CHAIRMAN'S MARK OF

INTRODUCTION

I. DESCRIPTION OF TECHNICAL CORRECTIONS TO THE TAXPAYER RELIEF ACT OF 1997

A. Amendments to Title I of the 1997 Act Relating to the Child Credit

1. Stacking rules for the child credit under the limitations based on tax liability

2. Treatment of a portion of the child credit as a supplemental child credit

B. Amendments to Title II of the 1997 Act Relating to Education Incentives

1. Clarifications to HOPE and Lifetime Learning tax credits

2. Educations IRAs

3. Treatment of cancellation of certain student loans

4. Deductibility of student loan interest

5. Enhanced deduction for corporate donations of computers

6. Qualified State tuition programs

7. Qualified zone academy bonds

C. Amendments to Title III of the 1997 Act Relating to Savings Incentives

1. Conversions of IRAs into Roth IRAs

2. Penalty-free distributions from IRAs for education expenses and purchase of first homes

3. Limits based on modified adjusted gross income

4. Contribution limit to Roth IRAs

5. Contribution limitations for active participation in an IRA

D. Amendments to Title III of the 1997 Act Relating to Capital Gains

1. Individual capital gain rate reductions

2. Rollover of gain from sale of qualified stock

3. Exclusion of gain on the sale of a principal residence owned and used less than two years

4. Effective date of the exclusion of gain on the sale of a principal residence

E. Amendments to Title IV of the 1997 Act Relating to Alternative Minimum Tax

1. Election to use AMT depreciation for regular tax purposes

2. Clarification of small business exemption

F. Amendments to Title V of the 1997 Act Relating to Estate and Gift Taxes

1. Clarification of phaseout range for 5-percent surtax to phase out benefits of the unified credit and graduated rates

2. Clarification of effective date for indexing of generation-skipping exemption

3. Coordination between unified credit and family-owned business exclusion

4. Clarification of businesses eligible for family-owned business exclusion

5. Clarification that interests eligible for family-owned business exclusion must be passed to a qualified heir

6. Clarification of "trade or business" requirement for family-owned business exclusion

7. Conversion of qualified family-owned business exclusion into a deduction

8. Other modifications to the qualified family-owned business provision

9. Clarification of interest on installment payment of estate tax on holding companies

10. Clarification on declaratory judgment jurisdiction of U.S. Tax Court regarding installment payment of estate tax

11. Clarification of rules governing revaluation of gifts

12. Clarification with respect to post-mortem conservation easements

G. Amendments to Title VII of the 1997 Act Relating to Incentives for the District of Columbia

H. Amendments to Title IX of the 1997 Act Relating to Miscellaneous Provisions

1. Clarification of effect on certain transfers to Highway Trust Fund

2. Clarification of Mass Transit Account portions of highway motor fuels taxes

3. Clarification of qualification for reduced rate of tax on certain hard ciders

4. Combined employment tax reporting demonstration project

5. Election for 1987 partnerships to continue exception from treatment of publicly traded partnerships as corporations

6. Depreciation limitations for electric vehicles

7. Modification of operation of elective carryback of existing net operating losses of the National Railroad Passenger Corporation ("Amtrak")

I. Amendments to Title X of the 1997 Act Relating to Revenue-Raising Provisions

1. Exemption from constructive sales rules for certain debt positions

2. Definition of forward contract under constructive sales rules

3. Treatment of mark-to-market gains of electing traders

4. Special effective date for constructive sale rules

5. Gain recognition for certain extraordinary dividends

6. Treatment of certain corporate distributions

7. Certain preferred stock treated as "boot"--statute of limitations

8. Certain preferred stock treated as "boot"--treatment of transferor

9. Application of section 304 to certain international transactions

10. Establish IRS continuous levy and improve debt collection

11. Clarification regarding aviation gasoline excise tax

12. Clarification of requirement that registered fuel terminals offer dyed fuel

13. Clarification of treatment of prepaid telephone cards

14. Modify UBIT rules applicable to second-tier subsidiaries

15. Clarification to provision expanding the limitations on deductibility of premiums and interest with respect to life insurance, endowment and annuity contracts

16. Clarification of allocation of basis of properties distributed by a partnership

17. Clarification to the definition of modified adjusted gross income for purposes of the earned income credit phaseout

J. Amendments to Title XI of the 1997 Act Relating to Foreign Provisions

1. Application of attribution rules under PFIC provisions

2. Treatment of PFIC option holders

3. Application of PFIC mark-to-market rules to RICs

4. Interaction between the PFIC provisions and other mark-to-market rules

5. Application of foreign tax credit holding period rule to RICs

K. Amendments to Title XII of the 1997 Act Relating to Simplification Provisions

1. Travel expenses of Federal employees participating in a Federal criminal investigation

2. Effective date for provisions relating to electing large partnerships, partnership returns required on magnetic media, and treatment of partnership items of individual retirement arrangements

3. Modification of distribution rule for REITS

L. Amendments to Title XIII of the 1997 Act Relating to Estate, Gift and Trust Simplification

1. Clarification of treatment of revocable trusts for purposes of the generation-skipping transfer tax

2. Provision of regulatory authority for simplified reporting of funeral trusts terminated during taxable year

M. Amendments to Title XV of the 1997 Act Relating to Pensions and Employee Benefits

1. Treatment of certain disability payments to public safety employees

N. Amendments to Title XVI of the 1997 Act Relating to Technical Corrections

1. Application of requirements for SIMPLE IRAs in the case of mergers and acquisitions

2. Treatment of Indian tribal governments under section 403(b)

II. TECHNICAL CORRECTIONS TO OTHER TAX LEGISLATION

A. Treatment of Adoption Tax Credit Carryovers

B. Disclosure Requirements for Apostolic Organizations

C. Allow Deduction for Unused Employer Social Security Credit

D. Earned Income Credit Qualification Rules

III. DIFFERENCES BETWEEN PROPOSED TECHNICAL CORRECTIONS CONTAINED IN THE CHAIRMAN'S MARK AND THE PROVISIONS OF TITLE VI OF H.R. 2676

INTRODUCTION

The Senate Committee on Finance has scheduled a markup of technical corrections provisions on March 31, 1998. This document,⁽¹⁾ prepared by the staff of the Joint Committee on Taxation, provides a description of the Chairman's mark for various technical corrections to previously enacted tax legislation, primarily the Taxpayer Relief Act of 1997 ("1997 Act"). As noted in the descriptions, these technical corrections generally are proposed to be effective as if included in the original provisions to which they relate. Proposed technical corrections that are clerical in nature generally are not described in this document.

Part I of the document is a description of technical corrections to the Taxpayer Relief Act of 1997, and Part II is a description of other technical correction provisions. Part III is a brief description of the differences between the proposed technical corrections in the Chairman's mark and those included in Title VI of H.R. 2676 ("Tax Technical Corrections Act of 1997") as passed by the House on November 5, 1997.⁽²⁾

I. DESCRIPTION OF TECHNICAL CORRECTIONS TO
THE TAXPAYER RELIEF ACT OF 1997

A. Amendments to Title I of the 1997 Act Relating to the Child Credit

1. Stacking rules for the child credit under the limitations based on tax liability (sec. 101 of the 1997 Act and sec. 24 of the Code)

Present law provides a $500 ($400 for taxable year 1998) tax credit for each qualifying child under the age of 17. A qualifying child is defined as an individual for whom the taxpayer can claim a dependency exemption and who is a son or daughter of the taxpayer (or a descendent of either), a stepson or stepdaughter of the taxpayer or an eligible foster child of the taxpayer. For taxpayers with modified adjusted gross income in excess of certain thresholds, the allowable child credit is phased out. The length of the phase-out range is affected by the number of the taxpayer's qualifying children.

Generally, the maximum amount of a taxpayer's child credit for each taxable year is limited to the excess of the taxpayer's regular tax liability over the taxpayer's tentative minimum tax liability (determined without regard to the alternative minimum foreign tax credit). In the case of a taxpayer with three or more qualifying children, the maximum amount of the taxpayer's child credit for each taxable year is limited to the greater of: (1) the amount computed under the rule described above, or (2) an amount equal to the excess of the sum of the taxpayer's regular income tax liability and the employee share of FICA taxes (and one-half of the taxpayer's SECA tax liability, if applicable) reduced by the earned income credit. In the case of a taxpayer with three or more qualifying children, the excess of the amount allowed in (2) over the amount computed in (1) is a refundable credit.

Nonrefundable credits may not be used to reduce tax liability below a taxpayer's tentative minimum tax. Certain credits not used as result of this rule may be carried over to other taxable years, while others may not. Special stacking rules apply in determining which nonrefundable credits are used in the current year. Generally, the stacking rules require that nonrefundable personal credits be considered first,⁽³⁾ followed by other credits, (e.g., the business credits). Refundable credits, which are not limited by the minimum tax, are not stacked until after the nonrefundable credits.

The proposal would clarify the application of the income tax liability limitation to the refundable portion of the child credit by treating the refundable portion of the child credit in the same way as the other refundable credits. Specifically, after all the other credits are applied according to the stacking rules of the income tax limitation then the refundable credits would be applied first to reduce the taxpayer's tax liability for the year and then to provide a credit in excess of income tax liability for the year.

The proposal would be effective for taxable years beginning after December 31, 1997.

2. Treatment of a portion of the child credit as a supplemental child credit (sec. 101 of the 1997 Act and sec. 32(m) of the Code)

A portion of the child credit may be treated as a supplemental child credit. The amount of the supplemental child credit, if any, equals the excess of (1) $500 times the number of qualifying children up to the excess of the taxpayer's income tax liability (net of applicable credits other than the earned income credit) over the taxpayer's tentative minimum tax (determined without regard to the alternative minimum foreign tax credit) over (2) the sum of the taxpayer's regular income tax liability (net of applicable credits other than the earned income credit) and the employee share of FICA taxes (and one-half of the taxpayer's SECA tax liability, if applicable) reduced by any earned income credit amount. The supplemental child credit is treated as provided under the earned income credit and the child credit amount is reduced by the amount of the supplemental child credit.

The proposal would clarify that the treatment of a portion of the child credit as a supplemental child credit under the earned income credit (sec. 32) and the offsetting reduction of the child credit (sec.24) does not effect any other credit available to the taxpayer. It would also clarify that the earned income credit rules (e.g., the phaseout of the earned credit) generally do not apply to the supplemental child credit.

The proposal would be effective for taxable years beginning after December 31, 1997.

