  Exchanges  under 
this  rule  may  be  consummated  before  the  date  of  enactment  of  the 
provision,  but  qualifying  exchanges  must  be  completed  no  later  than 
the  end  of  the  90th  day  after  enactment.  Second,  the  stocks  or  securities 
exchanged  must  also  have  been  deposited  with  the  bank  or  other  agent 
of  the  depositors  on  or  before  the  60th  day  after  the  date  on  which 
the  Act  became  law. 

The  Act  also  places  a  dollar  limit  on  the  total  size  of  the  grand- 
fathered funds.  If  stocks  or  securities  had  been  deposited  by  February 
29,  1976,  the  partnership  may  complete  exchanges  with  investors  of 
the  entire  dollar  value  of  securities  on  deposit  by  that  date  (or  a  lesser 
sum  if  securities  are  withdrawn  or  rejected  after  the  end  of  the  deposit 
period).  In  the  case  of  other  funds  which  had  not  begun  receiving 
deposits  by  February  29,  1976,  the  Act  permits  qualifying  partner- 
phi  ds  to  make  exchanges  with  depositors  in  the  amouni:  of  the  total 
dollar  value  of  the  deposited  stocks  on  the  60th  day  after  the  Act  be- 
came law  (or  if  earlier,  at  the  close  of  the  fund's  initial  deposit  period) , 
up  to  a  ceiling  of  $100  million  per  partnership  ($25  million  in  the 
case  of  private  offering).  These  valuation  ceilings  are  to  be  deter- 
minded  on  this  60th  day  (or,  if  earlier,  on  the  last  day  of  the  fund's 
initial  deposit  period). 

Trusts 

In  order  to  cover  the  possible  use  of  trusts  as  exchange  funds, 
the  Act  also  adds  a  specific  rule  to  the  Code  (new  section  683)  that 
gain,  but  not  loss)  will  be  recognized  to  the  transferor  on  a  transfer 
of  property  to  a  trust  in  exchange  for  an  interest  in  other  trust  prop- 
erty where  the  trust  would  be  an  "investment  company"  (within  the 
meaning  of  sec.  351)  if  the  trust  were  a  corporation.  The  hypothetical 
status  of  the  trust  as  a  corporation  for  purposes  of  new  section  683 
does  not  depend  on  the  actual  characteristics  of  the  trust  or  on  its 
being  classifiable  as  an  association  taxable  as  a  corporation  under 
section  7701  of  the  Code. 

Ordinarily,  a  transfer  of  property  to  a  trust  is  not  treated  as  a 
sale  or  other  disposition  of  the  property.  Consequently  a  transferor 
of  property  to  a  trust  is  ordinarily  not  required  to  recognize  gain  or 
loss  for  income  tax  purposes.  However,  Congress  concluded  that  it 

T  A  rnllnir  from  the  Service  relating  to  the  basic  classification  of  a  partnership  under 
section  7701  of  the  Code  is  not  suflBcient.  To  qualify,  the  ruling  must  have  been  based  on 
the  partnership's  plan  to  operate  as  an  investment  company  (within  the  meaniner  of  that 
term  In  these  provisions  of  the  Act)  and  the  ruling  must  have  held  that  nonrecognition 
treatment  can  be  obtained  under  section  721  of  prior  law. 

'The  March  26.  1976.  date  was  the  last  business  date  preceding  the  hearings  by  the 
Ho'ise  Ways  and  Means  Committee  on  legislation  in  this  area. 

Congress  also  Intends  that  a  partnership  which  submitted  a  ruling  renuest  with  the 
Internal  Revenue  Service  on  or  before  March  26,  1976,  to  operate  an  exchange  fund  as 
a  general  partnership  will  also  be  Included  within  the  grandfather  rule  if,  after 
the  March  26  date  and  because  of  securities  difficulties,  it  changes  to  a  limited  partnership 
similar  to  that  used  by  other  partnership  exchange  funds. 


660 

should  not  be  possible  to  use  a  trust  as  a  means  of  achieving  the  same 
advantages  as  a  partnership  exchange  fund  without  recognition  of 
gain  when  such  a  trust  is  initially  formed. 

Under  the  Act,  an  "exchange  for  an  interest  in  other  trust  prop- 
erty" will  occur,  for  example,,  where  numerous  persons  transfer 
property  to  a  trust  and  each  person  retains  a  proportionate  owner- 
ship in  all  of  the  property  held  in  the  trust.  Where  a  transfer  to  a 
trust  is  taxable  under  this  provision,  the  entire  amount  of  gain  on  all 
the  property  transferred  to  the  trust  will  be  recognized  even  though 
the  transferor  still  beneficially  owns  a  portion  of  the  property  trans- 
ferred to  the  trust.  "V^Hiere  the  transferor  retains  less  than  his  pro- 
portionate interest  in  the  trust,  it  is  expected  that  the  Service  will 
issue  regulations  determining  when  gain  must  be  recognized  and  the 
amount  of  gain  to  be  recognized  by  the  transferor. 

Where  a  transfer  to  a  trust  is  taxable  under  this  provision,  the  de- 
termination of  the  amount  of  gain  to  be  recognized  is  to  be  made 
property-by-property.  Thus,  losses  realized  on  one  property  will  not 
reduce  the  amount  of  gain  recognized  under  this  provision  on  other 
property  transferred  to  the  trust. 

This  provision  applies  only  to  trusts  which  are  subject  to  the  rules 
governing  normal  trusts  (subpart  J  of  chapter  1  of  the  Code).  Con- 
sequently, the  provision  does  not  apply  to  qualified  employee  benefit 
trusts  or  to  charitable  and  other  tax-exempt  organizations  which  are 
organized  as  trusts  (i.e.,  those  trusts  which  are  subject  to  subchap- 
ters D  and  F  of  chapter  1  of  the  Code) . 

In  addition,  the  Act  contains  an  exception  from  the  above  trust 
rules  for  transfers  to  a  pooled  income  fund  (as  defined  in  section 
642(c)  (5)).^ 

Effective  date. — The  provisions  relating  to  trusts  are  effective  for 
transfers  made  after  April  7, 1976. 

Common  trust  funds 

Congress  was  also  concerned  about  the  use  of  a  bank's  common  trust 
fund  as  an  exchange  fund.^°  To  cover  this  case,  the  Act  amends  sec. 
584(e)  of  the  Code  to  provide  that  the  admission  of  a  participant 
to  a  common  trust  fund  is  to  be  considered  to  be  the  purchase  of,  or 
an  exchange  for.  a  participating  interest  in  the  f imd. 

Where  the  consideration  for  the  participatinsr  interest  is  cash,  the 
transaction  will  be  considered  a  purchase  of  a  participating  interest. 
In  such  a  case,  the  participant  will  not  recogrnize  any  gain  because 
there  has  not  been  a  sale  or  other  disposition  of  property.  Where 
the  consideration  for  the  participating  interest  is  propertv,  the  trans- 
action will  be  considered  an  "exchange"  of  the  property  for  the  par- 
ticipating interest.  As  a  result,  gain  or  loss  will  be  realized  under 
section  1001  by  the  participant  on  the  transfer  of  property  to  the 

9  Under  existing:  law,  a  pooled  income  fund  is  treated  as  a  trust  (sec.  642(c)(5)).  This 
tyne  of  fund  is  jrenerally  a  trust  established  by  a  charity  to  receive  transfers  of  property 
Cinclndinc:  appreciated  stocks  or  securities)  from  one  or  more  donors  who  rf'celve  an  income 
interest  in  the  property  with  the  remainder  interest  beinfr  transferred  to  the  charity. 

1"  Common  trust  funds  are  maintained  by  a  hank  exclusively  for  the  collective  investment 
and  reinvestment  of  moneys  contributed  to  the  common  trust  fund  by  the  bank  acting  as 
trustee,  executor,  administrator  or  guardian  of  separate  trusts.  A  common  trust  fund  is 
not  a  separate  taxable  entity  and  its  income  is  taxable  to  the  separate  funds  participating 
in  the  common  fund  (see  sec.  584).  The  Code  contains  no  express  rule,  however,  requirine 
recognition  of  gain  or  loss  to  a  participant  who  contributes  appreciated  or  depreciated 
property  to  a  common  trust  fund. 


661 

common  trust  fund.  This  gain  or  loss  must  ordinarily  be  recognized 
to  the  participant  (sec.  1001  (c))  and,  if  the  property  transferred  is 
a  capital  asset,  the  gain  or  loss  will  be  capital  gain  or  loss. 

Congress  was  informed  that  the  Comptroller  of  the  Currency,  who 
regulates  these  funds,  generally  requires  that  if  an  individual  trust 
wants  to  join  an  existing  common  trust  fund,  appreciated  stocks  or 
securities  owned  by  the  trust  must  first  be  sold  (sometimes  to  the 
common  trust  fund  itself)  and  only  the  sale  proceeds  contributed  to 
the  fund.  However,  where  a  common  trust  fund  is  being  formed 
initially,  the  Comptroller  has  on  occasion  permitted  participants  to 
transfer  stocks  or  securities  in  kind  to  the  fund.  The  Act  will  not 
affect  transfers  of  cash  to  a  common  trust  fund.  It  will,  however  re- 
quire recognition  of  gain  where  the  Comptroller  permits  a  common 
trust  fund  to  be  created  by  contributions  in  kind,  if  the  effect  is  to 
achieve  a  diversification  of  the  transferrors'  investment  interests. 

Congress  also  understands  that  in  some  situations  when  banks 
merge  or  otherwise  reorganize  with  each  other,  the  combining  banks 
have  also  merged  (and  sometimes  also  divided)  separate  common  trust 
funds  formerly  maintained  by  each  bank.  Congress  was  also  in- 
formed that  the  Comptroller  of  the  Currency  requires  a  common 
trust  fund  to  maintain  a  diversified  portfolio  which  would  readily 
satisfy  the  diversification  test  in  the  Act  for  corporate  investment 
companies  (as  described  below) . 

Since  the  Act  permits  a  merger  of  corporate  investment  companies 
to  continue  to  receive  tax-free  treatment  if  both  companies  are  already 
diversified  (see  discussion  below),  a  similar  rule  is  implicit  in  the  bill 
for  common  trust  funds;  namely,  that  mergers  (or  divisions)  of 
common  trust  funds  regulated  by  the  Comptroller  of  the  Currency 
will  continue  eligible  for  tax-free  treatment  if  all  the  combming  (or 
dividing)  funds  have  diversified  portfolios  (within  the  meaning  of 
the  corporate  merger  rules  of  the  Act)  .^^ 

Effective  date. — The  amendment  to  the  common  trust  fund  rules 
is  effective  for  transfers  made  after  April  7, 1976. 

Mergers  of  two  or  more  hwe^tment  comjyanies 

The  Act  adds  an  exception  to  the  definition  of  a  taxfree  "reorganiza- 
tion'" in  prior  law  in  order  to  require  recognition  of  gain  or  loss  on 
exchanges  which,  from  an  investor's  standpoint,  resemble  the  forma- 
tion of  an  exchange  fund.  For  example,  a  group  of  individuals  each 
holding  a  few  undiversified  stocks  cannot  now  pool  their  stocks  directly 
in  a  corporate  exchange  fund.  But  they  might  be  able  to  circumvent 
this  rule  if  each  individual  could  successfully  place  his  own  stocks  in 
a  new  wholly-owned  corporation  and,  after  a  sufficient  (but  planned) 
interval,  merge  all  the  corporations  together  under  the  rules  of  section 
368.  In  effect,  each  investor  would  thereby  achieve  tax-free  diversifi- 
cation of  his  investment  assets.  Other  transactions  have  occurred  in 
which  conventional  mutual  funds  have  acquired  in  a  tax-free  reor- 
ganization assets  or  stock  of  an  undiversified  personal  holding  com- 
pany (or  other  closely  held  investment  corporation)  owning  a  port- 
al if  diversified  funds  are  merjring  (or  dividing).  Congress  thus  does  not  intend  to 
treat  the  participating  trusts  or  the  separate  funds  as  being  "admitted"  to  the  surviving 
(or  divided)  fund  in  order  to  make  the  merger  or  division  taxable  by  reason  of  the  amend- 
ment of  section  584. 


234-120  O  -  77  -  43 


662 

folio  of  stocks  or  securities.^^  In  some  cases  these  acquisitions  are 
prompted  by  business  reasons;  however,  in  most  cases  the  principal 
effect  (if  not  also  the  main  purpose)  of  these  transactions  is  the 
diversifying  of  investment  assets  while  the  appreciation  goes  untaxed 
to  the  transferors. 

The  Act  requires  recognition  of  gain  or  loss  on  a  statutory  merger 
or  other  exchange  of  assets  or  stock  of  an  undiversified  investment 
company  (as  specifically  defined  in  the  Act)  if  the  result  of  the  ex- 
change is  to  achieve  significantly  more  diversity  for  the  shareholders 
of  that  company  than  existed  before  the  exchange.  The  Act  continues 
to  allow  nonrecognition  treatment  generall}'  for  reorganizations,  how- 
ever. Also,  if  two  or  more  investment  companies  (or  their  share- 
holders) participate  in  an  exchange,  the  transaction  will  continue  to  be 
eligible  for  tax-free  reorganization  treatment  if  both  companies  have 
diversified  portfolios  before  the  exchange. 

More  specifically,  if  the  parties  to  an  exchange  otherwise  described 
in  the  tax-free  reorganization  provisions  (under  sec.  368(a)  (1))  in- 
clude two  or  more  "investment  companies,"  the  exchange  will  not 
qualify  for  customary  reorganization  treatment  as  to  one  or  more  of 
the  investment  companies  and  their  shareholders  and  security  holders 
if  that  company  owned  a  relatively  undiversified  portfolio  of  stock  or 
securities  before  the  exchange. 

This  rule  will  disqualify  only  the  portion  of  the  entire  transaction 
involving  the  undiversified  investment  company  and  its  shareholders 
and  security  holders.  The  tax  result  will  be  that  that  portion  of  the 
entire  transaction  will  be  treated  as  a  "taxable"  sale  and  purchase  of 
assets  or  stock  with  the  customary  tax  results  to  both  seller  and  buyer 
of  such  a  recognition  transaction."  For  example,  if  two  undiversified 
investment  companies  and  a  corporation  predominately  engaged  in  an 
active  business  combine  in  a  statutory  consolidation,  the  new  rule  treats 
each  acquired  investment  company  as  if  it  had  sold  its  assets  in  a 
taxable  transaction,  i.e.,  one  in  which  gain  or  loss  is  recognized  cur- 
rently." In  most  situations,  this  rule  will  also  treat  each  shareholder 
of  each  undiversified  investment  company  as  if  he  had  made  a  taxable 
exchange  of  his  former  stock  interest  for  stock  in  the  acquiring  com- 
pany." The  merger  of  the  operatinar  company's  assets  under  the  same 
plan,  however,  could  qualify  under  the  customary  reor<ranization  rules. 

Definition  of  '"'"investment  company^ — Tlie  Act  defines  an  invest- 
ment company   (for  purposes  of  the  reorganization  rule)  as  (1)   a 

^  The  Service  approved  a  transaction  of  this  kind  in  Rev.  Rul.  74-155,  1974-2  Cum. 
Bull.  R6. 

^^  The  acquiring  company  will  thus  take  a  cost  basis  (rafter  than  a  carryover  basis) 
In  the  assets  or  stock  acquired.  There  will  be  no  carryover  to  the  acquiring  company  of  tax 
Items  under  section  381  of  present  law  with  regard  to  the  portion  of  the  transaction  wh'ch 
is  denied  reorganization  status.  The  shareholders  and  security  holders  of  an  undiversified 
investment  company  which  participates  in  a  reorganization  made  taxable  under  the  Act 
will  also  be  denied  the  customary  nonrecognition  treatment  under  section  354  of  the  Code. 

"  The  new  rules  take  no  position  on  the  question  whether  the  provisions  of  section 
337  are  available  to  the  acquired  company  where  a  transfer  of  its  assets  fails  to  qualify  for 
nonrecognition  treatment  under  section  361.  Section  337  provides  nonrecosmition  treat- 
ment to  a  corporation  which  sells  its  assets  and  liquidates  completely  within  12  months 
after  adopting  a  plan  of  complete  liquidation.  The  possible  application  of  section  337  is 
to  be  determined  under  existing  law. 

1^  Where  a  shareholder  of  an  undiversified  investment  companj'  exchanges  his  stock 
solely  for  voting  stock  of  a  diversified  investment  company  in  an  exchange  otherwise  de- 
scribed in  sec.  36S(a)  (1)  (B> .  the  effect  of  disqualifying  that  exchange  for  tax-free  treat- 
ment will  be  to  treat  the  shareholder  of  the  undiversified  company  as  having  sold  his 
stock  in  a  taxable  exchange. 


663 

regfiilated  investment  company,  (2)  a  real  estate  investment  trust,  or 
(3)  a  corporation  over  50  percent  of  the  value  of  whose  total  assets 
consists  of  stocks  or  securities  and,  in  addition,  over  80  percent  of  the 
value  of  whose  total  assets  are  held  for  investment. ^*^  Investment  assets 
in  the  80-percent  category  include  stocks  or  securities  as  well  as  other 
kinds  of  property  held  for  investment  purposes.  A  company  which 
fits  within  any  of  the  above  three  classes  is  regarded  as  an  investment 
company  for  purposes  of  the  reorganization  rule.^^ 

It  is  important  to  distinguish  (in  definino-  an  investment  company) 
between  corporations  involved  in  relatively  passive  management  of 
portfolio  assets  as  an  investment  and  holding  companies  (including 
so-called  conglomerates)  which  render  management  services  to  operat- 
ing business  companies  in  which  it  (the  parent  company)  usually  owns 
the  controlling  stock.  The  Act  provides  that  in  applying  the  50-percent 
and  80-percent  asset  tests  (to  determine  Avherher  a  corporation  is 
an  "investment  company"),  a  corporation  will  be  deemed  to  own  di- 
rectly its  proportionate  share  of  the  assets  of  a  subsidiary  corporation 
in  which  the  parent  owns  50  percent  or  more  of  the  combined  voting 
power  of  all  voting  stock  of  the  subsidiary  or  50  percent  or  more  of  the 
total  value  of  all  classes  of  the  subsidiary's  outstanding  stock.^® 

In  determining  a  corporation's  "total  assets"  under  the  50-percent 
and  80-percent  tests,  cash  and  cash  items  (including  receivables)  are 
excluded  from  the  calculation  (sec.  368(a)  (2)  (F)  (iv) ).  U.S.  Gov- 
ernment securities  are  also  excluded  from  both  the  numerator  and 
denominator  in  this  calculation. 

A  further  rule  aims  at  preventing  manipulation  of  a  company's 
assets  in  order  to  make  one  or  more  of  the  parties  fail  to  be  an 
"investment  company"  (and  therefore  free  of  the  Act's  restrictions). 
Assets  acquired  by  a  corporation  for  purposes  of  causing  that  corpo- 
ration not  to  be  an  "investment  company"  are  to  be  disregarded  in 
determiniTig;  whether  that  corporation  is  an  investment  company  im- 
mediately before  the  transaction.  This  rule  is  not,  however,  intended 
to  affect  situations  where  a  corporation  purchases  or  otherwise  acquires 


"  Congress  believes  that  for  purposes  of  this  pro\islon  the  term  "securities"  should 
include  obligations  of  State  and  local  governments  (including  industrial  development 
bonds),  stoclv  warrants,  stock  options  and  rights,  commodity  futures,  mutual  fund  shares 
(both  oien  and  closed  endK  interests  in  real  estate  investment  trust,  commercial  paper, 
corporate  notes  (whether  or  not  secured  by  an  interest  in  real  property),  participating  in- 
terests in  Federallv  guaranteed  or  insured  mortgnge  or  other  loan  pools,  and  interests  in 
partnerships  the  sale  of  which  are  required  to  be  registered  with  the  Securities  and  Ex- 
change Commission  or  State  securities  offices. 

The  tyjjcs  of  stocks  and  securities  to  be  taken  into  account  under  this  third  category  of 
investment  company  include  closely  held  and  publicly  traded  investments  (i.e.,  the  latter 
covering  stocks  traded  on  a  stock  exchange  or  over-the-counter,  or  which  are  otherwise 
readily  marketable). 

"  An  investment  company  for  this  purpose  does  not  have  to  be  technically  a  "personal 
holding  company"  within  the  meaning  of  section  542  of  present  law.  The  nature  of  the 
shareholders  of  the  investment  company  is  also  immaterial  in  applying  these  rules. 

1**  To  illustrate,  suppose  that  all  the  assets  of  holding  company  X  consist  of  directly- 
owned  investment  assets  of  $.30,000  ;  small  amounts  of  stock  in  publicly  held  company  A 
worth  .«.'^0.000  and  in  public  company  B  worth  $25,000  ;  and  over  50  percent  of  the  stock 
of  operating  company  C  to  whicli  X  provides  management  services.  The  value  of  X'%  stock 
in  C  is  $15,000.  reflecting  its  allocable  share  of  C's  net  assets.  C  owns  no  investment  assets. 
The  value  of  A"s  ratable  share  of  C's  "total  assets"  (not  reduced  by  liabilities)  is  $70,000. 

T^nflfr  the  Act.  since  A'  ovns  50  percent  or  more  of  C.  X  will  be  deemed  to  own 
$70,000  of  C's  total  assets  directly  (in  lieu  of  its  stock  interest  in  C).  As  such.  A'  will  not 
he  an  in'-estment  coiMpnny  since  Ipss  than  half  of  its  total  assets  will  be  deemed  invested 
in  portfolio  stocks  ($55.000/!'^155.000).  Also,  less  than  SO  percent  of  A's  total  assets  will  be 
treated  as  held  for  investment  ($S5.0<)0/$155.000). 

If  tiipre  were  no  look-through  rule  of  this  kind.  X  would  be  treated  as  an  Investment 
company  because  more  than  50  percent  of  its  total  assets  would  consist  of  stocks  and 
over  80  percent  of  its  total  assets  would  be  held  for  investment  purposes. 


664 

portfolio  stocks  or  securities  in  the  ordinary  course  of  conducting  its  ac- 
tivities (such  as  buying  or  selling  in  response  to  trends  in  the  stock 
market).  This  rule  is  intended,  however,  to  affect  situations  where  a 
major  purpose  of  an  asset  acquisition  is  specifically  to  circumvent  the 
limitations  under  this  provision,  so  that  a  reorganization  involving 
that  corporation  can  subsequently  occur  and  escape  the  tax  treatment 
which  this  amendment  would  impose  if  the  company's  assets  had  not 
been  manipulated.  It  is  expected  that  specific  rules  for  tax  avoidance 
situations  of  this  kind  will  be  prescribed  by  the  Internal  Revenue 
Service. 