B. Amendments to Title II of the 1997 Act Relating to Education Incentives

1. Clarifications to HOPE and Lifetime Learning tax credits (sec. 201 of the 1997 Act and secs. 25A and 6050S of the Code)

Individual taxpayers are allowed to claim a nonrefundable HOPE credit against Federal income taxes up to $1,500 per student for qualified tuition and fees paid during the year on behalf of a student (i.e., the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer) who is enrolled in a post-secondary degree or certificate program at an eligible post-secondary institution on at least a half-time basis. The HOPE credit is available only for the first two years of a student's post-secondary education. The credit rate is 100 percent of the first $1,000 of qualified tuition and fees and 50 percent on the next $1,000 of qualified tuition and fees. The HOPE credit amount that a taxpayer may otherwise claim is phased out for taxpayers with modified adjusted gross income (AGI) between $40,000 and $50,000 ($80,000 and $100,000 for joint returns). For taxable years beginning after 2001, the $1,500 maximum HOPE credit amount and the AGI phase-out range will be indexed for inflation. The HOPE credit is available for expenses paid after December 31, 1997, for education furnished in academic periods beginning after such date.

If a student is not eligible for the HOPE credit (or in lieu of claiming a HOPE credit with respect to a student), individual taxpayers are allowed to claim a nonrefundable Lifetime Learning credit against Federal income taxes equal to 20 percent of qualified tuition and fees paid during the taxable year on behalf of the taxpayer, the taxpayer's spouse, or a dependent. In contrast to the HOPE credit, the student need not be enrolled on at least a half-time basis in order to be eligible for the Lifetime Learning credit, which is available for an unlimited number of years of post-secondary training. For expenses paid before January 1, 2003, up to $5,000 of qualified tuition and fees per taxpayer return will be eligible for the Lifetime Learning credit (i.e., the maximum credit per taxpayer return will be $1,000). For expenses paid after December 31, 2002, up to $10,000 of qualified tuition and fees per taxpayer return will be eligible for the Lifetime Learning credit (i.e., the maximum credit per taxpayer return will be $2,000). The Lifetime Learning credit amount that a taxpayer may otherwise claim is phased out over the same modified AGI phase-out range as applies for purposes of the HOPE credit. The Lifetime Learning credit is available for expenses paid after June 30, 1998, for education furnished in academic periods beginning after such date.

Section 6050S provides that certain educational institutions and other taxpayers engaged in a trade or business must file information returns with the IRS and certain individual taxpayers, as required by regulations prescribed by the Secretary of the Treasury, containing information on individuals who made payments for qualified tuition and related expenses or to whom reimbursements or refunds were made of such expenses.

The proposal would clarify that, under section 6050S, information returns containing information with respect to qualified tuition and fees must be filed by a person that is not an eligible educational institution only if such person is engaged in a trade or business of making payments to any individual under an insurance arrangement as reimbursements or refunds (or similar payments) of qualified tuition and related expenses. As under present law, section 6050S also would require the filing of information returns by persons engaged in a trade or business if, in the course of such trade or business, the person receives from any individual interest aggregating $600 or more for any calendar year on one or more qualified education loans.

The proposal would be effective as if included in the 1997 Act--i.e., for expenses paid after December 31, 1997, for education furnished in academic periods beginning after such date.

2. Education IRAs (sec. 213 of the 1997 Act and sec. 530 of the Code)

Section 530 provides that taxpayers may establish "education IRAs," meaning certain trusts or custodial accounts created exclusively for the purpose of paying qualified higher education expenses of a named beneficiary. Annual contributions to education IRAs may not exceed $500 per designated beneficiary, and may not be made after the designated beneficiary reaches age 18. Contributions to an education IRA may not be made by certain high-income taxpayers--i.e., the contribution limit is phased out for taxpayers with modified adjusted gross income between $95,000 and $110,000 ($150,000 and $160,000 for taxpayers filing joint returns). No contribution may be made to an education IRA during any year in which any contributions are made by anyone to a qualified State tuition program on behalf of the same beneficiary.

Until a distribution is made from an education IRA, earnings on contributions to the account generally are not subject to tax.⁽⁴⁾ In addition, distributions from an education IRA are excludable from gross income to the extent that the distribution does not exceed qualified higher education expenses incurred by the beneficiary during the year the distribution is made (provided that a HOPE credit or Lifetime Learning credit is not claimed with respect to the beneficiary for the same taxable year). The earnings portion of an education IRA distribution not used to pay qualified higher education expenses is includible in the gross income of the distributee and generally is subject to an additional 10-percent tax.⁽⁵⁾ However, the additional 10-percent tax does not apply if a distribution is made of excess contributions above the $500 limit (and any earnings attributable to such excess contributions) if the distribution is made on or before the date that a return is required to be filed (including extensions of time) by the contributor for the year in which the excess contribution was made. In addition, section 530 allows tax-free rollovers of account balances from an education IRA benefiting one family member to an education IRA benefiting another family member. Section 530 is effective for taxable years beginning after December 31, 1997.

Consistent with the legislative history to the 1997 Act, the proposal would provide that any balance remaining in an education IRA would be deemed to be distributed within 30 days after the date that the named beneficiary reaches age 30 (or, if earlier, within 30 days of the date that the beneficiary dies).

Under the proposal, the additional 10-percent tax provided for by section 530(d)(4) would not apply to a distribution from an education IRA, which (although used to pay for qualified higher education expenses) is includible in the beneficiary's gross income solely because the taxpayer elects to claim a HOPE or Lifetime Learning credit with respect to the beneficiary. The proposal further would provide that the additional 10-percent tax would not apply to the distribution of any contribution to an education IRA made during a taxable year if such distribution is made on or before the date that a return is required to be filed (including extensions of time) by the beneficiary for the taxable year during which the contribution was made (or, if the beneficiary is not required to file such a return, April 15th of the year following the taxable year during which the contribution was made). In addition, the proposal would amend section 4973(e) to provide that the excise tax penalty applies under that section for each year that an excess contribution remains in an education IRA (and not merely the year that the excess contribution is made).

The proposal would clarify that, in order for taxpayers to establish an education IRA, the designated beneficiary must be a life-in-being. The proposal also would clarify that, under rules contained in present-law section 72, distributions from education IRAs are treated as representing a pro-rata share of the principal (i.e., contributions) and accumulated earnings in the account.⁽⁶⁾

The proposal also would provide that, if any qualified higher education expenses are taken into account in determining the amount of the exclusion under section 530 for a distribution from an education IRA, then no deduction (under section 162 or any other section), or exclusion (under section 135) or credit would be allowed under the Internal Revenue Code with respect to such qualified higher education expenses.

In addition, because the 1997 Act allows taxpayers to redeem U.S. Savings Bonds and be eligible for the exclusion under present-law section 135 (as if the proceeds were used to pay qualified higher education expenses) provided the proceeds from the redemption are contributed to an education IRA (or to a qualified State tuition program defined under section 529) on behalf of the taxpayer, the taxpayer's spouse, or a dependent, the proposal would conform the definition of "eligible educational institution" under section 135 to the broader definition of that term under present-law section 530 (and section 529). Thus, for purposes of section 135, as under present-law sections 529 and 530, the term "eligible educational institution" would be defined as an institution which (1) is described in section 481 of the Higher Education Act of 1965 (20 U.S.C. 1088) and (2) is eligible to participate in Department of Education student aid programs.

The provisions would be effective as if included in the 1997 Act--i.e., for taxable years beginning after December 31, 1997.

3. Treatment of cancellation of certain student loans (sec. 225 of the 1997 Act and sec. 108(f) of the Code)

Under present law, an individual's gross income does not include forgiveness of loans made by tax-exempt educational organizations if the proceeds of such loans are used to pay costs of attendance at an educational institution or to refinance outstanding student loans and the student is not employed by the lender organization. The exclusion applies only if the forgiveness is contingent on the student's working for a certain period of time in certain professions for any of a broad class of employers. In addition, the student's work must fulfill a public service requirement.

The proposal would clarify that gross income does not include amounts from the forgiveness of loans made by educational organizations and certain tax-exempt organizations to refinance any existing student loan (and not just loans made by educational organizations). In addition, the proposal would clarify that refinancing loans made by educational organizations and certain tax-exempt organizations must be made pursuant to a program of the refinancing organization (e.g., school or private foundation) that requires the student to fulfill a public service work requirement.

The proposal would be effective as of August 5, 1997, the date of enactment of the 1997 Act.

4. Deduction for student loan interest (sec. 202 of the 1997 Act and sec. 221 of the Code)

Certain individuals who have paid interest on qualified education loans may claim an above-the-line deduction for such interest expenses, up to a maximum deduction of $2,500 per year. The deduction is allowed only with respect to interest paid on a qualified education loan during the first 60 months in which interest payments are required. Months during which the qualified education loan is in deferral or forbearance do not count against the 60-month period. No deduction is allowed to an individual if that individual is claimed as a dependent on another taxpayer's return for the taxable year.

A qualified education loan generally is defined as any indebtedness incurred to pay for the qualified higher education expenses of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred in attending (1) post-secondary educational institutions and certain vocational schools defined by reference to section 481 of the Higher Education Act of 1965, or (2) institutions conducting internship or residency programs leading to a degree or certificate from an institution of higher education, a hospital, or a health care facility conducting postgraduate training.

The proposal would clarify that the student loan interest deduction may be claimed only by a taxpayer who is required to make the interest payments pursuant to the terms of the loan. Thus, nonmandatory payments of interest, whether by the borrower or another person, are not deductible.

The proposal would be effective for interest payments due and paid after December 31, 1997, on any qualified education loan.

5. Enhanced deduction for corporate contributions of computer technology and equipment (sec. 224 of the 1997 Act and sec. 170(e)(6) of the Code)

In computing taxable income, a taxpayer who itemizes deductions generally is allowed to deduct the fair market value of property contributed to a charitable organization. However, in the case of a charitable contribution of inventory or other ordinary-income property, short-term capital gain property, or certain gifts to private foundations, the amount of the deduction is limited to the taxpayer's basis in the property. In the case of a charitable contribution of tangible personal property, a taxpayer's deduction is limited to the adjusted basis in such property if the use by the recipient charitable organization is unrelated to the organization's tax-exempt purpose.

The Taxpayer Relief Act of 1997 provided that certain contributions of computer and other equipment to eligible donees to be used for the benefit of elementary and secondary school children qualify for an augmented deduction. Under this special rule, the amount of the augmented deduction available to a corporation making a qualified contribution generally is equal to its basis in the donated property plus one-half of the amount of ordinary income that would have been realized if the property had been sold. However, the augmented deduction cannot exceed twice the basis of the donated property. To qualify for the augmented deduction, the contribution must satisfy various requirements.

The legislative history of the provision states that the special tax treatment for contributions of computer and other equipment was to be effective for contributions made during a three-year period in taxable years beginning after December 31, 1997, and before January 1, 2001.⁽⁷⁾ However, as a result of a drafting error, the statutory provision does not apply to contributions made during taxable years beginning after December 31, 1999.

The proposal would correct the termination date of the provision to provide that the special rule applies to contributions made during taxable years beginning after December 31, 1997, and before December 31, 2000.

In addition, the proposal would clarify that the requirement set forth in section 170(e)(6)(B)(vi) that the donated property fit productively into an education plan applies to property donated to educational organizations as well as to certain tax-exempt charitable entities. Similarly, the requirement regarding permissible use and disposition of the property set forth in section 170(e)(6)(B)(vii) applies both to educational organizations and certain tax-exempt charitable entities.

The proposal would be effective as of August 5, 1997, the date of enactment of the 1997 Act.

6. Qualified State tuition programs (sec. 211 of the 1997 Act and sec. 529 of the Code)

Section 529 provides tax-exempt status to "qualified State tuition programs," meaning certain programs established and maintained by a State (or agency or instrumentality thereof) under which persons may (1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary, or (2) make contributions to an account that is established for the purpose of meeting qualified higher education expenses of the designated beneficiary of the account. The term "qualified higher education expenses" means expenses for tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an eligible post-secondary educational institution, as well as room and board expenses (meaning the minimum room and board allowance applicable to the student as determined by the institution in calculating costs of attendance for Federal financial aid programs under sec. 472 of the Higher Education Act of 1965) for any period during which the student is at least a half-time student.

Section 529 also provides that no amount shall be included in the gross income of a contributor to, or beneficiary of, a qualified State tuition program with respect to any distribution from, or earnings under, such program, except that (1) amounts distributed or educational benefits provided to a beneficiary (e.g., when the beneficiary attends college) will be included in the beneficiary's gross income (unless excludable under another Code section) to the extent such amounts or the value of the educational benefits exceed contributions made on behalf of the beneficiary, and (2) amounts distributed to a contributor or another distributee (e.g., when a parent receives a refund) will be included in the contributor's/distributee's gross income to the extent such amounts exceed contributions made on behalf of the beneficiary. Earnings on an account may be refunded to a contributor or beneficiary, but the State or instrumentality must impose a more than de minimis monetary penalty unless the refund is (1) used for qualified higher education expenses of the beneficiary, (2) made on account of the death or disability of the beneficiary, or (3) made on account of a scholarship received by the designated beneficiary to the extent the amount refunded does not exceed the amount of the scholarship used for higher education expenses.

A transfer of credits (or other amounts) from one account benefiting one designated beneficiary to another account benefiting a different beneficiary will be considered a distribution (as will a change in the designated beneficiary of an interest in a qualified State tuition program), unless the beneficiaries are members of the same family. For this purpose, the term "member of the family" means persons described in paragraphs (1) through (8) of section 152(a)--e.g., sons, daughters, brothers, sisters, nephews and nieces, certain in-laws, etc--and any spouse of such persons.

The proposal would clarify that, under rules contained in present-law section 72, distributions from qualified State tuition programs are treated as representing a pro-rata share of the principal (i.e., contributions) and accumulated earnings in the account.

In addition, the proposal would modify section 529(e)(2) to clarify that--for purposes of tax-free rollovers and changes of designated beneficiaries--a "member of the family" includes the spouse of the original beneficiary.

The proposal would be effective for distributions made after December 31, 1997.

7. Qualified zone academy bonds (sec. 226 of the 1997 Act and sec. 1397E of the Code)

Certain financial institutions (i.e., banks, insurance companies, and corporations actively engaged in the business of lending money) that hold "qualified zone academy bonds" are entitled to a nonrefundable tax credit in an amount equal to a credit rate (set monthly by the Treasury Department⁽⁸⁾) multiplied by the face amount of the bond (sec. 1397E). The credit rate applies to all such bonds issued in each month. A taxpayer holding a qualified zone academy bond on the credit allowance date (i.e., each one-year anniversary of the issuance of the bond) is entitled to a credit. The credit is includible in gross income (as if it were an interest payment on the bond), and may be claimed against regular income tax and AMT liability.

"Qualified zone academy bonds" are defined as any bond issued by a State or local government, provided that (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a "qualified zone academy"--meaning certain public schools located in empowerment zones or enterprise communities or with a certain percentage of students from low-income families--and (2) private entities have promised to make contributions to the qualified zone academy with a value equal to at least 10 percent of the bond proceeds.

A total of $400 million of "qualified zone academy bonds" may be issued in each of 1998 and 1999. The $400 million aggregate bond cap will be allocated each year to the States according to their respective populations of individuals below the poverty line.⁽⁹⁾ Each State, in turn, will allocate the credit to qualified zone academies within such State. A State may carry over any unused allocation into subsequent years.

The proposal would modify section 6655(g)(1)(B) to provide that the credit for certain holders of qualified zone academy bonds may be claimed for estimated tax purposes. Similarly, the proposal would clarify under section 6401(b)(1) the manner in which the credit is taken into account when determining whether a taxpayer has made an overpayment of tax.

The proposal would be effective for obligations issued after December 31, 1997.

1. Conversions of IRAs into Roth IRAs (sec. 302 of the 1997 Act and secs. 408A and 72(t) of the Code)

A taxpayer with adjusted gross income of less than $100,000 may convert a present-law deductible or nondeductible IRA into a Roth IRA at any time. The amount converted is includible in income in the year of the conversion, except that if the conversion occurs in 1998, the amount converted is includible in income ratably over the 4-year period beginning with the year in which the conversion occurs.⁽¹⁰⁾ Amounts includible in income as a result of the conversion are not taken into account in determining whether the $100,000 threshold is exceeded. The 10-percent tax on early withdrawals does not apply to conversions of IRAs into Roth IRAs.

In general, distributions of earnings from a Roth IRA are excludable from income if the individual has had a Roth IRA for at least 5 years and certain other requirements are satisfied. The 5-year holding period with respect to conversion Roth IRAs begins from the year of the conversion. (Distributions that are excludable from income are referred to as qualified distributions.)

Present law does not contain a specific rule addressing what happens if an individual dies during the 4-year spread period for 1998 conversions.

Distributions of converted amounts

Distributions before the end of the 4-year spread

The proposal would modify the rules relating to conversions of IRAs into Roth IRAs in order to prevent taxpayers from receiving premature distributions from a Roth conversion IRA while retaining the benefits of 4-year income averaging. In the case of conversions to which the 4-year income inclusion rule applies, income inclusion would be accelerated with respect to any amounts withdrawn before the final year of inclusion. Under this rule, a taxpayer that withdraws converted amounts prior to the last year of the 4-year spread would be required to include in income the amount otherwise includible under the 4-year rule, plus the lesser of (1) the taxable amount of the withdrawal, or (2) the remaining taxable amount of the conversion (i.e., the taxable amount of the conversion not included in income under the 4-year rule in the current or a prior taxable year). In subsequent years (assuming no such further withdrawals), the amount includible in income under the 4-year will be the lesser of (1) the amount otherwise required under the 4-year rule (determined without regard to the withdrawal) or (2) the remaining taxable amount of the conversion.

Under the proposal, application of the 4-year spread would be elective. The election would be made in the time and manner prescribed by the Secretary. An election with respect to the 4-year spread could not be changed after the due date for the return for the first year of the income inclusion (including extensions).

The following example illustrates the application of these proposed rules.

Example: Taxpayer A has a nondeductible IRA with a value of $100 (and no other IRAs). The $100 consists of $75 of contributions and $25 of earnings. A converts the IRA into a Roth IRA in 1998 and elects the 4-year spread. As a result of the conversion, $25 is includible in income ratably over 4 years ($6.25 per year). The 10-percent early withdrawal tax does not apply to the conversion. At the beginning of 1999, the value of the account is $110, and A makes a withdrawal of $10. Under the proposal, the withdrawal would be treated as attributable entirely to amounts that were includible in income due to the conversion. In the year of withdrawal, $16.25 would be includible in income (the $6.25 includible in the year of withdrawal under the 4-year rule, plus $10 ($10 is less than the remaining taxable amount of $12.50 ($25-$12.50)). In the next year, $2.50 would be includible in income under the 4-year rule. No amount would be includible in income in year 4 due to the conversion.

Application of early withdrawal tax to converted amounts

The proposal would modify the rules relating to conversions to prevent taxpayers from receiving premature distributions (i.e., within 5 years) while retaining the benefit of the nonpayment of the early withdrawal tax. Under the proposal, if converted amounts are withdrawn within the 5-year period beginning with the year of the conversion, then, to the extent attributable to amounts that were includible in income due to the conversion, the amount withdrawn would be subject to the 10-percent early withdrawal tax.⁽¹¹⁾

Applying this rule to the example above, the $10 withdrawal would be subject to the 10-percent early withdrawal tax (unless as exception applies).

Application of 5-year holding period

The proposal would also eliminate the special rule under which a separate 5-year holding period begins for purposes of determining whether a distribution of amounts attributable to a conversion is a qualified distribution; thus, the 5-year holding rule for Roth IRAs would begin with the year for which a contribution is first made to a Roth IRA. A subsequent conversion would not start the running of a new 5-year period.

Ordering rules

Ordering rules would apply to determine what amounts are withdrawn in the event a Roth IRA contains both conversion amounts (possibly from different years) and other contributions. Under these rules, regular Roth IRA contributions would be deemed to be withdrawn first, then converted amounts (starting with the amounts first converted). Withdrawals of converted amounts would be treated as coming first from converted amounts that were includible in income. As under present law, earnings would be treated as withdrawn after contributions. For purposes of these rules, all Roth IRAs would be considered a single Roth IRA.

Corrections

In order to assist individuals who erroneously convert IRAs into Roth IRAs or otherwise wish to change the nature of an IRA contribution, contributions to an IRA (and earnings thereon) may be transferred from any IRA to another IRA by the due date for the taxpayer's return for the year of the contribution (including extensions). Any such transferred contributions will be treated as if contributed to the transferee IRA (and not to the transferor IRA).

Effect of death on 4-year spread

Under the proposal, in general, any amounts remaining to be included in income as a result of a 1998 conversion would be includible in income on the final return of the taxpayer. If the surviving spouse is the beneficiary of the Roth IRA, the spouse could continue the deferral by including the remaining amounts in his or her income over the remainder of the 4-year period.

Calculation of AGI limit for conversions

The proposal would clarify that, for purposes of applying the $100,000 AGI limit on IRA conversions into Roth IRAs, the conversion amount (to the extent otherwise includible in AGI) is subtracted from AGI as determined under the rules relating to IRAs (sec. 219). Thus, for example, the AGI-based phase out of the exemption from the disallowance for passive activity losses form rental real estate activities (sec. 469(i)(3)) would be applied taking into account the amount of the conversion that is includible in AGI, and then the amount of the conversion would be subtracted from AGI in determining whether a taxpayer is eligible to convert and IRA into a Roth IRA.