Diversification  test. — A  company  meeting  the  definition  of  an  "in- 
vestment company"  is  considered  to  have  an  undiversified  portfolio 
unless  (immediately  before  the  reorganization)  it  is  a  regulated  in- 
vestment company  as  defined  in  section  851  of  the  Code,  a  real  estate 
investment  trust  as  defined  in  section  856  of  the  Code,  or  a  company 
which  satisfies  both  of  the  following  rules:  (a)  it  does  not  own  any  5 
or  fewer  stocks  or  securities  whose  combined  value  constitutes  over 
50  percent  of  the  fair  market  value  of  all  of  the  corporation's  assets, 
and  (b)  no  one  stock  or  security  constitutes  over  25  percent  of  the 
total  fair  market  value  of  all  of  its  assets.  In  applying  the  tests,  an 
investment  company  which  fails  either  or  both  tests  will  be  consid- 
ered undiversified.  Also,  total  assets  will  be  determined  by  reference  to 
the  same  rules  (described  above)  which  apply  in  determining  whether 
a  corporation  is  an  investment  company.^**  (Thus,  for  example,  cash 
is  ignored  in  determining  whether  one  stock  constitutes  over  25  per- 
cent of  the  value  of  all  of  the  company's  assets) . 

The  Act  also  delegates  authority  to  the  Service  to  disregard  active 
business  assets  or  other  properties  which  an  investment  company  de- 
liberately acquires  before  a  planned  reorganization  for  the  purpose  of 
qualifying  the  company  as  divereified  under  the  above  tests.^" 

"For  purposes  of  this  rule,  stock  or  securities  are  to  have  the  same  meaning  as  they 
have  in  (^efinine  an  investment  ''0"ipanv  under  this  reorganization  rule.  In  nddition.  the 
stock:  of  all  members  of  a  controlled  group  of  corporations  (as  defined  in  section  1563(a) 
of  the  Code)  are  to  be  treated  as  the  stock  of  a  sinele  company. 

A  look-through  rule  similar  to  the  rule  used  in  defining  an  "investment  company"  also 
applies  in  determining  whether  an  investment  company  is  diversified.  In  the  examole 
SPt  forth  in  footnote  18.  Z  would  be  deemed  to  own  .$70,000  of  G's  assets  directly.  As  stich. 
X  would  be  considered  diversified  because  neither  stock  A  nor  stock  B  would  be  valued 
at  over  25  percent  of  Z's  total  assets  ($155,000).  and  the  combined  value  of  the  two 
portfolio  stocks  {A  and  B)  would  not  be  greater  than  half  the  value  of  all  of  X's  total" 
assets  ($155,000).  Without  this  look-through  rule,  the  value  of  X's  stock  in  A  would  ex- 
ceed 25  percent  of  X's  total  assets  ($30.000/$100.000)  and  the  rule  would  treat  X 
as  undiversified. 

2"  Assume,  for  example,  that  the  onlv  assets  owned  by  Corporation  X  are  anpreciated 
stock  in  listed  company  y  worth  $100,000  and  appreciated  real  estate  worth  $75,000.  In 
a  deliberate  attempt  to  satisfy  the  diversification  test,  X  borrows  $225,000  and  purchases 
stock  in  nine  other  listed  companies  for  .i;25.O00  each.  X  would  then  satisfv  the  diversifi- 
cation test  because  no  more  than  25  percent  of  its  total  assets  (i.e.,  no  more  than  $100,000 
of  $400,000)  would  be  invested  in  the  stock  of  one  issuer,  and  no  combination  of  five  or 
fewer  stocks  would  amount  to  over  50  percent  of  the  valne  of  X's  total  assets  (i.e.,  the 
combined  value  of  no  five  or  fewer  stocks  would  exceed  $200,000). 

Under  the  delegation  (sec.  36S(a)  (2)  (F)  (iv) ),  however,  the  stock  in  the  nine  corpora- 
tions purchased  by  X  to  satisfy  the  diversification  test  is  to  be  disreirarded  in  determining 
whether  X  is  diversified.  As  a  result,  X  would  not  meet  the  diversification  test  because 
more  than  25  percent  of  its  total  assets  (i.e..  .$100,000  of  total  assets  of  $175,000,  disre- 
garding the  stock  in  the  nine  corporations)  would  be  invested  in  one  issuer  (company  Y). 

The  intended  scope  of  the  authority  delegated  to  the  Service  under  the  diversification 
test  is  identical  to  the  scope  of  the  authority  delegated  to  the  Service  in  determining 
whether  a  corporation  is  an  investment  company  for  purposes  of  this  provision  (see  the 
earlier  discussion  of  the  latter  delegation). 


665 

Other  provisions. — The  specific  reorganizations  to  which  the  above 
rules  will  apply  are  the  five  exchanges  listed  in  section  368(a)  (1)  (A), 
(B),(C),(D);and(F)- 

An  express  exception  is  made  to  the  denial  of  tax-free  reorganization 
treatment  for  situations  where  the  stock  of  two  or  more  investment 
companies  is  owned  substantially  by  the  same  persons  in  the  same 
proportions.  In  these  cases  the  shareholders  and  security  holders  of  the 
companies  being  combined  ordinarily  will  not  diversify  their  stock 
investments  after  the  transaction :  the  Act  accordingly  permits  reor- 
ganizations of  commonly  controlled  investment  companies  to  continue 
tax-free.  It  is  expected  that  the  Service  will  set  forth  by  regulation  the 
detailed  rules  needed  to  cany  out  the  purposes  of  this  exception.^^ 

Since  denial  of  tax-free  reorganization  treatment  adversely  affects 
the  acquired  company  (and  its  shareholders)  but  does  not  require 
recognition  of  gain  or  loss  by  the  acquiring  company  (or  its  share- 
holders), a  rule  is  added  to  cover  what  is,  in  effect,  a  "reverse  acquisi- 
tion." This  rule  (in  new  section  368(a)  (2)  (F)  (vi) )  is  designed  to 
assure  that  regardless  whether  an  investment  company  is,  in  form,  the 
acquired  or  acquiring  party,  tax-free  reorganization  treatment  will  be 
denied  for  the  portion  of  the  exchange  involving  an  undiversified  in- 
vestment company  (and  its  shareholders  and  security  holders).  If  two 
or  more  undiversified  investment  companies  combine  with  each  other, 
gain  should  be  recognized  by  both  companies  (and  by  their  share- 
holders and  security  holders  as  appropriate)  rather  than  solely  by  the 
company  which  is  formally  acquired  by  the  other.  Otherwise,  an  un- 
diversified investment  company  which  is  the  acquiring  company  will 
obtain  tax-free  diversification. 

Therefore,  the  Act  provides  that  an  undiversified  investment  com- 
pany (and  its  shareholders  and  security  holders)  Avhich  is  the  acquir- 
ing or  surviving  party  is  to  be  considered  as  having  been  acquired  by 
the  other  party  in  an  exchange  which  must  itself  be  tested  under  sec- 
tion 368(a)(2)(F). 

For  example,  if  an  undiversified  investment  company  acquires  the 
assets  of  a  diversified  investment  company  in  a  statutory  merger  or 
a  "C"  reorganization,  the  acquired  company  or  its  shareholders  may 
continue  to  qualify  for  reorganization  treatment  (since  that  company 
is  an  already-diversified  investment  company).  However,  for  purposes 

21  A  recapitalization  (sec.  868(a)(1)(E)  is  not  included  because  a  recapitalization  in- 
volves only  one  corporation,  and  although  various  tax-free  changes  are  permitted  to  be 
made  in  an  existing  shareholder's  rights  in  the  same  corporation  (such  as  changes  in 
voting  rights  and  changes  from  debt  to  equity  interests),  this  does  not  produce  the  kind 
of  diversification  in  investors'  interests  which  resembles  the  tax-free  formation  of  an  ex- 
change fund. 

22  It  is  anticipated  that  the  Service  will  provide  a  rule  that  if  common  control  over  two 
or  morp  oorporntions  is  obtained  for  the  specific  purpose  of  bringing  a  later  reorganization 
under  this  exception,  the  exception  will  not  be  available.  (A  similar  rule  is  contained  in 
sect'on  1..382(b)-l(d)  (.3)  of  the  Income  Tax  Regulations.) 

Several  courts  have  held  that  a  combination  of  two  or  more  commonly  owned  operating 
corDorations  may  qualify  as  an  "F"  reorganization  (sec.  368(a)(1)(F)).  The  Service 
has  accepted  this  treatirent  if  several  conditions  are  satisfied,  including  a  complete 
Identitv  of  shareholders  and  their  proprietary  interests  in  the  transferor  and  acquiring 
corporations  (Rev.  Rul.  7.5-561,  1975-2  CB.  129).  Congress  does  not  intend  the  changes 
m<ide  by  the  Act  to  affect  the  question  whet'^er  an  "F"  reorganization  can  occur  where 
two  or  more  coniorations  are  combined  or,  if  so,  whether  an  "F"  reorganization  can 
occur  if  complete  identity  of  ownership  does  not  exist. 


666 

of  determining  recognition  of  gain  or  loss,  the  Act  treats  the  acquiring 
company  and  its  shareholders  (and  security  holders)  as  having  bee^i 
acquired  by  the  other  company  in  a  statutory  merger  or  "C  reorgani- 
zation. Since  nonrecognition  treatment  will  be  denied  on  such  a  con- 
structive exchange,  the  undiversified  company  would  be  treated  as  if  it 
had  exchanged  its  assets  in  a  taxable  exchange  for  stock  of  the 
diversified  company  and  then  had  distributed  that  stock  to  its  own 
shareholders  and  security  holders  in  a  taxable  exchange  for  their  stock 
in  the  undiversified  company. 

If  two  undiversified  investment  companies  merge  with  each  other, 
the  general  nile  (new  section  368(a)  (2)  (F)  (i) )  denies  reorganization 
status  to  the  acquired  company  and  its  shareholders.  The  special 
"reverse  acquisition"  rule  will  also  test  the  company  which  is  formally 
the  acquiring  company  as  though  it  and  its  shareholders  had  been  the 
acquired  parties.  As  a  result,  that  company  (and  its  shareholders)  wdll 
be  considered  to  have  made  an  exchange  and,  since  the  exchange  will  be 
considered  made  with  another  undiversified  investment  company,  the 
special  rule  will  deny  nonrecognition  treatment  to  that  constructive  ex- 
change (and  treat  that  company  as  having  made  a  taxable  exchange) ." 
Both  companies  in  this  example  will  be  treated  as  having  made  a 
taxable  exchange  with  each  other. 

Where  the  reverse  acquisition  rule  requires  recognition  of  gain  or 
loss  by  an  acxquiring  investment  company  or  by  its  shareholders  and 
security  holders,  collateral  tax  consequences  of  the  exchange  will  be 
determined  as  though  that  company  had  made  a  taxable  sale  or  ex- 
change of  its  assets,  and  as  though  its  shareholders  and  security  hold- 
ers had  made  a  taxable  exchange  of  their  interests  in  their  own  com- 
pany. For  the  effects  on  basis  and  on  section  381  items,  see  footnote  13. 

Under  these  rules,  no  change  is  made  in  the  tax-free  treatment  avail- 
able under  present  law  where  one  or  more  regulated  investment  com- 
panies or  real  estate  investment  trusts  merge  (or  otherwise  reorganize) 
with  each  other.  The  A  jt  will  also  not  affect  mergers  solely  involving 
active  business  companies  which  are  not  "investment  companies"  (as 
defined  in  the  Act).  Nor  will  the  new  rules  prevent  a  tax-free  merger 
solely  of  one  undiversified  investment  company  with  an  active  busi- 
ness company  (which  is  not  an  investment  company  after  the  merger) . 

23  Where  an  undiversified  investment  company  acquires  the  stock  of  another  corporation 
in  an  exchange  described  in  section  368(a)  (1)  (B).  the  sliareholders  of  the  acauiring  com- 
pany may  be  treated  as  having  made  a  taxable  exchange.  The  shareholders  will  be  treated 
as  having  exchanged  their  stoclj  for  stocli  of  the  other  corporation  ;  that  constructive 
exchange  will  then  be  tested  under  the  general  rule  of  new  section  368(a)  (2)  (F).  If,  under 
that  test,  the  constructive  exchange  does  not  qualify  for  nonrecognition  treatment  (be- 
cause, for  example,  the  other  corporation  is  also  an  undiversified  investment  company),  the 
shareholders  of  the  undiversified  company  will  be  deemed  to  have  received  stock  in  the 
constructive  exchange  equal  in  value  to  the  value  of  their  stock  in  their  own  company. 
The  intent  of  the  second  sentence  of  section  368(a)  (2)  (F)  (vi)  is  that  the  shareholders  of 
the  undiversified  investment  company,  in  this  situation,  must  recognize  gain  in  the  amount 
of  the  difference  between  the  basis  and  fair  market  value  of  their  stock  in  their  own  com- 
pany determined  immediately  after  the  actual  exchange. 

For  example,  if  undivprslfied  investment  company  X,  whose  total  fair  market  value  is 
$1  million,  acquires  all  of  the  stock  (worth  $2  million)  of  undiversified  investment  company 
Y.  the  shareholders  of  X  must  recognize  gain  eq'ial  to  the  excess  of  the  $1  million  value 
of  their  X  stock  over  their  basis  in  their  X  shares.  If  the  acquisition  had  actually  taken 
the  reverse  form,  i.e..  had  corporation  Y  acquired  all  the  stock  of  corporation  X.  the 
combined  value  of  the  two  companies  after  the  exchange  would  have  been  $3  million 
and  X's  former  shareholders  would  have  received  a  one-third  stock  interest  in  the 
acquiring  company  Y,  which  stock  interest  would  have  been  worth  $1  million.  The 
amount  of  gain  required  to  be  recognized  in  this  situation  under  the  Act  thus  conforms 
to  the  amount  of  gain  that  would  be  recognized  if  the  actual  acquisition  had  been  reversed 
and  if  nonrecognition  treatment  were  denied  to  the  exchange  as  reversed. 


667 

Effective  date 
These  reorganization  rules  apply  to  exchanges  consummated  after 
February  17,  1976.  The  Act  makes  an  exception  for  exchanges  occur- 
ring after  February  17,  1976,  pursuant  to  a  private  tax  ruling  issued 
by  the  Internal  Revenue  Service  before  February  18,  1976.  The  tax 
ruling  must  have  held  that  the  proposed  reorganization  will  qualify 
as  a  reorganizatioii  under  sec.  368(a)  (1)  of  present  law. 

Revenue  effect 
It  is  estimated  that  these  provisions  will  increase  budget  receipts  by 
less  than  $5  million  annually. 

32.  Contributions  of  Certain  Government  Publications  (sec.  2132 

of  the  Act  and  sec.  1221  of  the  Code) 

Prior  law 
In  most  situations,  Government  publications  received  by  taxpayers 
without  charge  (e.g.,  copies  of  the  Congressional  Record  received  by 
Members  of  Congress)  or  at  a  reduced  price  were  treated  as  capital 
assets  under  prior  law.  One  consequence  of  that  treatment  was  that 
taxpayers  could  claim  a  deduction  for  the  full  fair  market  value  of 
any  Government  publication  which  they  contribut-ed  to  a  charity  (such 
as  a  library  or  a  university)  for  a  use  related  to  the  charity's  exempt 
purpose. 

Reasons  for  change 
Congress  felt  that  it  was  not  appropriate  for  taxpayers  to  receive 
deductions  for  the  full  fair  market  value  of  Government  publications 
they  contributed  to  charity  in  situations  where  they  received  the  Gov- 
ernment publications  free  of  charge  or  at  a  reduced  price  and  were  not 
required  to  include  in  income  the  value  of  the  free  publications  or  the 
bargain  element  in  the  case  of  publications  purchased  at  a  reduced 
price. 

Explanatimi  of  'pravisions 

Under  the  Act,  U.S.  Government  publications  which  are  received 
from  the  Government  without  charge  or  below  the  price  at  which  they 
are  sold  to  the  general  public  are  no  longer  to  be  treated  as  capital 
assets  in  the  hands  of  the  taxpayer  receiving  the  publications.  This 
treatment  is  also  to  apply  to  any  Government  publication  held  by  a 
taxpayer  in  whose  hands  the  basis  of  that  publication  is  determined  by 
reference  to  its  basis  in  the  hands  of  a  person  who  received  it  free  or  at 
a  reduced  price. 

Effective  date 

This  provision  applies  to  sales,  exchanges,  and  (contributions  made 
after  the  date  of  enactment  (October  4,  1976). 

Revenue  effect 
This  provision  will  result  in  a  negligible  revenue  gain. 

33.  Study  of  Tax  Incentives  by  Joint  Committee  (sec.  2133  of 

the  Act) 

Prior    lato 
There  was  no  specific  requirement  for  a  Congressional  study  of  the 
impact  of  various  tax  incentives. 


668 

Reasons  for  change 
The  Congress  often  has  incomplete  background  information  as  to 
what  are  the  best  tax  incentives  or  what  the  effect  of  tax  cuts  on  the 
economy  is.  The  information  provided  by  a  staff  study  would  enable 
the  Congress  to  make  sure  that  tax  incentives,  like  other  forms  of 
Federal  expenditures,  would  be  as  cost  effective  as  possible. 

Explanation  of  provision 
The  Act  requires  the  Joint  Committee  on  Taxation  to  study,  in 
consultation  with  Treasury,  tax  incentives,  especially  as  used  to 
provide  stimulus  to  the  economy  during  a  recession.  A  report  is  to 
be  made  to  the  Senate  Finance  Committee  and  the  House  Ways  and 
Means  Committee  no  later  than  September  30, 1977. 

Effective  date 
This  provision  is  effective  upon  enactment. 

Revenue  effect 
This  provision  has  no  revenue  effect. 

34.  Prepaid  Legal  Services  (sec.  2134  of  the  Act  and  sees.  120 
and  501(c)  (20)  of  the  Code) 

Prior  law 

Prepaid  group  legal  services  plans  are  a  recent,  innovative  means  of 
providing  legal  services.  Because  of  the  relative  novelty  of  these  fringe 
benefit  plans  and  the  variety  of  their  design,  'the  tax  treatment  of  the 
employer  contriputions  on  behalf  of  the  employee  and  the  tax  treat- 
ment of  the  benefits  received  by  the  employee  under  such  plans  had 
not  been  clearly  established. 

However,  depending  on  the  structure  of  the  plan,  it  appears  that 
under  prior  law  the  employee  was  required  to  include  in  his  income 
either  ( 1 )  his  share  of  the  amounts  contributed  by  his  employer  to  the 
group  legal  services  plan  or  (2)  the  value  of  legal  services  or  reim- 
bursement of  expenses  for  legal  services  received  under  the  employer- 
funded  plan,  or  both.  (If  plans  were  funded  with  contributions  which 
were  partially  taxable  and  partially  tax-free  to  the  employee,  the  em- 
ployee might  have  been  required  to  include  any  benefits  in  income  to  the 
extent  the  contributions  for  the  plan  constituted  amounts  not  pre- 
viously included  in  the  employee's  income.) 

However,  amounts  contributed  by  the  employer  for  an  employee 
to  a  group  legal  services  plan  or  the  value  of  services  or  reimburse- 
ments if  provided  directly  by  the  employer  to  the  employee  under 
a  plan  are  deductible  by  the  employer  as  ordinary  and  necessary  busi- 
ness expenses,  if  they  meet  the  usual  standards  for  trade  or  business 
deductions. 

Reasons  for  change 
The  Congress  believed  that  it  was  appropriate  to  provide  a  tax  in- 
centive to  promote  prepaid  legal  services  plans.  Within  the  last  3  years, 
the  American  Bar  Association  and  many  State  bar  associations  have 
endorsed  the  creation  of  this  type  of  arrangement  as  a  means  of 
making  legal  services  more  generally  available.  Several  unions  have 
already  established  prepaid  group  legal  services  plans  which  are 
supported  entirely  or  in  part  by  employer  contributions. 


669 

The  Congress  believed  that  excluding  such  employer  contributions 
from  the  employees'  income  would  promote  interest  in  such  plans  and 
increase  the  access  to  legal  services  for  many  taxpayers  by  encourag- 
ing employers  to  offer  and  employees  to  seek  such  plans  as  a  fringe 
benefit. 

The  Congress  decided  a  tax  incentive,  which  would  increase  the 
availability  of  legal  services,  would  be  especially  helpful  to  middle- 
income  taxpayers  who  at  present  may  be  the  most  under-represented 
economic  group  in  terms  of  legal  services.  Lower-income  persons  have 
access  to  publicly-supported  legal  aid  services,  while  taxpayers  with 
higher  incomes  can  generally  afford  their  own  legal  expenses. 

The  Congress  believed  that  providing  favorable  tax  treatment  for 
group  prepaid  legal  services  plans  (which  has  some  similarity  to  the 
tax  treatment  provided  for  accident  and  health  plans)  would  grant 
taxpayers  some  relief  from  the  high  cost  of  legal  fees  and  would  pro- 
mote the  adoption  and  implementation  of  such  plans  by  many  em- 
ployers and  employees. 

In  order  to  insure  that  the  tax  law  encourages  only  those  plans 
which  may  be  considered  nondiscriminatory  employee  fringe  benefits, 
the  Congress  decided  that  it  was  necessary  to  adopt  rules  which  would 
prohibit  discrimination  and  minimize  the  possibility  of  abuse  of  the 
tax  incentive  by  those  taxpayers  who  might  create  such  plans  to  chan- 
nel otherwise  taxable  compensation  through  a  plan  providing  a  tax- 
free  fringe  benefit. 

Explanation  of  provision 

The  Act  excludes  from  an  employee's  income  amounts  contributed 
by  an  employer  to  a  qualified  group  legal  services  plan  for  employees 
(or  their  spouses  or  dependents)  as  well  as  any  services  received  by 
an  employee  or  any  amounts  paid  to  an  employee  under  such  a  plan 
as  reimburserpent  for  legal  ser\dces  for  the  employee,  his  spouse,  or 
his  dependents.  The  exclusion  does  not  apply  to  direct  reimburse- 
ments made  by  the  employer  to  the  employee. 

In  order  to  be  a  qualified  plan  under  which  employees  are  entitled 
to  the  tax-free  benefits  provided  by  the  Act,  a  group  legal  services 
plan  mu^t  fulfill  several  requirements  with  regard  to  its  provisions, 
the  employer,  and  the  covered  employees.  In  determining  whether  the 
statutory  requirements  are  fulfilled,  the  "plan"  which  is  to  fulfill 
such  requirements  is  the  prepaid  legal  services  arrangement  agreed 
upon  by  the  emplover  and  his  employees.  The  requirements  are  de- 
signed to  insure  that  the  tax-free  fringe  benefits  are  provided  on  a 
nondiscriminatory  basis  and  tliat  the  possibility  of  tax  abuse  through 
the  misuse  of  such  plans  is  minimized. 

A  qualified  group  legal  services  plan  must  be  a  separate  written 
plan  of  an  employer  for  the  exclusive  benefit  of  his  employees  or  their 
spouses  or  deoendents.  The  plan  must  supply  the  employees,  their 
spouses,  and  dependents  with  specified  l^enefits  consisting  of  personal 
(i.e.,  nonbusiness)  legal  services  through  prepayment  of,  or  provision 
in  advance  for,  all  or  part  of  an  employee's,  his  spouse's,  or  his  de- 
pendents' legal  fees.  Benefits  must  be  set  forth  so  that  the  employees 
understand  what  legal  services  are  covered  by  the  plan. 