The provision would be effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

2. Penalty-free distributions for education expenses and purchase of first homes (secs. 203 and 303 of the 1997 Act and sec. 402 of the Code)

The 10-percent early withdrawal tax does not apply to distributions from an IRA if the distribution is for first-time homebuyer expenses, subject to a $10,000 life-time cap, or for higher education expenses. These exceptions do not apply to distributions from employer-sponsored retirement plans. A distribution from an employer-sponsored retirement plan that is an "eligible rollover distribution" may be rolled over to an IRA. The term "eligible rollover distribution" means any distribution to an employee of all or a portion or the balance to the credit of the employee in a qualified trust. Distributions from cash or deferred arrangements made on account of hardship are eligible rollover distributions. An eligible rollover distribution which is not transferred directly to another retirement plan or an IRA is subject to 20-percent withholding on the distribution.

Under present law, participants in employer-sponsored retirement plans can avoid the early withdrawal tax applicable to such plans by rolling over hardship distributions to an IRA and withdrawing the funds from the IRA. The proposal would modify the rules relating to the ability to roll over hardship distributions from employer-sponsored retirement plans in order to prevent such avoidance of the 10-percent early withdrawal tax. The proposal would provide that distributions from cash or deferred arrangements and similar arrangements made on account of hardship of the employee are not eligible rollover distributions. Such distributions would not be subject to the 20-percent withholding applicable to eligible rollover distributions.

The proposal would be effective for distributions after December 31, 1998.

3. Limits based on modified adjusted gross income (sec. 302(a) of the 1997 Act

and sec. 72(t) of the Code)

The $2,000 Roth IRA maximum contribution limit is phased out for individual taxpayers with adjusted gross income ("AGI") between $95,000 and $110,000 and for married taxpayers filing a joint return with AGI between $150,000 and $160,000. The maximum deductible IRA contribution is phased out between $0 and $10,000 of AGI in the case of married couples filing a separate return.

The proposal would clarify the phase-out range for the Roth IRA maximum contribution limit for a married individual filing a separate return and conform it to the range for deductible IRA contributions. Under the proposal, the phase-out range for married individuals filing a separate return would be $0 to $10,000 of AGI.

The proposal would be effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

4. Contribution limit to Roth IRAs (sec. 302 of the 1997 Act and sec. 408A(c) of the Code)

An individual who is an active participant in an employer-sponsored plan may deduct annual IRA contributions up to the lesser of $2,000 or 100 percent of compensation if the individual's adjusted gross income ("AGI") does not exceed certain limits. For 1998, the limit is phased-out over the following ranges of AGI: $30,000 to $40,000 in the case of a single taxpayer and $50,000 to $60,000 in the case of married taxpayers. An individual who is not an active participant in an employer-sponsored retirement plan (and whose spouse is not an active participant) may deduct IRA contributions up to the limits described above without limitation based on income. An individual who is not an active participant in an employer-sponsored retirement plan (and whose spouse is such an active participant) may deduct IRA contributions up to the limits described above if the AGI of the such individuals filing a joint return does not exceed certain limits. The limit is phased for out for such individuals with AGI between $150,000 and $160,000.

An individual may make nondeductible contributions up to the lesser of $2,000 or 100 percent of compensation to a Roth IRA if the individual's AGI does not exceed certain limits. An individual may make nondeductible contributions to an IRA to the extent the individual does not or cannot make deductible contributions to an IRA or contributions to a Roth IRA. Contributions to all an individual's IRAs for a taxable year may not exceed $2,000.

The proposal would clarify the intent of the Act that an individual may contribute up to $2,000 a year to all the individual's IRAs. Thus, for example, suppose an individual is not eligible to make deductible IRA contributions because of the phase-out limits, and is eligible to make a $1,000 Roth IRA contribution. The individual could contribute $1,000 to the Roth IRA and $1,000 to a nondeductible IRA.

The proposal would be effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

5. Contribution limitations for active participants in an IRA (sec. 301(b) of the 1997 Act and sec. 219(g) of the Code)

Under present law, if a married individual (filing a joint return) is an active participant in an employer-sponsored retirement plan, the $2,000 IRA deduction limit is phased out over the following levels of adjusted gross income ("AGI"):

An individual is not considered an active participant in an employer-sponsored retirement plan merely because the individual's spouse is an active participant. The $2,000 maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is, is phased out for taxpayers with AGI between $150,000 and $160,000.

The proposal would clarify the intent of the Act relating to the AGI phase-out ranges for married individuals who are active participants in employer-sponsored plans and the AGI phase-out range for spouses of such active participants as described above.

The proposal would be effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

1. Individual capital gain rate reductions (sec. 311 of the 1997 Act and sec. 1(h) of the Code)

The 1997 Act provided lower capital gains rates for individuals. Generally, the 1997 Act reduced the maximum capital gains rate from 28 percent to 20 percent and provided a 10-percent rate for capital gains otherwise taxed at a 15-percent rate. The 1997 Act generally retained a 28-percent maximum rate for gain from collectibles, gain included in income from the sale of certain small business stock, net gain properly taken into account before May 7, 1997, and net gain properly taken into account after July 28, 1997, from property held more than one year but not more than 18 months. In addition, a maximum rate of 25 percent is provided for the long-term capital gain attributable to real estate depreciation. Lower rates are also provided in the future for certain property held more than five years.

Under the provisions of the 1997 Act, net short-term capital losses and long-term capital loss carryovers offset gain taxed at a 20-percent rate before offsetting gain taxed at the 25- or 28- percent rates.

The proposal would make the following technical corrections to the individual capital gain rate reduction provisions of the 1997 Act:

Collectibles gains and losses, certain small business stock gain included in income, capital gains and losses properly taken into account after July 28, 1997, from the disposition of property held more than one year but not more than 18 months, and long-term capital gains and losses properly taken into account before May 7, 1997, would be placed in one basket ("28-percent rate gain") taxed a maximum rate of 28 percent. All the gains and losses in this basket would be netted for purposes of determining the amount taxed at a maximum 28-percent rate.

Any net short-term capital loss for the taxable year and any long-term capital loss carryover to the taxable year would be placed in the 28-percent rate gain basket. This would allow these capital losses to offset gain taxed at the 28-percent rate before offsetting gain taxed at lower rates. Any net loss in the 28-percent rate gain basket next would offset gain taxed at the 25-percent rate.

Several conforming amendments would be made to coordinate the multiple holding periods with other provisions of the Code. Inherited property and certain patents would be deemed to have a holding period of more than 18 months, thus, allowing the lower 10- and 20-percent rates to apply. The proposal would clarify that long-term capital gain or loss on a section 1256 contract would be treated as gain or loss from property held more than 18 months. Also, the short sale holding period rules of section 1233 and the holding period rules of section 1092(f) would be amended to conform those rules with the new 12-18 month holding period. Amounts treated as ordinary income by reason of section 1231(c) would be allocated among categories of gain in accordance with IRS forms or regulations.

Finally, the proposal would reorder some of the provisions and make other minor technical changes, including a provision to reduce the minimum tax preference on small business stock to 28 percent, beginning in 2006.

The proposal would be effective for taxable years ending after May 6, 1997.

2. Rollover of gain from sale of qualified stock (sec. 313 of the 1997 Act and sec. 1045 of the Code)

The 1997 Act provided that gain from the sale of qualified small business stock held by an individual for more than 6 months can be "rolled over" tax-free to other qualified small business stock.

Under the proposal, a partnership or an S corporation can roll over gain from qualified small business stock held more than 6 months if (and only if) all the interests in the partnership or S corporation are held by individuals, estates, or trusts (other than trusts with corporations as beneficiaries) at all times during the taxable year.

The proposal would be effective on August 5, 1997, the date of enactment of the 1997 Act.

3. Exclusion of gain on the sale of a principal residence owned and used less than two years (sec. 312(a) of the 1997 Act and sec. 121 of the Code)

Under present law, a taxpayer generally is able to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, the taxpayer must have owned the residence and used it as a principal residence for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or unforeseen circumstances is able to exclude a fraction of the taxpayer's realized gain equal to the fraction of the two years that the requirements are met.

The proposal would clarify that an otherwise qualifying taxpayer who fails to satisfy the two-year ownership and use requirements is able to exclude an amount equal to the fraction of the $250,000 ($500,000 if married filing a joint return), not the fraction of the realized gain which is equal to the fraction of the two years that the ownership and use requirements are met. For example, an unmarried taxpayer who owns and uses a principal residence for one year then sells at realized gain of $500,000 may exclude $125,000 of gain (one-half of $250,000) not $250,000 of gain (one-half of the realized gain). Similarly, an unmarried taxpayer who owns and uses a principal residence for one year then sells at a realized gain of $50,000 may exclude the entire $50,000 of gain since it is less than one half of $250,000. The exclusion is not limited to $25,000 (one-half of the $50,000 realized gain).

In addition, the proposal would provide that if a married couple filing a joint return does not qualify for the $500,000 exclusion, the amount of the exclusion claimed by the couple will be the sum of each spouse's exclusion determined on a separate basis.

The proposal would be effective as if included in section 312 of the 1997 Act.

4. Effective date of the exclusion of gain on the sale of a principal residence (sec. 312(d)(2) of the 1997 Act and sec. 121 of the Code)

The exclusion for gain on sale of a principal residence under the 1997 Act generally applies to sales or exchanges occurring after May 6, 1997. A taxpayer may elect, however, to apply prior law to a sale or exchange (1) made before the date of enactment of the Act, (2) made after the date of enactment pursuant to a binding contract in effect on such date, or (3) where a replacement residence was acquired on or before the date of enactment (or pursuant to a binding contract in effect on the date of enactment) and the prior-law rollover provision would apply.

The proposal would clarify that a taxpayer may elect to apply prior law with respect to a sale or exchange on the date of enactment of section 312 of the 1997 Act.

The proposal would be effective as if included in section 312 of the 1997 Act.

1. Election to use AMT depreciation for regular tax purposes (sec. 402 of the Act and sec. 168 of the Code)

For regular tax purposes, depreciation deductions for certain shorter-lived tangible property may be determined using the 200-percent declining balance method over 3-, 5-, 7-, or 10-year recovery periods (depending on the type of property). For alternative minimum tax ("AMT") purposes, depreciation on such property placed in service after 1986 and before 1999 is computed by using the 150-percent declining balance method over the longer class lives prescribed by the alternative depreciation system of section 168(g). A taxpayer may elect to use the methods and lives applicable to AMT depreciation for regular tax purposes.