The  Act  also  provides  that  amounts  contributed  by  employers 
under  a  plan  may  be  paid  only  (1)  to  insurance  companies  or  to  orga- 


670 

nizations  or  persons  that  provide  personal  legal  services  or  indemnifi- 
cation against  tix  cost  of  personal  legal  services,  in  exchange  for  a 
prepayment  or  a  payment  of  a  premium ;  (2)  to  organizations  or  trusts 
exempo  under  new  section  501(c)  (20),  described  Delow;  (3)  to  orga- 
nizations described  in  section  501(c)  wnich  are  permitted  to  receive 
employer  contributions  tor  one  or  more  qualilied  group  legal  services 
plans,  provided  the  organizations  pay  or  credit  the  employer  contribu- 
tions to  another  organization  or  trust  which  is  exempt  under  section 
501(c)  (20) ;  (4)  as  prepayments  to  providers  of  legal  services  under 
the  plan,  or  (5)  to  a  combination  of  the  four  permissible  types  of 
payment  arrangements. 

In  order  to  be  a  qualified  plan,  a  group  legal  services  plan  must 
also  meet  requirements  with  respect  to  nondiscrimination  in  contri- 
butions or  benefits  and  in  eligibility  for  enrollment.  The  Act  requires 
that  the  contributions  paid  by  an  employer  and  the  benefits  provided 
under  a  plan  may  not  discriminate  m  favor  of  employees  who  are 
officers,  shareholders,  self-employed  individuals,  or  higiily-compen- 
sated.  The  plan  must  benefit  employees  who  qualify  under  a  classifi- 
cation which  the  employer  sets  up  and  which  the  JService  determines 
does  not  discriminate  in  favor  of  employees  who  are  officers,  share- 
holders, self-employed  individuals,  or  highly-compensated.  How- 
ever, in  determining  whether  the  classification  is  discriminatory  the 
employer  may  exclude  from  the  calculations  those  employees  who 
are  members  of  a  collective  bargaming  miit  if  there  is  evidence  that 
group  legal  services  plan  benents  were  the  subject  of  good  faith 
bargainmg  between  representatives  of  that  group  and  the  employer. 

A  limit  is  placed  on  the  proportion  of  tlie  amounts  contributed 
under  the  plan  which  can  be  tor  employees  who  own  more  than  5  per- 
cent of  the  stock  or  of  the  capital  or  profits  interest  in  the  employer 
corporation  or  unincorporated  trade  or  business.  The  aggregate  of 
the  contributions  for  those  employees  and  their  spouses  and  depend- 
ents must  not  be  more  than  25  percent  of  the  total  contributions. 

Under  the  Act,  in  order  to  be  treated  as  a  qualified  group  legal  serv- 
ices plan,  the  plan  must  notify  the  Internal  Kevenue  Service  that  it  is 
applying  for  recognition  of  this  qualified  status.  If  the  plan  fails  to 
notify  the  Service  by  the  time  prescribed  in  Treasury  regulations, 
then  the  plan  cannot  be  regarded  as  a  qualified  plan  for  any  period 
before  it  in  fact  gave  notice.  For  example,  if  the  Treasury  regulations 
provide  that  a  plan  is  required  to  notify  the  Service  before  the  end  of 
.  the  first  plan  year  in  order  to  be  treated  as  a  qualified  plan  from  the 
beginning  of  the  first  plan  year,  and  the  organization  does  not  file  its 
notice  until  half-way  through  the  second  plan  year,  then  (1)  the  orga- 
nization is  not  qualified  for  its  first  plan  year,  and  (2)  the  organization 
is  not  qualified  for  that  part  of  the  second  plan  year  preceding  the  date 
on  which  the  notice  finally  was  filed.  However,  if  the  notice  was  filed 
on  the  last  day  of  the  first  plan  year,  then  the  organization  would  be 
qualified  from  the  first  day  of  that  first  plan  year.^ 

1  Recognizing  that  existing  plans  are  to  be  covered  by  this  provision  and  that  there 
may  be  a  delay  in  the  final  publication  of  these  notification  regulations,  the  Act  also 
provides  that  this  initial  notice  is  to  be  considered  timely  if  it  is  given  at  any  time 
through  the  90th  day  after  the  publication  of  the  first  final  Treasury  Regulations  on  this 
point. 


671 

Furthermore,  several  additional  special  rules  and  definitions  apply 
to  qualitied  group  legal  services  plans. 

An  individual  wlio  qualifies  as  an  employee  within  the  definition  in 
section  401  (c)  ( 1)  of  the  Code  is  also  an  employee  for  purposes  of  these 
group  legal  services  provisions.  This  means  that,  in  general,  the  term 
"self-employed  individual"  means,  and  the  term  "employee"  includes, 
individuals  who  have  earned  income  for  a  taxable  year,  as  well  as  indi- 
viduals who  would  have  earned  income  except  tiiat  tlieir  trades  or 
businesses  did  not  have  net  profits  for  a  taxable  year. 

An  individual  who  owns  the  entire  interest  in  an  unincorporated 
trade  or  business  is  treated  as  his  own  employer.  A  partnei-ship  is 
considered  the  employer  of  eacli  partner  who  is  also  an  employee  of  the 
partnership.  Under  a  special  rule  for  the  allocation  of  contributions, 
the  Treasury  Department  s  regulations  must  provide  that  allocations 
of  amounts  contributed  under  the  j)ian  shall  take  into  account  the 
expected  relative  utilization  of  benelits  to  be  provided  under  the  plan 
from  those  contributions  or  plan  assets  and  the  manner  in  w^hich  any 
premium  charge  (or  retainer  or  other  price)  for  the  plan  was 
developed. 

The  term  "dependent"  has  the  meaning  given  to  it  under  section 
152.  Therefore,  the  plan  may  cover  an  individual  whose  relationship 
to  the  employee  is  listed  in  section  152,  if  the  employee  provides  oyer 
half  of  the  support  for  that  individual  for  the  calendar  year  in  which 
the  employee's  taxable  year  begins.  Since  the  plan  must  be  for  the 
exclusive  benefit  of  employees  and  their  spouses  and  dependents,  the 
plan  may  not  cover  any  other  persons. 

For  determining  stock  ownership  in  corporations,  the  Act  adopts 
the  attribution  rules  provided  under  subsections  (d)  and  (e)  of  sec- 
tion 1563  (without  regard  to  sec.  1563(e)(3)(C)).  The  Treasury 
Department  is  to  issue  regulations  for  determining  ownership  interests 
in  unincorporated  trades  or  businesses,  such  as  partnerships  or  pro- 
prietorships, following  the  principles  governing  the  attribution  of 
stock  ownership. 

The  Act  also  provides  that  an  organization  or  trust  created  or  orga- 
nized in  the  United  States,  whose  exclusive  function  is  to  form  part  of 
a  qualified  group  legal  services  plan  under  section  120,  is  to  be  exempt 
from  income  tax  (new  sec.  501(c)  (20)).  Such  a  trust  shall  be  subject 
to  the  rules  governing  organizations  exempt  under  section  501(c),  in- 
cluding the  taxation  of  any  unrelated  business  income,  an  exempt  orga- 
nization or  trust  which  receives  employer  contributions  for  a  group 
legal  services  plan  because  of  section  120(c)  (5)  (C)  will  not  be  pre- 
vented from  qualifying  for  exemption  under  section  501(c)  (20) 
merely  because  it  provides  legal  services  or  indemnification  for  legal 
services  unassociated  with  a  qualified  group  legal  services  plan. 

The  Act  also  requires  a  study  to  be  done  by  the  Departments  of 
the  Treasury  and  of  Labor,  about  the  desirability  and  feasibility  of 
continuing  the  benefits  provided  by  this  provision,  with  final  reports 
to  be  submitted  to  the  President  and  the  Congress  not  later  than 
December  31, 1980. 

Effective  date 
This  provision  applies  prospectively  for  five  taxable  years  beginning 
after  December  31, 1976,  and  ending  before  January  1, 1982. 


672 

The  time  within  which  a  plan  must  apply  to  the  Internal  Revenue 
Service  for  recognition  of  its  status  as  a  qualified  group  legal  services 
plan  under  the  notice  requirement  of  the  Act  does  not  expire  before 
the  90th  day  after  the  Treasury  Department's  regulations  on  this  point 
first  become  final. 

A  written  group  legal  services  plan  that  was  in  existence  on  June  4, 
1976,  is  to  be  treated  as  meeting  the  requirements  for  a  qualified 
plan  up  to  the  180th  day  after  the  date  of  enactment.  If,  on  June  4, 
1976,  the  plan  was  maintained  under  a  collecti^-e  bargaining  agree- 
ment, then  the  plan  is  to  continue  to  be  treated  as  qualifying  under  the 
Act  until  the  180th  day  after  enactment  or  either  until  the  date  on 
which  the  last  of  the  collective  bargaining  agreement  under  which  the 
plan  is  maintained  terminates  or  December  31,  1981,  whichever  is 
earlier  (determined  without  regard  to  any  extension  of  the  agreements 
after  October  4,  1976,  i.e.,  the  date  of  enactment  of  the  Act.)  After  the 
applicable  date,  the  plan  must  comply  with  the  antidiscrimination, 
etc.,  requirements  set  forth  in  this  provision  (new  sec.  120)  in  order 
for  the  tax  benefits  provided  by  the  Act  to  apply. 

Revenue  effect 
It  is  estimated  that  this  provision  will  decrease  budget  receipts  by 
$5  million  for  fiscal  year  1977,  $8  million  for  fiscal  year  1978,  and  $33 
million  for  fiscal  year  1981. 

35.  Certain  Charitable  Contributions  of  Inventory  (sec.  2135  of  the 
Act  and  sec.  170  of  the  Code) 

Prior  law 

Under  prior  law  (sec.  170(e)),  a  taxpayer  who  made  a  charitable 
contribution  of  property  was  required  to  reduce  the  amount  of  the 
deduction  (from  fair  market  value)  by  the  amount  of  ordinary  gain  he 
would  have  realized  had  the  property  been  sold  instead  of  donated  to 
charity.  (Under  certain  circumstances,  a  taxpayer  was  also  required  to 
reduce  the  amount  of  his  charitable  contribution  by  a  portion  of  the 
capital  gain  he  would  have  received  if  the  property  had  been  sold.) 
Thus,  the  donor  of  appreciated  ordinary  income  property  (property 
the  sale  of  which  would  not  give  rise  to  long-term  capital  gain)  could 
deduct  only  his  basis  in  the  property  rather  than  its  full  fair  market 
value. 

"When  this  rule  was  added  to  the  Code  in  1969,  it  was  intended,  in 
part,  to  prevent  the  abuse  situations  in  which  taxpayers  in  high  mar- 
ginal tax  brackets  and  corporations  could  donate  to  charity  substan- 
tially appreciated  ordinary  income  property  and  actually  be  better 
off,  after  tax,  than  they  would  have  been  if  they  had  sold  the  proper- 
ties and  retained  all  the  after-tax  proceeds  of  the  sales. 

Reasons  for  change 
The  rule  that  the  donor  of  appreciated  ordinary  income  property 
could  deduct  only  his  basis  in  the  property  effectively  eliminated  the 
abuses  which  led  to  its  enactment ;  however,  at  the  same  time,  it  has 
resulted  in  reduced  contributions  of  certain  types  of  property  to 
charitable  institutions.  In  particular,  those  charitable  organizations 
that  provide  food,  clothing,  medical  equipment,  and  supplies,  etc.,  to 
the  needy  and  disaster  victims  have  found  that  contributions  of  such 
items  to  those  organizations  were  reduced. 


673 

Congress  believed  that  it  was  desirable  to  provide  a  greater  tax 
incentive  than  in  prior  law  for  contributions  of  certain  types  of 
ordinary  income  property  which  the  donee  charity  uses  in  the  perform- 
ance of  its  exempt  purposes.  However,  Congress  believed  that  the 
deduction  allowed  should  not  be  such  that  the  donor  could  be  in  a 
better  after-tax  situation  by  donating  the  property  than  by  selling  it. 

Explanation  of  pt'o  vision 

The  Act  allows  a  corporation  (other  than  a  subchapter  S  corpora- 
tion) a  deduction  for  up  to  half  of  the  appreciation  on  certain  types 
of  ordinary  income  property  contributed  to  a  public  charity  (other 
than  a  governmental  unit)  or  a  private  operating  foundation. 

In  order  to  qualify  for  this  treatment,  the  following  conditions  must 
be  satisfied:  (1)  the  donee  must  use  the  property  in  a  use  related 
to  its  exempt  jnirpose  and  solely  for  the  care  of  the  ill,  the  needy, 
or  infants;  (2)  the  donee  must  not  transfer  the  property  in  exchange 
for  money,  other  property,  or  services;  (3)  the  donor  must  receive 
a  statement  from  the  donee  representing  that  its  use  and  disposition  of 
the  property  will  comply  with  requirements  (1)  and  (2)  above;  and 
(4)  the  property  must  satisfy  the  relevant  requirements  of  the  Federal 
Food,  Drug,  and  Cosmetic  Act  in  effect  on  the  date  of  transfer  and  for 
180  days  prior  to  such  transfer. 

If  all  these  conditions  are  complied  with,  the  charitable  deduction 
is  generally  for  the  sum  of  (1)  the  taxpayer's  basis  in  the  property 
and  (2)  one-half  of  the  unrealized  appreciation.  However,  in  no  event 
is  a  deduction  to  be  allowed  for  an  amount  which  exceeds  twice  the 
basis  of  the  property.  Furthermore,  no  deduction  is  to  be  allowed  for 
any  part  of  the  unrealized  appreciation  which  would  have  been  ordi- 
nary income  (if  the  property  had  been  sold)  because  of  the  application 
of  the  recapture  provisions  relating  to  depreciation,  certain  mining 
exploration  expenditures,  certain  excess  farm  losses,  certain  soil 
and  water  conservation  expenditures,  and  certain  land-clearing 
expenditures. 

Effective  date 
This  provision  applies  to  charitable  contributions  made  after  Octo- 
ber 4, 1976. 

Revenue  effect 
It  is  estimated  that  this  provision  will  result  in  a  decrease  in  budget 
receipts  of  $19  million  in  fiscal  vear  1977,  $22  million  in  fiscal  year 
1978,  and  $24  million  in  fiscal  year  1981. 

36.  Tax  Treatment  of  Grantor  of  Certain  Options  (sec.  2136  of 
the  Act  and  sec.  1234  of  the  Code) 

Prior  law 
The  tax  treatment  of  puts  and  calls  under  prior  law  was  based 
largely  on  several  widely  publicized  private  letter  ladings  issued  to 
the  Chicago  Board  of  Options  Exchange  (CBOE)  in  which  the  In- 
ternal Revenue  Servac«  interpreted  the  application  of  Internal  Reve- 
nue Code  sections  1233  (relating  to  short  sales)  and  1234  (relating 
generally  to  options  to  buy  or  sell),  the  regulations  under  those  sec- 
tions and  previously  published  revenue  rulings  to  option  transactions. 
The  rulings  assume  that  options  are  capital  assets  in  the  hands  of  their 


674 

holders,  and  that  the  securities  which  would  underlie  or  would  be  ac- 
quired in  connection  with  options  are  also  capital  assets  in  the  hands 
of  the  holders  or  writers  (sec.  1234(a) ). 

One  aspect  of  the  private  rulings,  the  tax  treatment  of  closing 
transactions,  has  significant  tax  planning  potential.  In  a  closing 
transaction,  the  writer  (seller)  of  an  option  cancels  his  obligation 
under  that  option  by  purchasing  from  the  exchange  an  option  with 
terms  identical  to  the  option  he  had  previously  written.  Under  the 
Service's  ruling,  the  difference  between  the  amount  paid  in  the  closing 
transaction  and  the  premium  originally  received  by  the  option  writer 
is  ordinary  income  or  loss. 

The  Service  has  also  ruled  that  premium  income  from  the  lapse 
of  an  option  is  ordinary  income  to  the  option  writer  (see  reg. 
§  1.1234-1  (b)). 

Reasons  for  change 

Since  the  decision  of  whether  or  not  to  enter  a  closing  transaction  is 
usually  within  the  discretion  of  the  taxpayer,  the  revenue  ruling  de- 
scribed above  has  resulted  in  an  opportunity  for  some  taxpayers  to 
plan  tax  strategies  (described  in  more  detail  below)  under  which  they 
realize  ordinary  loss  on  one  pait  of  a  transaction,  while  realizing  long 
or  short  term  capital  gain  on  another  related  transaction  involving 
the  same  stock  or  securities. 

Assume,  for  example,  that  a  taxpayer  in  the  50  percent  tax  bracket 
purchases  100  shares  of  IBM  for  $200  a  share ;  he  also  writes  a  call  on 
the  stock  at  a  striking  price  of  $200  per  share,  for  a  premium  of  $2,500. 
If  the  value  of  the  stock  rises  to  $250  per  share,  and  the  taxpayer  has 
held  his  stock  for  more  than  6  months,  he  may  sell  the  stock,  realizing 
a  long-term  capital  gain  of  $5,000  on  which  he  owes  $1,250  tax.  He  also 
enters  a  closing  transaction  with  repsect  to  his  call  by  purchasing  a  call 
on  IBM  at  a  striking  price  of  $200  per  share ;  he  would  pay  a  premium 
of  about  $5,000  under  these  circumstances,  and  the  resulting  loss  of 
$2,500  (determined  by  subtracting  the  premium  the  taxpayer  received 
for  the  call  he  wrote  from  the  premium  he  paid  for  the  call  he  pur- 
chased) would  be  ordinary  loss  which  could  be  offset  against  ordinary 
income  for  a  tax  saving  of  $1,250.  The  net  result  is  that  the  taxpayer 
pays  no  tax  on  transactions  producing  a  net  economic  income  of  $2,500. 

To  prevent  this  situation  from  occurring  in  the  future,  the  Act,  in 
effect,  reverses  the  private  ruling  Avith  respect  to  closing  transactions 
by  providing  that  gain  or  loss  from  a  closing  transaction  is  to  be 
treated  as  short-term  capital  gain  or  loss.^ 

Explanation  of  provisions 

The  Act  provides  that  gain  or  loss  from  a  closing  transaction  would 
be  taxed  as  short-term  capital  gain  or  loss  rather  than  as  ordinary  in- 
come. The  effect  of  this  change  would  eliminate  the  feature  of  existing 
law  which  permits  conversion  of  ordinary  income  into  capital  gain. 

Under  the  Act,  any  loss  on  a  closing  transaction  would  be  treated  as 
a  short-term  capital  loss  which  would  have  to  be  netted  against  the 

1  This  provision  is  virtually  identical  with  H.R.  12224.  The  Ways  and  Means  Committee 
Report  on  that  provision  is  House  Report  94-1192.  For  a  further  discussion  of  reasons  for 
change  in  this  area,  see  that  report  at  pages  5-8. 


675 

taxpayer's  capital  gains.-  Thus,  in  the  example  described  above,  the 
$2,500  short-term  capital  loss  would  be  subtracted  from  the  $5,000 
long-term  capital  gain,  leaving  a  net  long-term  capital  gain  of  $2,500. 
A  taxpayer  in  the  50-percent  bracket  would  pay  a  tax  of  $625  on  this 
amount. 

Options  covered  under  the  rules  of  the  Act  include  options  (and 
privileges)  in  stock  and  securities  (including  stock  and  securities 
dealt  with  on  a  "when  issued"  basis)  and  options  in  commodities  and 
commodity  futures. 

Treattiient  of  income  from  lapsed  options. — Under  the  ruling  issued 
to  the  CBOE,  premium  income  from  a  lapsed  option  is  treated  as 
ordinary  income  to  the  option  writer.  In  some  cases  this  rule  can  result 
in  a  serious  hardship  for  some  investors. 

Under  the  tax  law,  a  person  who  has  substantial  capital  losses  may 
not  otfset  those  losses  (except  to  a  very  limited  extent)  against  pre- 
mium income,  even  if  the  capital  losses  result  from  transactions  in 
stock  underlying  covered  options.  Thus,  for  example,  assume  that  X 
purchases  1,000  shares  of  IBM  at  $200  per  share  and  writes  a  call  on 
the  stock  at  that  price,  receiving  a  premium  of  $10,000.  If  the  stock 
declines  to  190,  the  call  will  lapse  (because  it  is  worthless)  and,. under 
present  law,  X  will  have  ordinary  income  of  $10,000-  If  he  sells  the 
IBM  stock,  he  will  also  have  a  $10,000  capital  loss  but,  under  prior 
law,  only  $1,000  of  this  amount  could  be  offset  against  the  income  from 
writing  the  call. 

The  Act  deals  with  this  problem  by  providing  that  income  from  a 
lapsed  option  is  to  be  treated  as  short  term  capital  gain-  Thus,  in  the 
example  set  forth  above,  the  $10,000  gain  from  writing  the  option 
could  be  offset  against  the  $10,000  capital  loss  which  the  taxpayer 
experienced  with  respect  to  the  sale  of  the  stock- 

Treatment  of  broker-dealers — Under  the  Act,  the  rules  just  outlined 
with  respect  to  closing  transactions  and  option  lapse  income  are  not 
to  apply  in  the  case  of  options  written  by  the  taxpayer  in  the  ordi- 
nary course  of  his  trade  or  business.  Gain  or  loss  from  transactions 
in  options  written  in  the  ordinary  course  of  the  taxpayer's  trade  or 
business  would  continue  to  be  treated  as  ordinary  income  or  loss.  This 
rule  is  consistent  with  the  provisions  of  the  tax  law  generally  con- 
cerning the  tax  treatment  of  broker-dealers  in  stock  or  securities.  It  is 
possible,  of  course,  that  some  taxpayers  may  write  certain  options  in 
the  ordinary  coui-se  of  their  trade  or  business,  and  may  write  other 
options  in  connection  with  their  investment  activities.  In  such  cases, 
the  new  rules  would  apply  to  options  written  in  connection  with  the 
taxpayer's  investment  activities.  The  determination  as  to  whether  an 
option  is  written  in  the  ordinary  course  of  a  taxpayer's  trade  or  busi- 
ness, or  as  an  investment,  is  to  be  determined  under  principles  similar 
to  those  which  apply  the  tax  law  in  the  case  of  a  broker-dealer  in  secu- 
rities. Generally,  it  is  anticipated  that  persons  who  are  treated  as 
writers  of  options  in  the  ordinary  course  of  their  trade  or  business  will 
be  those  who  "make  a  market"  with  respect  to  a  particular  option. 


=  Under  the  tax  law,  a  taxpayer's  short-term  capital  losses  are  netted  against  his  short- 
term  caiiital  gains,  if  any.  The  net  short-term  capital  loss  is  then  netted  against  his  long-term 
capital  gains.  The  remaining  net  loss,  if  any,  may  then  be  deducted  against  ordinary  in- 
come to  the  extent  of  $1,000  per  year,  hut  under  section  1401  of  the  Act,  this  is  increased 
to  §2,000  for  taxable  years  beginning  in  1977  and  to  $3,000  for  years  beginning  after  1977. 