The 1997 Act conformed the recovery periods (but not the methods) used for purposes of the AMT depreciation to the recovery periods used for purposes of the regular tax, for property placed in service after 1998. The 1997 Act did not make a conforming change to the election to use the pre-1998 AMT recovery methods and recovery periods for regular tax purposes.

For property placed in service after 1998, a taxpayer would be allowed to elect, for regular tax purposes, to compute depreciation on tangible personal property otherwise qualified for the 200-percent declining balance method by using the 150-percent declining balance method over the recovery periods applicable to the regular tax (rather than the longer class lives of the alternative depreciation system of sec. 168(g)).

The proposal would be effective for property placed in service after December 31, 1998.

2. Clarification of the small business exemption (sec. 401 of the Act and sec. 55 of the Code)

The corporate alternative minimum tax is repealed for small corporations for taxable years beginning after December 31, 1997. A small corporation is one that had average gross receipts of $5 million or less for a prior three-year period. A corporation that meets the $5 million gross receipts test will continue to be treated as a small corporation exempt from the alternative minimum tax so long as its average gross receipts do not exceed $7.5 million.

The proposal would clarify the application of the $5 million and $7.5 million gross receipts tests that a corporation must meet to be a small corporation exempt from the AMT. For example, in order for an existing corporation to qualify as a small corporation for its first taxable year beginning after December 31, 1997, (1) the corporation's average gross receipts for the three-taxable year period beginning after December 31, 1993 must be $5 million or less and (2) the corporation's average gross receipts for the three-taxable year period beginning after December 31, 1994 must be $7.5 million or less.

The proposal would be effective for taxable years beginning after December 31, 1997.

1. Clarification of phaseout range for 5-percent surtax to phase out the benefits of the unified credit and graduated rates (sec. 501 of the 1997 Act and sec. 2001(c)(2) of the Code)

Prior to the 1997 Act, a 5-percent surtax was imposed upon cumulative taxable transfers between $10 million and $21,040,000 to phase out the benefits of the graduated rates and the unified credit. The 1997 Act increased the unified credit beginning in 1998, from an effective exemption of $600,000 to an effective exemption of $1,000,000 in 2006. A conforming amendment was made to the 5-percent surtax provision in section 2001(c)(2) that was intended to reflect the increased unified credit. However, the conforming amendment was drafted in a manner that had the effect of phasing out the benefits of the graduated rates but not the unified credit.

The proposal would clarify section 2001(c)(2) to properly phase out the benefits of both the graduated rates and the unified credit.

The proposal would be effective for decedents dying, and gifts made, after December 31, 1997.

2. Clarification of effective date for indexing of generation-skipping exemption (secs. 501(d) and (f) of the 1997 Act and sec. 2631(c) of the Code)

The 1997 Act provided for the indexation of the $1 million exemption from generation-skipping transfers effective for decedents dying after December 31, 1998.

The proposal would clarify that the indexing of the exemption from generation-skipping transfers would be effective with respect to all generation-skipping transfers (i.e., direct skips, taxable terminations, and taxable distributions) made after 1998.

With respect to existing trusts, transferors would be permitted to make a late allocation of any additional GST exemption amount attributable to indexing adjustments in accordance with the present-law rules applicable to late allocations as set forth in sections 2632 and 2642, and the regulations promulgated thereunder. For example, assume an individual transferred $2 million to a trust in 1995, and allocated his entire $1 million GST exemption to the trust at that time (resulting in an inclusion ratio of .50). Assume further that in 2001, the GST exemption has increased to $1,100,000 as the result of indexing, and that the value of the trust assets is now $3 million. If the individual is still alive in 2001, he would be permitted to make a late allocation of $100,000 of GST exemption to the trust, resulting in a new inclusion ratio of

1-(($1,500,000+100,000)/$3,000,000), or .467.

The proposal would be effective for generation-skipping transfers made after December 31, 1998.

3. Coordination between unified credit and family-owned business exclusion (sec. 502 of the 1997 Act and sec. 2033A(a) of the Code)

The 1997 Act effectively increased the amount of lifetime gifts and transfers at death that are exempt from unified estate and gift tax from $600,000 to $1,000,000 over the period 1997 to 2006, through increases in an individual's unified credit. In addition, the 1997 Act provided a limited exclusion for certain family-owned business interests. The exclusion for family-owned business interests may be taken only to the extent that the exclusion for family-owned business interests, plus the amount effectively exempted by the unified credit, does not exceed $1.3 million. As a result, for years after 1998, the maximum amount of exclusion for family-owned business interests is reduced by increases in the dollar amount of transfers effectively exempted through the unified credit.

Because the structure of the 1997 Act increases the unified credit over time (until 2006) while decreasing over the same period the benefit of the closely-held business exclusion, the estate tax on estates with family-owned businesses increases over time until 2006. This increase in estate tax results from the fact that increases in the unified credit provide a benefit at the decedent's lowest estate tax brackets, while the exclusion for family-owned businesses provides a benefit at the decedent's highest estate tax brackets.

Under the proposal, if an executor elects to utilize the qualified family-owned business exclusion, the estate tax liability would be calculated as if the estate were allowed a maximum qualified family-owned business exclusion of $675,000 and an applicable exclusion amount under section 2010 (i.e., the amount exempted by the unified credit) of $625,000, regardless of the year in which the decedent dies. If the estate includes less than $675,000 of qualified family-owned business interests, the applicable exclusion amount would be increased on a dollar-for-dollar basis, but only up to the applicable exclusion amount generally available for the year of death.

For example, assume the decedent dies in 2005, when the applicable exclusion amount under section 2010 is $800,000. If the estate includes qualified family-owned business interests valued at $675,000 or more, the estate tax liability would be calculated as if the estate were allowed a qualified family-owned business exclusion of $675,000, and the applicable exclusion amount under section 2010 would be limited to $625,000. If the estate includes qualified family-owned business interests of $500,000 or less, all of the qualified family-owned business interests could be excluded from the estate, and the applicable exclusion amount under section 2010 would be $800,000. If the estate includes qualified family-owned business interests valued between $500,000 and $675,000, all of the qualified family-owned business interests could be excluded from the estate, and the applicable exclusion amount under section 2010 would be calculated as the excess of $1.3 million over the amount of qualified family-owned business interests. (For example, if the qualified family-owned business interests were valued at $600,000, the applicable exclusion amount under section 2010 would be $700,000.)

If a recapture event occurs with respect to any qualified family-owned business interest, the total amount of estate taxes potentially subject to recapture would be calculated as the difference between the actual amount of estate tax liability for the estate, and the amount of estate taxes that would have been owed had the qualified family-owned business election not been made.

The proposal would be effective for decedents dying after December 31, 1997.

4. Clarification of businesses eligible for family-owned business exclusion (sec. 502 of the 1997 Act and sec. 2033A(b)(3) of the Code)

In order to be eligible to exclude from the gross estate a portion of the value of a family-owned business, the sum of (1) the adjusted value of family-owned business interests includible in the decedent's estate, and (2) the amount of gifts of family-owned business interests to family members of the decedent that are not included in the decedent's gross estate, must exceed 50 percent of the decedent's adjusted gross estate.

The proposal would clarify the formula for determining the amount of gifts of family-owned business interests made to members of the decedent's family that are not otherwise includible in the decedent's gross estate.

The proposal would be effective with respect to decedents dying after December 31, 1997.

5. Clarification that interests eligible for family-owned business exclusion must be passed to a qualified heir (sec. 502 of the Act and sec. 2033A(a)(1) of the Code)

The 1997 Act provided a new exclusion for qualified family-owned business interests. One of the requirements for the exclusion is that such interests must pass to a "qualified heir," which includes members of the decedent's family and any individual who has been actively employed by the trade or business for at least 10 years prior to the date of the decedent's death.

The proposal would clarify section 2033A(a)(1) to provide that qualified family-owned business interests must be passed to a qualified heir in order to qualify for the exclusion.

The proposal would be effective with respect to estates of decedents dying after December 31, 1997.

6. Clarification of "trade or business" requirement for family-owned business exclusion (sec. 502 of the Act and sec. 2033A(e) of the Code)

A qualified family-owned business interest is defined as any interest in a trade or business that meets certain requirements--e.g., the decedent and members of his family must own certain percentages of the trade or business, the decedent or members of his family must have materially participated in the trade or business for five of the eight years preceding the decedent's death, and the qualified heir or members of his family must materially participate in the trade or business for at least five years of any eight-year period within 10 years following the decedent's death.

The proposal would clarify that an individual's interest in property used in a trade or business may qualify for the qualified family-owned business exclusion as long as such property is used in a trade or business by the individual or a member of the individual's family. Thus, for example, if a brother and sister inherit farmland upon their father's death, and the sister cash-leases her portion to her brother, who is engaged in the trade or business of farming, the "trade or business" requirement is satisfied with respect to both the brother and the sister.

The proposal would be effective with respect to estates of decedents dying after December 31, 1997.

7. Conversion of qualified family-owned business exclusion into a deduction (sec. 502 of the Act and sec. 2033A of the Code)

The qualified family-owned business provision in the 1997 Act provides an exclusion from estate taxes for certain qualified family-owned business interests. It is unclear whether the provision provides an exclusion of value or an exclusion of property from the estate, and thus it is unclear how the new provision interacts with other provisions in the Internal Revenue Code (e.g., secs. 1014, 2032A, 2056, 2612, and 6166).

The proposal would convert the qualified family-owned business exclusion into a deduction. The requirements of the provision would otherwise remain unchanged. The qualified family-owned business deduction would not be available for generation-skipping tax purposes.

The proposal would be effective with respect to estates of decedents dying after December 31, 1997.

8. Other modifications to the qualified family-owned business provision (sec. 502 of the 1997 Act and sec. 2033A of the Code)

The qualified family-owned business provision incorporates by cross-reference several other provisions of the Code, including a number of provisions in section 2032A and the personal holding company rules of section 543(a).

The proposal would modify section 2033A(g) (relating to the security requirements for noncitizen qualified heirs) by deleting the cross-reference to section 2033A(i)(3)(M), which does not appear to be appropriate. The proposal also would make rules similar to those set forth in section 2032A(h) and (i) (relating to conversions and exchanges of property under sections 1031 and 1033) applicable for purposes of section 2033A. Finally, the proposal would clarify that, in identifying assets that produce (or are held for the production of) income of a type described in section 543(a), section 543(a) would be applied without regard to section 543(a)(2)(B) (the dividend requirement for corporate entities).

The proposal would be effective with respect to estates of decedents dying after December 31, 1997.

9. Clarification of interest on installment payment of estate tax on holding companies (sec. 503 of the 1997 Act and secs. 6166(b)(7)(A) and 6166(b)(8)(A) of the Code)

If certain conditions are met, a decedent's estate may elect to pay the estate tax attributable to certain closely-held businesses over a 14-year period. The 1997 Act provided for a 2-percent interest rate on the estate tax on first $1 million in value of interests in qualified closely-held businesses, and a rate equal to 45 percent of the regular deficiency rate on the amount in excess of the portion eligible for the 2-percent rate, but also provided that none of interest on the deferred payment of estate taxes would be deductible for income or estate tax purposes. Interests in holding companies and non-readily-tradeable business interests are not eligible for the 2-percent rate.

The proposal would clarify that deferred payments of estate tax on holding companies and non-readily-tradable business interests do not qualify for the 2-percent interest rate, but instead are subject to a rate of 45 percent of the regular deficiency rate. Such interest payments are not deductible for income or estate tax purposes.

The proposal generally would be effective for decedents dying after December 31, 1997.

10. Clarification on declaratory judgment jurisdiction of U.S. Tax Court regarding installment payment of estate tax (sec. 505 of the 1997 Act and sec. 7479(a) of the Code)

If certain conditions are met, a decedent's estate may elect to pay estate tax attributable to certain closely-held business over a 14-year period. The 1997 Act provided that the U.S. Tax Court would have jurisdiction to determine whether the estate of a decedent qualifies for the 14-year installment payment of estate tax.

The proposal would clarify that the jurisdiction of the U.S. Tax Court to determine whether an estate qualifies for installment payment of estate tax on closely-held businesses extends to determining which businesses in an estate are eligible for the deferral.

The proposal would be effective for decedents dying after the date of enactment of the 1997 Act.

11. Clarification of rules governing revaluation of gifts (sec. 506 of the 1997 Act and sec. 2504(c) of the Code)

The valuation of a gift becomes final for gift tax purposes after the statute of limitations on any gift tax assessed or paid has expired. The 1997 Act extended that rule to apply for estate tax purposes, provided for a lengthened statute of limitations for gift tax purposes if certain information is not disclosed with the gift tax return, and provided jurisdiction to the U.S. Tax Court to determine the value of any gift.

The proposal would clarify that in determining the amount of taxable gifts made in preceding calendar periods, the value of prior gifts is the value of such gifts as finally determined, even if no gift tax was assessed or paid on that gift. For this purpose, final determinations would include, e.g., the value reported on the gift tax return (if not challenged by the IRS prior to the expiration of the statute of limitations), the value determined by the IRS (if not challenged through the declaratory judgment procedure by the taxpayer), the value determined by the courts, or the value agreed to by the IRS and the taxpayer in a settlement agreement.

The proposal would be effective with respect to gifts made after the date of enactment of the 1997 Act.

12. Clarification with respect to post-mortem conservation easements (sec. 506 of the 1997 Act and sec. 2031(c) of the Code)

A deduction is allowed for estate tax purposes for a contribution of a qualified real property interest to a charity (or other qualified organization) exclusively for conservation purposes (sec. 2055(f)). The 1997 Act also provided an election to exclude from the taxable estate 40 percent of the value of any land subject to a qualified conservation easement that meets certain requirements. The 1997 Act provided that the executor of the decedent's estate, or the trustee of a trust holding the land, could grant a qualifying easement after the decedent's death, as long as the easement is granted prior to the date of the election (generally, within nine months after the date of the decedent's death).

The proposal would clarify that, in the case of a qualified conservation contribution made after the date of the decedent's death, an estate tax deduction would be allowed under section 2055(f). However, no income tax deduction would be allowed to the estate or the qualified heirs with respect to such post-mortem conservation easements.

The proposal would be effective with respect to estates of decedents dying after December 31, 1997.

Designation of D.C. Enterprise Zone

Certain economically depressed census tracts within the District of Columbia are designated as the "D.C. Enterprise Zone," within which businesses and individual residents are eligible for special tax incentives. The census tracts that compose the D.C. Enterprise Zone for purposes of the wage credit, expensing, and tax-exempt financing incentives include all census tracts that presently are part of the D.C. enterprise community and census tracts within the District of Columbia where the poverty rate is not less than 20 percent. The D.C. Enterprise Zone designation generally will remain in effect for five years for the period from January 1, 1998, through December 31, 2002.

Empowerment zone wage credit, expensing, and tax-exempt financing

The following tax incentives generally are available in the D.C. Enterprise Zone: (1) a 20-percent wage credit for the first $15,000 of wages paid to D.C. residents who work in the D.C. Enterprise Zone; (2) an additional $20,000 of expensing under Code section 179 for qualified zone property placed in service by a "qualified D.C. Zone business"; and (3) special tax-exempt financing for certain zone facilities.

Qualified D.C. Zone business

For purposes of the increased expensing under section 179, as well as for purposes of the zero percent capital gains rate (described below), a corporation or partnership is a qualified D.C. Zone business if: (1) the sole trade or business of the corporation or partnership is the active conduct of a "qualified business" (defined below) within the D.C. Zone; (2) at least 50 percent (80 percent for purposes of the zero percent capital gains rate) of the total gross income of such entity is derived from the active conduct of a qualified business within the D.C. Zone; (3) a substantial portion of the use of the entity's tangible property (whether owned or leased) is within the D.C. Zone; (4) a substantial portion of the entity's intangible property is used in the active conduct of such business; (5) a substantial portion of the services performed for such entity by its employees are performed within the D.C. Zone; and (6) less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to (a) certain financial property, or (b) collectibles not held primarily for sale to customers in the ordinary course of an active trade or business. Similar rules apply to a qualified business carried on by an individual as a proprietorship.

In general, a "qualified business" means any trade or business. However, a "qualified business" does not include any trade or business that consists predominantly of the development or holding of intangibles for sale or license. In addition, a qualified business does not include any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, liquor store, or certain large farms (so-called "excluded businesses"). The rental of residential real estate is not a qualified business. The rental of commercial real estate is a qualified business only if at least 50 percent of the gross rental income from the real property is from qualified D.C. Zone businesses. The rental of tangible personal property to others also is not a qualified business unless at least 50 percent of the rental of such property is by qualified D.C. Zone businesses or by residents of the D.C. Zone.

For purposes of the tax-exempt financing provisions, the term "D.C. Zone business" generally is defined as for purposes of the increased expensing under section 179. However, a qualified D.C. Zone business for purposes of the tax-exempt financing provisions includes a business located in the D.C. Zone that would qualify as a D.C. Zone business if it were separately incorporated. In addition, under a special rule applicable only for purposes of the tax-exempt financing rules, a business is not required to satisfy the requirements applicable to a D.C. Zone business until the end of a startup period if, at the beginning of the startup period, there is a reasonable expectation that the business will be a qualified D.C. Zone business at the end of the startup period and the business makes bona fide efforts to be such a business. With respect to each property financed by a bond issue, the startup period ends at the beginning of the first taxable year beginning more than two years after the later of (1) the date of the bond issue financing such property, or (2) the date the property was placed in service (but in no event more than three years after the date of bond issuance). In addition, if a business satisfies certain requirements applicable to a qualified D.C. Zone business for a three-year testing period following the end of the start-up period and thereafter continues to satisfy certain business requirements, then it will be treated as a qualified D.C. Zone business for all years after the testing period irrespective of whether it satisfies all of the requirements of a qualified D.C. Zone business.

Zero-percent capital gains rate

A zero-percent capital gains rate applies to capital gains from the sale of certain qualified D.C. Zone assets held for more than five years. For purposes of the zero-percent capital gains rate, the D.C. Enterprise Zone is defined to include all census tracts within the District of Columbia where the poverty rate is not less than 10 percent. Only capital gain that is attributable to the 10-year period beginning December 31, 1997, and ending December 31, 2007, is eligible for the zero-percent rate.

In general, qualified "D.C. Zone assets" mean stock or partnership interests held in, or tangible property held by, a D.C. Zone business. Such assets must generally be acquired after December 31, 1997, and before January 1, 2003. However, under a special rule, qualified D.C. Zone assets include property that was a qualified D.C. Zone asset in the hands of a prior owner, provided that at the time of acquisition, and during substantially all of the subsequent purchaser's holding period, either (1) substantially all of the use of the property is in a qualified D.C. Zone business, or (2) the property is an ownership interest in a qualified D.C. Zone business.

First-time homebuyer tax credit

First-time homebuyers of a principal residence in the District are eligible for a tax credit of up to $5,000 of the amount of the purchase price, except that the credit phases out for individual taxpayers with adjusted gross income ("AGI") between $70,000 and $90,000 ($110,000-$130,000 for joint filers). The credit is available with respect to property purchased after the date of enactment and before January 1, 2001. Any excess credit may be carried forward indefinitely to succeeding taxable years.

Eligible census tracts

The proposal would clarify that the determination of whether a census tract in the District of Columbia satisfies the applicable poverty criteria for inclusion in the D.C. Enterprise Zone for purposes of the wage credit, expensing, and special tax-exempt financing incentives (poverty rate of not less than 20 percent) or for purposes of the zero-percent capital gains rate (poverty rate of not less than 10 percent), would be based on 1990 decennial census data. Thus, data from the 2000 decennial census would not result in the expansion or other reconfiguration of the D.C. Enterprise Zone.

Qualified D.C. Zone business

The proposal would modify section 1400B(c) to clarify that a proprietorship can constitute a D.C. Zone business for purposes of the zero-percent capital gains rate.

The proposal also would clarify that qualified D.C. Zone businesses that take advantage of the special tax-exempt financing incentives do not become subject to a 35-percent zone resident requirement after the close of the testing period.

Zero-percent capital gains rate

The proposal would clarify that there is no requirement that D.C. Zone business property be acquired by a subsequent purchaser prior to January 1, 2003, to be eligible for the special rule applicable to subsequent purchasers.

In addition, the proposal would clarify that the termination of the D.C. Enterprise Zone designation at the end of 2002 will not, by itself, result in property failing to be treated as a qualified D.C. Zone asset for purposes of the zero-percent capital gains rate, provided that the

property would otherwise continue to qualify were the D.C. Zone designation in effect.

First-time homebuyer credit

The proposal would clarify that, for purposes of the first-time homebuyer credit, a "first-time homebuyer" means any individual if such individual (and, if married, such individual's spouse) did not have a present ownership interest in a principal residence in the District of Columbia during the one-year period ending on the date of the purchase of the principal residence to which the credit applies.

The proposal also would clarify that the phaseout of the credit for individual taxpayers with adjusted gross income between $70,000 and $90,000 ($110,000-$130,000 for joint filers) applies only in the year the credit is generated, and does not apply in subsequent years to which the credit may be carried over.