676 

Trading  in  options  hy  regulated  investment  companies. — Under 
the  tax  law,  regulated  investment  companies  are  treated  in  many 
respects  as  a  conduit  to  their  shareholders;  that  is,  the  mutual  fund 
itself  is  not  subject  to  tax  on  income  which  it  distributes  to  share- 
holders. Instead,  the  shareholders  are  taxed,  and  the  income  received 
by  the  shareholders  generally  has  the  same  character  in  their  hands 
(long  or  short  term  capital  gain,  dividends,  interest,  etc.)  as  it  would 
have  had  if  the  shareholders  had  made  the  underlying  portfolio 
investments  directly,  rather  than  through  the  mutual  fund.  The  pur- 
pose of  these  rules  is  to  give  the  average  investor  an  opportunity  to 
participate  in  a  diversified  portfolio. 

However,  regulated  investment  companies  are  also  subject  to  a 
number  of  rules  and  restrictions  with  respect  to  their  operations. 
Among  these  rules  is  a  requirement  that  at  least  90  percent  of  gross 
income  must  be  derived  from  dividends,  interest,  and  gains  from 
the  sale  of  "stock  or  securities"  (sec.  851(b)(2)  of  the  Code).  The 
purpose  of  these  and  other  requirements  is  to  help  ensure  that  the 
regulated  investment  company  is  essentially  engaging  in  passive  in- 
vestment activities,  and  is  not  operating  as  a  normal  business 
corporation. 

The  Service  has  ruled  in  Rev.  Rul.  63-183,  1963-2  C.B.  285,  that 
amounts  derived  by  a  regulated  investment  company  from  writing  put 
and  call  options  which  lapse  do  not  constitute  gains  from  the  sale  or 
other  disposition  of  stock  or  securities  within  the  meaning  of  section 
851(b)  (2).^  Accordingly,  a  corporation  under  prior  law  would  not 
qualify  as  a  regulated  investment  company  if  more  than  10  percent  of 
its  gross  income  consisted  of  premiums  from  the  writing  of  puts  and 
calls  which  lapse. 

Under  the  provisions  of  the  Act,  options  are  to  be  treated  as  capital 
transactions.  Options  are  often  written  in  connection  with  a  taxpayer's 
transactions  in  stock  or  securities  underlying  the  options  and  can,  in 
many  cases,  be  a  means  of  protecting  a  taxpayer's  gains  or  minimizing 
his  risks  in  the  securities  market.  Moreover,  income  from  the  writing 
of  options  would  appear  to  be  the  kind  of  passive  investment  income 
which  a  regulated  investment  company  is  intended  to  receive. 

Thus,  there  would  appear  to  be  no  reason  why  income  from  the 
lapse  of  a  covered  or  uncovered  put  or  call  should  not  be  treated  as 
qualifying  income  for  purposes  of  the  income  source  test  which  regu- 
lated investment  companies  are  required  to  meet  under  section  851(b) 
(2)  of  the  Code.  Accordingly,  the  Congress  intends  that  such  income 
is  to  be  treated  as  income  from  the  sale  or  other  disposition  of  a  stock 
or  security  within  the  meaning  of  that  test.  In  addition,  it  is  intended 
that  income  from  a  closing  transaction  in  options,  as  well  as  income 
from  the  lapse  of  an  option,  is  to  be  treated  as  qualifying  income. 

Also,  under  section  851(b)  (3)  of  the  Code,  less  than  30  percent  of 
the  gross  income  of  a  regulated  investment  company  can  be  derived 
from  the  sale  or  other  disposition  of  stock  or  securities  held  for  less 
than  3  months.  The  Congress  intends  that  for  purposes  of  this  inle, 
the  holding  period  of  the  option  which  the  regulated  investment  com- 
pany writes  is  to  be  treated  as  commencing  on  the  date  when  the  option 


3  If  a  call  Is  exercised,  the  premium  would  be  treated  as  income  received  by  the  mutual 
fund  on  the  underlying  stock. 


677 

is  written.  For  purposes  of  section  851  (b)  (4) ,  the  "issuer"  of  an  option 
is  the  corporation  whose  stock  or  securities  underlie  the  option  (even 
though  the  option  may  be  written  by  an  options  exchange,  for 
example,). 

Also,  under  the  tax  law,  exempt  organizations  are  generally  subject 
to  tax  only  on  their  "unrelated  business  income."  In  the  case  of  most 
exempt  organizations,  capital  gains  are  excluded  from  the  unrelated 
business  income  tax.  Since  income  from  the  lapse  of  options  and  from 
closing  transactions  was  treated  as  ordinary  income  under  prior  law, 
this  income  was  not  excluded  from  the  unrelated  business  income  tax 
base.  Under  the  Act,  these  items  of  income  would  be  treated  as  short 
term  capital  gains,  and  therefore  income  from  the  lapse  of  a  covered 
or  uncovered  option,  or  from  a  closing  transaction  in  a  covered  or  un- 
covered option,  would  not  be  treated  as  unrelated  business  income.* 

Tax  Treatment  of  Foreign  Option  Writers. — The  tax  law  provides, 
in  general,  that  interest,  dividends  and  other  similar  types  of  income 
of  a  nonresident  alien  or  a  foreign  corporation  are  subject  to  a  30- 
percent  tax  on  the  gross  amount  paid  if  the  income  or  gains  are  not 
effectively  connected  with  the  conduct  of  a  trade  or  business  within  the 
United  States  (sees.  871(a)  and  881).  This  tax  is  generally  collected 
through  withholding  by  the  person  making  the  dividend,  interest  or 
other  payment  to  the  foreign  recipient  of  the  income  (sees.  1441  and 
1442). 

Nonresident  alien  individuals  are  only  subject  to  tax  on  their  non- 
effectively  connected  capital  gains  if  they  are  present  in  the  United 
States  for  183  days  or  more  during  the  taxable  year.  Those  capital 
gains  which  are  subject  to  tax  (because  of  the  183  day  rule)  are 
subject  to  a  30-percent  tax  on  the  net  amount  of  the  gains  and  losses 
for  the  year.  Also,  corporations  are  not  subject  to  tax  on  their  noneffec- 
tively  connected  capital  gains.  Any  income  or  gain  of  a  foreign  person 
which  is  effectively  connected  with  the  conduct  of  a  trade  or  business 
within  the  United  States  is  subject  to  the  regular  individual  or  cor- 
porate tax  rates  as  the  case  may  be  (sec.  871  or  881  or  882).  However, 
the  trading  in  stocks  or  securities  by  a  foreign  investor  for  his  own 
account  is  not  to  be  deemed  engaging  in  a  trade  or  business  within  the 
United  States. 

The  rules  under  prior  law  dealing  with  the  tax  treatment  of  income 
derived  by  a  foreign  pereon  from  the  writing  of  an  option  were  not 
clear  in  all  situations.  For  example,  if  a  call  option  written  by  a  for- 
eign investor  is  exercised,  then  the  premium  is  considered  as  part  of 
any  gain  realized  by  the  foreign  investor  from  the  sale  of  the  underly- 
ing stock  and  the  investor  is  only  subject  to  U.S.  tax  on  the  gain  if  he 
is  present  in  the  United  States  for  183  days  or  more,  or  if  the  gain  was 
effectively  connected  with  the  conduct  of  a  trade  or  business  within  the 
United  States.  In  no  case  is  a  30-percent  withholding  tax  on  the 
gross  amount  of  the  premium  from  writing  the  option  imposed.  A 
tax  would  either  be  imposed  at  a  30-percent  rate  on  the  net  amount  of 
gain  for  the  entire  year  (by  reason  of  the  183  day  rule),  or  at  the 


<  Those  Interested  in  this  area  should  also  be  aware  of  Public  Law  94-396.  which  amends 
section  512fh){5)  of  the  Code  to  t>rovide  that  income  from  the  lapse  of  an  option  or 
from  a  closinsr  transaction  is  not  to  be  treated  as  unrelated  business  income.  That  Act 
annlies  to  options  which  lapse,  or  which  are  the  subject  of  a  closing  transaction,  which 
occurs  on  or  after  January  1,  1978. 


678 

applicable  individual  or  corporate  rates  (in  the  event  of  effectively 
connected  capital  gains).  On  the  other  hand,  the  tax  treatment  under 
prior  law  with  respect  to  gain  or  loss  realized  on  the  lapse  of  an 
option  or  in  a  closing  transaction  is  unclear.  Some  concluded  that  the 
premium  was  subject  to  the  30-percent  tax  on  the  gross  amount  while 
others  concluded  that  the  premium  was  not  subject  to  this  tax. 

Under  the  Act,  since  option  lapse  income  and  income  or  loss  from 
closing  transactions  is  to  be  treated  as  short  term  capital  gain  or  loss, 
the  result  is  that  gain  from  the  lapse  of  an  option  or  from  a  closing 
transaction  is  exempt  from  U.S.  tax  in  most  instances.  The  Congress 
believes  that  this  is  a  sound  result  since  it  is  not  administratively 
feasible  to  impose  a  30-percent  withholding  tax  on  the  amount  of  the 
premium  because  when  the  premium  is  paid  it  is  not  known  whether 
the  option  will  be  exercised,  will  be  allowed  to  lapse,  or  will  be  sub- 
ject to  a  closing  transaction.^ 

The  Congress  understands  that  a  question  exists  under  the  tax  law 
as  to  whether  a  corporation  realizes  income  when  warrants  to  pur- 
chase the  corporation's  stock  expire  unexercised.  This  issue  was  not 
considered  by  the  Congress  in  connection  with  this  revision,  and  no 
inference  is  intended  (for  the  past  or  for  the  future)  with  respect  to 
whether  the  expiration  of  warrants  issued  by  a  corporation  for  its 
own  stock  should,  or  should  not,  result  in  recognition  of  taxable  in- 
come to  the  corporation. 

Effective  date. — The  amendments  made  by  the  act  are  to  apply  to 
options  granted  after  September  1, 1976. 

Revenue  effect 

It  is  estimated  that  this  revision  will  result  in  a  revenue  gain  of 
$3  million  in  fiscal  year  1977,  and  $10  million  per  year  thereafter. 

37.  Exempt-Interest  Dividends  of  Regulated  Investment   Com- 
panies (sec.  2137  of  the  Act  and  sees.  265  and  852  of  the  Code) 

Prior  law 

Generally,  distributions  by  a  regulated  investment  company  (com- 
monly called  a  mutual  fund)  from  capital  gains  recognized  by  it  may 
be  treated  as  capital  gain  to  its  shareholders  (i.e.,  the  character  of  the 
capital  gain  is  "flowed-through"  to  the  shareholders).  Under  certain 
conditions,  similar  flow-through  treatment  is  provided  for  dividend 
income.  However,  there  is  presently  no  flow-through  treatment  for 
tax-exempt  interest  and,  consequently,  distributions  of  tax-exempt 
interest  by  a  regulated  investment  company  are  taxable  income  to  its 
shareholders. 

Reasons  for  change 
Congress  believes  that  small  investors  should  be  permitted  to  invest 
in  tax-exempt  securities  and  still  obtain  the  advantages  of  diversifica- 
tion and  expert  management  available  through  the  use  of  regulated 
investment  companies.  In  order  to  achieve  these  aims.  Congress  be- 
lieves that  the  character  of  tax-exempt  interest  from  certain  govern- 
mental obligations  should  be  "flowed-through"  to  shareholders  of 


^  Also,  it  is  the  Congress'  intention  that  trading  in  options  is  to  be  treated  in  the  same 
way  as  trading  in  the  underlying  stock,  securities,  or  commodities  for  purposes  of  section 
864(b)(2)  of  the  code. 


679 

regulated  investment  companies  that  invest  most  of  their  funds  in 
these  kinds  of  assets. 