In addition, the proposal would clarify that the term "purchase price" means the adjusted basis of the principal residence on the date the residence is purchased. Newly constructed residences would be treated as purchased by the taxpayer on the date the taxpayer first occupies such residence.

The proposal would clarify that the first-time homebuyer credit is a nonrefundable personal credit and would provide that the first-time homebuyer credit is claimed after the credits described in Code sections 25 (credit for interest on certain home mortgages) and 23 (adoption credit).

Finally, the proposal would clarify that the first-time homebuyer credit would be available only for property purchased after August 4, 1997, and before January 1, 2001. Thus, the credit would be available to first-time home purchasers who acquire title to a qualifying principal residence on or after August 5, 1997, and on or before December 31, 2000, irrespective of the date the purchase contract was entered into.

The proposal would be effective as of August 5, 1997, the date of enactment of the 1997 Act.

H. Amendments to Title IX of the 1997 Act Relating to Miscellaneous Provisions

1. Clarification of effect of certain transfers to Highway Trust Fund (sec. 901 of the 1997 Act, and sec. 9503 of the Code)⁽¹²⁾

The 1997 Act provided for the transfer of an additional 4.3 cents per gallon of the highway motor fuels tax revenues from the General Fund to the Highway Trust Fund, and provided that revenues transferred to the Trust Fund under this provision could not be used in a manner resulting in changes in direct spending. The 1997 Act further changed the dates by which certain taxes would be required to be deposited with the Treasury in fiscal year 1998.

The proposal would clarify that the tax deposit delays included in the provisions affecting transfers to the Highway Trust Fund, like the revenue transfers themselves, do not affect direct spending from the Trust Fund.

The proposal would be effective as if included in the 1997 Act.

2. Clarification of Mass Transit Account portions of highway motor fuels taxes (sec. 907 of the 1997 Act, and sec. 9503 of the Code)⁽¹³⁾

The 1997 Act provided for the transfer to the Highway Trust Fund of revenues attributable to a General Fund fuels tax rate of 4.3 cents per gallon. That Act further enacted reduced rates, based on energy content, for propane, liquefied natural tax, compressed natural gas, and methanol produced from natural gas. When deposited in the Highway Trust Fund, revenues from the taxes on each of these products are divided between the Trust Fund's Highway Account and the Mass Transit Account.

The proposal would clarify that the Mass Transit Account portion of the highway motor fuels taxes generally is 2.86 cents per gallon and that taxes on the four fuels eligible for reduced rates are divided between the Highway Account and the Mass Transit Account in the same proportion as is the tax on gasoline.

The proposal would be effective as if included in the 1997 Act.

3. Clarification of qualification for reduced rate of tax on certain hard ciders (section 908 of the 1997 Act and section 5041 of the Code)

Present Law

Distilled spirits are taxed at a rate of $13.50 per proof gallon; beer is taxed at a rate of $18 per barrel (approximately 58 cents per gallon); and still wines of 14 percent alcohol or less are taxed at a rate of 1.07 per wine gallon. The Code defines still wines as wines containing not more than 0.392 gram of carbon dioxide per hundred milliliters of wine. Higher rates of tax are applied to wines with greater alcohol content, to sparkling wines (e.g., champagne), and to artificially carbonated wines.

Certain small wineries may claim a credit against the excise tax on wine of 90 cents per wine gallon on the first 100,000 gallons of still wine produced annually (i.e., net tax rate of 17 cents per wine gallon on wines with an alcohol content of 14 percent or less). No credit is allowed on sparkling wines. Certain small breweries pay a reduced tax of $7.00 per barrel (approximately 22.6 cents per gallon) on the first 50,000 barrels of beer produced annually.

Hard cider is a wine fermented solely from apples or apple concentrate and water, containing no other fruit product and containing at least one-half of one percent and less than seven percent alcohol by volume. The 1997 Act provided a lower excise tax rate of 22.6 cents per gallon on hard cider. Qualifying small producers that produce 250,000 gallons or less of hard cider and other wines in a calendar year may claim a credit of 5.6 cents per wine gallon on the first 100,000 gallons of hard cider produced. This credit produces an effective tax rate of 17 cents per gallon, the same effective rate as that applied to small producers of still wines having an alcohol content of 14 percent or less. This credit is phased out for production in excess of 100,000 gallons but less than 250,000 gallons annually.

Description of the Proposal

The proposal would clarify that the 22.6-cents-per-gallon tax rate applies only to apple cider that otherwise would be a still wine.

Effective Date

The proposal would be effective as if included in the 1997 Act.

4. Combined employment tax reporting demonstration project (sec. 976 of the 1997 Act and sec. 6103 of the Code)

Traditionally, Federal tax forms are filed with the Federal Government and State tax forms are filed with individual states. This necessitates duplication of items common to both returns. Some States have recently been working with the IRS to implement combined State and Federal reporting of certain types of items on one form as a way of reducing the burdens on taxpayers. The State of Montana and the IRS have cooperatively developed a system to combine State and Federal employment tax reporting on one form. The one form would contain exclusively Federal data, exclusively State data, and information common to both: the taxpayer's name, address, TIN, and signature.

The Internal Revenue Code prohibits disclosure of tax returns and return information, except to the extent specifically authorized by the Internal Revenue Code (sec. 6103). Unauthorized disclosure is a felony punishable by a fine not exceeding $5,000 or imprisonment of not more than five years, or both (sec. 7213). An action for civil damages also may be brought for unauthorized disclosure (sec. 7431). No tax information may be furnished by the Internal Revenue Service ("IRS") to another agency unless the other agency establishes procedures satisfactory to the IRS for safeguarding the tax information it receives (sec. 6103(p)).

Implementation of the combined Montana-Federal employment tax reporting project had been hindered because the IRS interprets section 6103 to apply that provision's restrictions on disclosure to information common to both the State and Federal portions of the combined form, although these restrictions would not apply to the State with respect to the State's use of State-requested information if that information were supplied separately to both the State and the IRS.

The 1997 Act permits implementation of a demonstration project to assess the feasibility and desirability of expanding combined reporting in the future. There are several limitations on the demonstration project. First, it is limited to the State of Montana and the IRS. Second, it is limited to employment tax reporting. Third, it is limited to disclosure of the name, address, TIN, and signature of the taxpayer, which is information common to both the Montana and Federal portions of the combined form. Fourth, it is limited to a period of five years.

The proposal would permit Montana to use this information as if it had collected it separately by eliminating Federal penalties for disclosure of this information. The proposal would also correct a cross-reference to the provision.

The proposal would be effective on the date of enactment of the 1997 Act (August 5, 1997), and will expire on the date five years after the date of enactment of the 1997 Act.

5. Election for 1987 partnerships to continue exception from treatment of publicly traded partnerships as corporations (sec. 964 of the 1997 Act and sec. 7704 of the Code)

In general

In the case of an electing 1987 partnership that elects to be subject to a 3.5-percent tax on gross income from the active conduct of a trade or business, the general rule treating a publicly traded partnership as a corporation does not apply. The 3.5-percent tax was intended to approximate the corporate tax the partnership would pay if it were treated as a corporation for Federal tax purposes.

Tax on partnership

The 3.5-percent tax is imposed on the electing 1987 partnership under the provision (sec. 7704(g)(3)). The provision does not specifically make inapplicable, however, the general rule that a partnership as such is not subject to income tax, but rather, the partners are liable for the tax in their separate or individual capacities (sec. 701).

Estimated tax payments

The provision does not specifically make applicable the requirements for payment of estimated tax that apply generally to payments of corporate tax.

Tax on partnership

The proposal would clarify that the general rule of section 701(a) that a partnership as such is not subject to income tax, but rather, the partners are liable for the tax in their separate or individual capacities does not apply to the payment of the 3.5-percent tax by the partnership. Thus, the proposal would clarify that the partnership pays the tax.

Estimated tax payments

The proposal would make applicable to the 3.5-percent tax payable by an electing 1987 partnership the requirements for payment of estimated tax that apply generally to payments of corporate tax.

Tax on partnership

The proposal would be effective as if enacted with the 1997 Act.

Estimated tax payments

The proposal would be effective for taxable years beginning after the date of enactment.

6. Depreciation limitations for electric vehicles (sec. 971 of the Act and sec. 280F of the Code)

Annual depreciation deductions with respect to passenger automobiles are limited to specified dollar amounts, indexed for inflation. Any cost not recovered during the 6-year recovery period of such vehicles may be recovered during the years succeeding the recovery period, subject to similar limitations. The recovery-period limitations are trebled for vehicles that are propelled primarily by electricity.

The depreciation limitations applicable to post-recovery periods would be trebled for vehicles that are propelled primarily by electricity.

The proposal would be effective for property placed in service after August 5, 1997 and before January 1, 2005.

7. Modification of operation of elective carryback of existing net operating losses of the National Railroad Passenger Corporation ("Amtrak") (sec. 977 of the 1997 Act)

Present Law

The 1997 Act provides elective procedures that allow Amtrak to consider the tax attributes of its predecessors (i.e., those railroads that were relieved of their responsibility to provide intercity rail passenger service as a result of the Rail Passenger Service Act of 1970) in the use of Amtrak's net operating losses. The benefit allowable under these procedures is limited to the least of: (1) 35 percent of Amtrak's existing qualified carryovers, (2) the net tax liability for the carryback period, or (3) $2,323,000,000. One half of the amount so calculated will be treated as a payment of the tax imposed by chapter 1 of the Internal Revenue Code of 1986 for Amtrak's taxable year ending December 31, 1997, and a similar amount for Amtrak's taxable year ending December 31, 1998.

The availability of the elective procedures is conditioned on Amtrak (1) agreeing to make payments of one percent of the amount it receives to each of the non-Amtrak States to offset certain transportation related expenditures and (2) using the balance for certain qualified expenses. Non-Amtrak States are those States that are not receiving Amtrak service at any time during the period beginning on the date of enactment and ending on the date of payment.

The proposal would provide that a State would not lose its status as a non-Amtrak State with respect to any payment by reason of acquiring Amtrak service with any payment from Amtrak under the 1997 Act provision.

The proposal would be effective as if included in section 977 of the 1997 Act.

I. Amendments to Title X of the 1997Act Relating to Revenue-Raising Provisions

1. Exception from constructive sales rules for certain debt positions (sec. 1001(a) of the 1997 Act and sec. 1259(b)(2) of the Code)

Present Law

A taxpayer is required to recognize gain (but not loss) upon entering into a constructive sale of an "appreciated financial position," which generally includes an appreciated position with respect to any stock, debt instrument or partnership interest. An exception is provided for positions with respect to debt instruments that have an unconditionally payable principal amount, that are not convertible into the stock of the issuer or a related person, and the interest on which is either fixed, payable at certain variable rates or based on certain interest payments on a pool of mortgages.

Description of Proposal

The proposal would clarify that, to qualify for the exception for positions with respect to debt instruments, the position would have to either itself meet the requirements as to unconditional principal amount, non-convertibility and interest terms or, alternatively, be a hedge of a position meeting these requirements. A hedge for this purpose would include any position that reduces the taxpayer's risk of interest rate or price changes or currency fluctuations with respect to another position.

Effective Date

The proposal would generally be effective for constructive sales entered into after June 8, 1997.

2. Definition of forward contract under constructive sales rules (sec. 1001(a) of the 1997 Act and sec. 1259(d)(1) of the Code)

Present Law

A constructive sale of an appreciated financial position generally results when the taxpayer enters into a forward contact to deliver the same or substantially identical property. A forward contract for this purpose is defined as a contract that provides for delivery of a substantially fixed amount of property at a substantially fixed price.

Description of Proposal

The proposal would clarify that the definition of a forward contract includes a contract that provides for cash settlement with respect to a substantially fixed amount of property at a substantially fixed price.

Effective Date

The proposal would generally be effective for constructive sales entered into after June 8, 1997.

3. Treatment of mark-to-market gains of electing traders (sec. 1001(b) of the 1997 Act and sec. 475(f)(1)(D) of the Code)

Present Law

Securities and commodities traders may elect application of the mark-to-market accounting rules. Gain or loss recognized by an electing taxpayer under these rules is treated as ordinary gain or loss.

Under the Self-Employment Contributions Act ("SECA"), a tax is imposed on an individual's net earnings from self-employment ("NESE"). Gain or loss from the sale or exchange of a capital asset is excluded from NESE.

A publicly-traded partnership generally is treated as a corporation for Federal tax purposes. An exception to this rule applies if 90 percent or more of the partnership's gross income consists of passive-type income, which includes gain from the sale or disposition of a capital asset.

Description of Proposal

The proposal would clarify that gain or loss of a securities or commodities trader that is treated as ordinary solely by reason of election of mark-to-market treatment would not be treated as other than gain or loss from a capital asset for purposes of determining NESE for SECA tax purposes, determining whether the passive-type income exception to the publicly-traded partnership rules is met or for purposes of any other Code provision specified by the Treasury Department in regulations.

Effective Date

The proposal would apply to taxable years of electing securities and commodities traders ending after the date of enactment of the 1997 Act.

4. Special effective date for constructive sale rules (sec. 1001(d) of the 1997 Act and sec. 1259 of the Code)

Present Law

The constructive sales rules contain a special effective date provision for decedents dying after June 8, 1997, if (1) a constructive sale of an appreciated financial position occurred before such date, (2) the transaction remains open for not less than two years, (3) the transaction remains open at any time during the three years prior to the decedent's death, and (4) the transaction is not closed within the 30-day period beginning on the date of enactment of the 1997 Act. If the requirements of the special effective date provision are met, both the appreciated financial position and the transaction resulting in the constructive sale are generally treated as property constituting rights to receive income in respect of a decedent under section 691. However, gain with respect to a position in a constructive sale transaction that accrues after the transaction is closed is not included in income in respect of a decedent.

Description of Proposal

The proposal would clarify the special effective date rule to provide that the rule does not apply if the constructive sale transaction is closed at any time prior to the end of the 30th day after the date of enactment of the 1997 Act.

Effective Date

The proposal would be effective for decedents dying after June 8, 1997.

5. Gain recognition for certain extraordinary dividends (sec. 1011 of the Act and sec. 1059 of the Code)

A corporate shareholder generally can deduct at least 70 percent of a dividend received from another corporation. This dividends received deduction is 80 percent if the corporate shareholder owns at least 20 percent of the distributing corporation and generally 100 percent if the shareholder owns at least 80 percent of the distributing corporation.

Section 1059 of the Code requires a corporate shareholder that receives an "extraordinary dividend" to reduce the basis of the stock with respect to which the dividend was received by the nontaxed portion of the dividend. Whether a dividend is "extraordinary" is determined, among other things, by reference to the size of the dividend in relation to the adjusted basis of the shareholder's stock. In addition, a dividend resulting from a non pro rata redemption or a partial liquidation is an extraordinary dividend. Gain is recognized if the reduction in basis of stock exceeds the basis in the stock with respect to which an extraordinary dividend is received.

The consolidated return regulations provide similar basis adjustment rules with respect to dividends paid within a consolidated group of corporations. These rules provide that a dividend paid from one member of a group to its parent reduces the parent's basis in the stock of the payor and if such reduction exceeds the parent's basis, an "excess loss account" is created or increased. Except as provided in regulations, the extraordinary dividend provisions do not apply to result in a double reduction in basis in the case of distributions between members of an affiliated group filing consolidated returns or in the double inclusion of earnings and profits.

The proposal would provide coordination between the basis adjustment rules of section 1059 and the consolidated return regulations. These rules generally would provide that, except as provided in regulations, section 1059 will not cause current gain recognition to the extent that the consolidated return regulations require the creation or increase of an excess loss account.

The proposal generally would be effective for distributions after May 3, 1995.

6. Treatment of certain corporate distributions (sec. 1012 of the 1997 Act and secs. 355(e)(3)(A)(iv) and 358(c) of the Code)

The 1997 Act (sec. 1012(a)) requires a distributing corporation ("distributing") to recognize corporate level gain on the distribution of stock of a controlled corporation ("controlled") under section 355 of the Code if, pursuant to a plan or series of related transactions, one or more persons acquire a 50-percent or greater interest (defined as 50 percent or more of the voting power or value of the stock) of either the distributing or controlled corporation (Code sec. 355(e)). Certain transactions are excepted from the definition of acquisition for this purpose, including, under section 355(e)(3)(A)(iv), the acquisition by a person of stock in a corporation if shareholders owning directly or indirectly stock possessing more than 50 percent of the voting power and more than 50 percent of the value of the stock in distributing or any controlled corporation before such acquisition own directly or indirectly stock possessing such vote and value in such distributing or controlled corporation after such acquisition.⁽¹⁴⁾

In the case of a 50-percent or more acquisition of either the distributing corporation or the controlled corporation, the amount of gain recognized is the amount that the distributing corporation would have recognized had the stock of the controlled corporation been sold for fair market value on the date of the distribution. The Statement of Managers states that no adjustment to the basis of the stock or assets of either corporation is allowed by reason of the recognition of the gain.⁽¹⁵⁾

The 1997 Act (sec. 1012(b)(1)) also provides that, except as provided in regulations, section 355 shall not apply to the distribution of stock from one member of an affiliated group of corporations (as defined in section 1504(a)) to another member of such group (an intragroup spin-off) if such distribution is part of a such a plan or series of related transactions pursuant to which one or more persons acquire stock representing a 50-percent or greater interest in a distributing or controlled corporation, determined after the application of the rules of section 355(e).

In addition, the 1997 Act (sec. 1012(c)) provides that in the case of any distribution of stock of one member of an affiliated group of corporations to another member under section 355, the Treasury Department has regulatory authority under section 358(c) to provide adjustments to the basis of any stock in a corporation which is a member of such group, to reflect appropriately the proper treatment of such distribution.

The 1997 Act also modified certain rules for determining control immediately after a distribution in the case of certain divisive transactions in which a controlled corporation is distributed and the transaction meets the requirements of section 355. In such cases, under section 351 and modified section 368(a)(2)(H) with respect to reorganizations under section 368(a)(1)(D), those shareholders receiving stock in the distributed corporation are treated as in control of the distributed corporation immediately after the distribution if they hold stock representing a greater than 50 percent interest in the vote and value of stock of the distributed corporation.

The effective date (Act section 1012(d)(1)) states that the forgoing provisions of the 1997 Act apply to distributions after April 16, 1997, pursuant to a plan (or series of related transactions) which involves an acquisition occurring after such date (unless certain transition provisions apply).

Acquisition of a 50-percent or greater interest

The proposal would clarify that the acquisitions described in Code section 355(e)(3)(A) are disregarded in determining whether there has been an acquisition of a 50-percent or greater interest in a corporation. However, other transactions that are part of a plan or series of related transactions could result in an acquisition of a 50-percent or greater interest.

In the case of acquisitions under section 355(e)(3)(A)(iv), the proposal clarifies that the acquisition of stock in the distributing corporation or any controlled corporation is disregarded to the extent that the percentage of stock owned directly or indirectly in such corporation by each person owning stock in such corporation immediately before the acquisition does not decrease.

Example: Shareholder A owns 10 percent of the vote and value of the stock of corporation D (which owns all of corporation C). There are nine other equal shareholders of D. A also owns 100 percent of the vote and value of the stock of unrelated corporation P. D distributes C to all the shareholders of D. Thereafter, pursuant to a plan or series of related transactions, D (worth 100x) merges with corporation P (worth 900x). After the merger, each of the former shareholders of corporation D owns stock of the merged entity reflecting the vote and value attributable to that shareholder's respective 10 percent former stock ownership of D. Each of the former shareholders of D owns 1 percent of the stock of the merged corporation, except that shareholder A (who owned 100 percent of corporation P and 10 percent of corporation D before the merger) now owns 91 percent of the stock of the merged corporation. In determining whether a 50-percent or greater interest in D has been acquired, the interest of each of the continuing shareholders is disregarded only to the extent there has been no decrease in such shareholder's direct or indirect ownership. Thus, the 10 percent interest of A, and the 1 percent interest of each of the nine other former shareholder of D, is not counted. The remaining 81 percent ownership of the merged corporation, representing a decrease of nine percent in the interests of each of the nine former shareholders other than A, is counted in determining the extent of an acquisition. Therefore, a 50-percent or greater interest in D has been acquired.

Treasury regulatory authority

The proposal would also clarify that the regulatory authority of the Treasury Department under section 358(c) applies to distributions after April 16, 1997, without regard to whether a distribution involves a plan (or series of related transactions) which involves an acquisition.

As stated in the Conference Report to the Act, with respect to the Treasury Department regulatory authority under section 358(c) as applied to intragroup spin-off transactions that are not part of a plan or series of related transactions that involve an acquisition of a 50-percent of greater interest under new section 355(f), it is expected that any Treasury regulations will be applied prospectively, except in cases to prevent abuse.

Section 351(c) and section 368(a)(2)(H) "control immediately after" requirement

The proposal would clarify that in the case of certain divisive transactions in which a corporation contributes assets to a controlled corporation and then distributes the stock of the controlled corporation in a transaction that meets the requirements of section 355 (or so much of section 356 as relates to section 355), the "control immediately after" requirement of section 351(c) and section 368(a)(2)(H) shall be deemed satisfied.

The proposal generally would be effective for di