ExplatiatioTi,  of  provision 

The  Act  amends  the  provisions  of  the  Code  dealing  with  regulated 
investment  companies  to  permit,  under  certain  circumstances,  the 
shareholders  of  those  companies  to  treat  dividends  paid  by  the  com- 
pany from  tax-exempt  interest  as  if  the  shareholders  had  received 
the  tax-exempt  interest  directly  themselves.  In  order  to  qualify  for 
this  treatment,  a  regulated  investment  company  must  invest  at  least 
50  percent  of  the  value  of  its  assets  in  tax-exempt  securities.  In  addi- 
tion, the  regulated  investment  company  must  distribute  at  least  90  per- 
cent of  both  its  investment  company  taxable  income  and  its  net  income 
from  tax-exempt  securities. 

The  amount  of  tax-exempt  income  qualifying  for  the  "flow  through" 
treatment  is  the  amount  of  tax-exempt  interest  received  by  the  regu- 
lated investment  company  less  an  allocable  portion  of  the  admin- 
istrative and  other  expenses  that  are  attributable  to  the  tax-exempt 
interest.  An  amendment  is  made  to  section  265  of  the  Code  to  pro- 
vide that  this  allocable  portion  is  determined  by  multiplying  the 
administrative  and  other  expenses  by  the  ratio  that  the  tax-exempt 
interest  is  to  the  sum  of  the  gross  income  of  the  company  (excluding 
capital  gains  net  income)  and  the  tax-exempt  interest. 

Qualifying  dividends  paid  by  a  regulated  investment  company  out 
of  its  tax-exempt  interest  will  be  treated  by  the  company's  share- 
holders as  interest  income  from  tax-exempt  securities  for  all  pur- 
poses. Consequently,  such  dividends  do  not  constitute  an  item  of  gross 
income  in  the  hands  of  the  shareholder.  An  amendment  is  made  to 
section  265  to  make  it  clear  that  interest  on  indebtedness  incurred  or 
continued  to  purchase  or  carry  shares  of  stock  in  a  regulated  invest- 
ment company  that  pays  qualifying  dividends  is  not  deductible.  "Where 
a  regulated  investment  company  pays  dividends  from  both  taxable 
and  tax-exempt  income,  it  is  expected  that  the  Treasury  Department 
will  issue  regulations  providing  that  an  allocable  portion  of  interest 
on  indebtedness  incurred  or  continued  to  purchase  or  carry  shares  in 
that  company  is  not  deductible. 

Effective  date 
The  new  rules  apply  to  taxable  vears  beginning  after  December  31, 
1975. 

Revenue  Effect 
It  is  expected  that  the  new  rules  will  have  no  effect  on  revenues. 

38.  Common    Trust    Fund    Treatment    of    Certain    Custodial 
Accounts  (sec.  2138  of  the  Act  and  sec.  584  of  the  Code) 

Present  law 
Banks  may  generally  hold  in  a  common  trust  fund  assets  held 
by  the  bank  in  its  capacity  as  trustee,  executor,  administrator  or 
guardian.  However,  under  prior  law,  common  ti-ust  fund  treatment 
did  not  apply  to  custodian  accounts. 

Reasons  for  change 
Most  States  have  a  Uniform  Gift  to  Minors  Act  which  provides  a 
convenient  way  to  make  gifts  to  minor  children  with  the  property 


680 

taken  out  of  the  custody  of  the  parent  and  administered  by  the  bank 
or  some  other  independent  trustee.  Tlie  concern  had  been  expressed  to 
Congress  that  gifts  through  these  accounts  were  being  discouraged 
because  under  prior  law  they  did  not  qualify  for  common  trust  fund 
treatment. 

Explanation  of  prevision 
The  Act  extends  common  trust  fund  treatment  to  custodial  accounts 
The  acts  defines  custodial  accounts  as  those  which  the  Secretary  deter- 
mines are  established  under  a  State  law  substantially  similar  to  the 
Uniform  Gifts  to  Minors  Act  (as  published  by  the  American  Law 
Institute)  and  for  which  it  is  established  to  the  satisfaction  of  the  Sec- 
retary by  the  bank  that  the  bank  has  responsibilities  similar  to  that  of  a 
trustee  or  guardian. 

Effective  date 
The  provision  is  effective  as  of  October  3, 1976. 

Revenue  effect 
This  amendment  will  have  no  revenue  effect. 

39.  Support  Test  for  Dependent  Children  of  Separated  or  Divorced 
Parents  (sec.  2139  of  the  Act  and  sec.  152(e)  of  the  Code) 

Prior  law 
Under  prior  law,  the  noncustodial  parent  received  an  exemption  for 
a  child  (of  separated  or  divorced  parents)  if  (1)  he  or  she  contributed 
at  least  $1,200  for  support  of  all  the  children  of  the  separated  or 
divorced  couple,  and  (2)  the  custodial  parent  did  not  clearly  establish 
the  payment  of  more  support  for  the  child  than  the  noncustodial  par- 
ent. Otherwise,  the  custodial  parent  received  the  exemption. 

Reasons  for  change 

At  present,  the  noncustodial  parent  gets  the  exemption  for  all  of  the 
children,  no  matter  how  many  there  are,  if  that  parent  contributes 
$1,200  for  their  collective  support.  The  only  thing  that  will  keep  that 
parent  from  getting,  say,  four  exemptions  for  four  children  by  simply 
contributing  $1,200  is  for  the  custodial  parent  to  come  in  and  clearly 
establish  a  greater  contribution. 

In  these  inflationary  times,  the  Congress  believes  the  noncustodial 
parent  should  not  automatically  get  such  an  exemption  for  all  the 
children.  It  should  be  $1,200  for  each  child  before  the  custodial  parent 
has  the  burden  of  such  proof. 

Expla'}iation  of  provision 
The  Act  allows  the  noncustodial  parent  to  receive  an  exemption  for 
a  child  only  if  he  or  she  contributes  at  least  $1,200  for  each  of  the  chil- 
dren in  cases  where  the  custodial  parent  cannot  clearly  establish  the 
payment  of  greater  support. 

Effective  date 
The  provision  is  effective  for  taxable  years  beginning  after  the  date 
of  enactment  (after  October  4, 1976). 

Revenue  effect 
This  provision  has  no  effect  on  revenues,  because  it  merely  shifts  the 
exemption  from  one  taxpayer  to  another. 


681 

40.  Deferral  of  Gain  on  Involuntary  Conversion  of  Real  Property 

(sec.  2140  of  the  Act  and  sec.  1033(g)  of  the  Code) 

PrioT  lam 
A  taxpayer  can  elect  to  defer  any  gain  realized  on  the  involuntary 
conversion  of  real  property  held  for  productive  use  in  a  trade  or 
business  (and  not  stock  in  trade  or  other  property  held  primarily  for 
sale)  if  the  converted  property  is  replaced  by  property  of  a  like  kind. 
However,  under  prior  law,  the  converted  property  must  have  been 
replaced  no  later  than  two  years  after  the  close  of  the  first  taxable  year 
in  which  any  of  the  gain  was  realized. 

Reasons  for  change 

If  through  condemnation  proceedings  property  is  taken  for  public 
projects,  such  as  a  road  or  irrigation  project,  under  prior  law,  the 
owner  was  allowed  2  years  in  which  to  buy  other  similar  property,  in 
order  to  avoid  a  capital  gains  tax. 

The  Congress  believes  that  a  farm,  for  example,  which  has  been 
condemned  for  a  project,  is  very  difficult  to  replace  within  a  2-year 
period. 

This  amendment  gives  a  farmer  or  other  property  owner  one  more 
year,  or  3  years,  instead  of  2  years,  to  acquire  the  exchanged  property. 

Explan/ition  of  provision 
The  Act  extends  the  period  for  replacement  to  three  years  after  the 
close  of  the  first  taxable  year  in  which  any  of  the  gain  from  the 
conversion  is  realized. 

Effective  date 
The  provision  applies  to  dispositions  of  property  after  1974  unless 
condemnation  proceedings  began  prior  to  the  date  of  enactment.  That 
is,  if  property  Avas  disposed  of  under  the  threat  or  imminence  of  con- 
demnation after  1974,  and  no  condemnation  proceeding  ^yas  filed  in  a 
court  or  with  the  appropriate  administrative  agency  prior  to  enact- 
ment (October  4,  1976),  the  seller  has  three  years  to  replace  it  with 
like  property. 

Reventte  effect 
This  provision  is  expected  to  have  a  negligible  effect  on  revenues. 

41.  Livestock  Sold  on  Account  of  Drought  (sec.  2141  of  the  Act 

and  sec.  451(e)  of  the  Code) 

Prior  Jaw 
A  cash  method  taxpayer  must  include  income  from  a  sale  or  exchange 
in  the  taxable  year  of  the  sale  or  exchange. 

Reasons  for  change 

The  Congress  is  concerned  that  as  a  result  of  severe  drought  condi- 
tions, many  livestock  producers  have  been  forced  to  speed  up  the 
sale  of  their  stock — often  at  sacrifice  prices.  In  a  great  many  instances, 
they  are  even  selling  their  foundation  herds. 

The  sale  of  foundation  herds  which  can  subsequently  be  replaced 
poses  no  particular  tax  problem.  Prior  law  gave  those  dairy- 
men and  beef  producers  a  2-year  period  in  which  to  carry  out 
the  replacement.  However,  for  the  sale  of  cattle  which  are  not  to  be 


682 

replaced  as  part  of  the  foundation  herd,  tlie  forced  sale  aspect  posed 
a  serious  problem.  In  effect,  the  rancher  is  being  forced  to  sell  not 
only  this  year's  cattle  but  next  year's  as  well.  Consider,  for  example, 
the  situation  of  a  livestock  producer  who  might  normally  sell  400  to 
500  yearling  cattle  in  a  marketing  year.  This  same  farmer  from  his 
foundation  herds  produces  a  number  of  young  calves  who  normally 
would  be  pastured  all  during  the  current  tax  year  and  sold  in  the 
coming  tax  year.  Due  to  a  lack  of  feed  he  is  forced  to  make  an  involun- 
tary conversion  this  year  of  the  young  calves  now  selling  for  about  $100 
a  piece.  A  typical  example  is  a  farmer  making  his  normal  sales  of  400 
to  500  yearlings  and  another  200  small  calves  giving  him  additional 
$20,000  of  income  in  the  current  year  which  would  normally  be  de- 
ferred until  next  year. 

Similar  problems  arise  with  farmers  who  keep  calves  over  as  year- 
lings and  then  feed  them  out  as  fat  cattle  and  sell  them  in  the  third  year. 
The  Congress  has  learned  that  in  1976  many  of  them  were  forced  to 
sell  the  fat  cattle,  the  yearlings,  and  also  the  calves  giving  them  effec- 
tively 3  years  of  income  in  the  tax  year. 

The  Congress  has  previously  dealt  with  a  similar  problem  under 
section  451  (d)  relating  to  crop  insurance  payments. 

Explanation  of  provision 
Under  the  Act,  a  cash  method  taxpayer  may  elect  to  include  in  the 
taxable  year  following  the  taxable  year  of  sale  or  exchange  income 
from  the  sale  or  exchange  of  livestock  sold  on  account  of  drought.  This 
treatment  is  limited  to  income  from  the  sale  or  exchange  of  livestock 
(1)  the  number  of  which  is  in  excess  of  usual  business  practice,  and  (2) 
which  would  not  have  been  sold  but  for  the  drought.  Also,  the  drought 
must  occur  in  an  area  which  is  designated  as  eligible  for  Federal  assist- 
ance. The  election  is  available  only  to  a  taxpayer  whose  principal  trade 
or  business  is  farming. 

Effective  date 
The  election  is  effective  for  taxable  years  beginning  after  December 
31, 1975. 

Revenue  effect 
This  provision  is  expected  to  result  in  a  revenue  loss  of  $20  million 
in  fiscal  1977  and  a  revenue  gain  of  $20  million  in  fiscal  1978. 

U.S.  GOVERNMENT  PRINTING  OFFICE  :  1977     O-234-120