AICPA TAX SIMPLIFICATION RECOMMENDATIONS

 

TABLE OF CONTENTS:

 

INDIVIDUAL TAXATION SIMPLIFICATION

Earned Income Tax Credit
Individual Alternative Minimum Tax
"Kiddie Tax"
Mileage Allowance
Divorce and Separation
Interest Expense
Sale of Residence
Interest on Underpayments and Overpayments

 

SMALL BUSINESS TAXATION SIMPLIFICATION

Health Insurance Premium Deduction
Depreciation
Refund Checks and Adjustment Notices
Interest Capitalization

 

EMPLOYEE BENEFIT TAXATION SIMPLIFICATION

Distributions After Death
Distributions Before Retirement
Prohibition on Qualified Plan Loans
Life Expectancy for Purposes of the Minimum Distribution Requirements
Half-Year Requirements
Design-Based Safe Harbor for Minimum Distribution Requirements
Defined Contribution Keogh

 

TRUST, ESTATE AND GIFT TAXATION SIMPLIFICATION

Throwback Rules Applicable to Domestic Trusts
Gift Tax Return Exclusion Rules
Unified Credit and Generation-Skipping Transfer Tax Exemption Portability Between Spouses
Estate Tax Inclusion Period Regulations
Charitable Lead Annuity Trust Rules
Income Taxation of Powers of Appointment
Property Transferred Into a Trust at Grantorís Marginal Rate
Generation-Skipping Transfer Tax
Section 2642(c)
Allocation to a Single Trust

 

CORPORATE AND SHAREHOLDER TAXATION SIMPLIFICATION

Earnings and Profits
Ownership Attribution Rules
Safe Harbor Provisions for Corporate Estimated Tax Payments
Collapsible Corporation Rules
Adjusted Current Earnings Adjustment
Small Business Exception
Personal Holding Company Tax as Applied to Consolidated Returns
Accumulated Earnings Tax Credit Limits

 

FINANCIAL SERVICES AND PRODUCTS TAXATION SIMPLIFICATION

Exception to Market Discount Rules for Tax-Exempt Obligations
Policy Acquisition Expenses for Reinsurance Transactions
Life-Nonlife Consolidation
Consistent Application of Policy Interest Rates
Reporting of Foreign Income Taxes Paid by RICs Under Section 853
Safe Harbor Permitting RICs to Avoid PFIC Treatment
Interest on Loans on Non-Accrual
Short-Short Test for Regulated Investment Companies
Mark-to-Market Accounting

 

INTERNATIONAL TAXATION SIMPLIFICATION

Translation of Foreign Taxes at Average Exchange Rates
Passive Foreign Investment Company/Controlled Foreign Corporation Overlap
Dividends From All "10/50" Companies in One Foreign Tax Credit Limitation Basket
High Tax Kick Out Rule
Uniform Capitalization Rules

 

EARNED INCOME TAX CREDIT

 

Present Law

The refundable earned income tax credit (EITC) was enacted in 1975 with the policy goals of providing relief to low-income families from the regressive effect of social security taxes and improving work incentives for this group. According to the Internal Revenue Service (IRS), EITC rules affect almost 15 million individual taxpayers.

Over the last few years, the most common individual income tax return errors discovered by the IRS during return processing have involved the EITC, including the failure of eligible taxpayers to claim the EITC and the use of the wrong income figures when computing the EITC. The frequent changes made to the EITC over the past twenty years contribute greatly to the credit's high error rate and compliance problems.

In fact, the credit has been changed 12 times (1976, 1977, 1978, 1979, 1984, 1986, 1988, 1990, 1993, 1994, 1995, and 1996). The credit now is a nightmare of eligibility tests, requiring a maze of worksheets. Computation of the credit currently requires the taxpayer to consider nine eligibility requirements:

 

As part of the Self-Employed Health Insurance Act of 1995, a new factor was added for determining eligibility -- the amount of interest (taxable and tax-exempt), dividends, and net rental and royalty income (if greater than zero) received by a taxpayer, even if total income is low enough to otherwise warrant eligibility for the EITC. A threshold of this type of disqualified income was set at $2,350 in 1995, but was then altered as part of the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 to be $2,200. In addition, in 1996, capital gain net income and net passive income (if greater than zero) that is not self-employment income were added to this disqualified income test.

 

In 1996, the credit computation became even more complicated, with the introduction of a modified AGI definition for phasing out the credit, wherein certain types of nontaxable income need to be considered and certain losses are disregarded. Specifically, nontaxable items to be included are: tax-exempt interest, and nontaxable distributions from pensions, annuities, and individual retirement arrangements (but only if rolled over into similar vehicles during the applicable rollover period). The losses that are to be disregarded are:

 

In addition to the prior requirement that a taxpayer identification number (TIN) be supplied for each qualifying child, starting in 1996, the taxpayer must be authorized to be employed in the U.S. in order to claim the credit, and failure to provide a correct TIN is now treated as a mathematical or clerical error.

 

To claim the credit, the taxpayer may need to complete:

 

For guidance, the taxpayer may refer to 7 pages of instructions (and 39 pages of IRS Publication 596). The credit is determined by multiplying the relevant credit rate by the taxpayer's earned income up to an earned income threshold. The credit is reduced by a phaseout rate multiplied by the amount of earned income (or AGI, if less) in excess of the phaseout threshold.

 

While Congress and the IRS may expect that the AICPA and its members can comprehend the many pages of instructions and worksheets, it is unreasonable to expect those individuals entitled to the credit (who will almost certainly NOT be expert in tax matters) to deal with this complexity. Even our members, who tend to calculate the credit for taxpayers as part of their volunteer work, find this area to be extremely challenging. In fact, we have found that the EITC process can be a lot more demanding than completing the Schedule A -- Itemized Deductions, which many of our members complete on a regular basis for their clients.

 

Our analysis suggests that most of the EITC complexity arises from the definitional distinctions in this area. While each departure from definitions used elsewhere in the Internal Revenue Code (IRC) can be understood in a context of accomplishing a specific legislative purpose, the sum of all the variances in definitions causes this IRC section to be unmanageable for taxpayers and even the IRS. We recognize that many of the additions and restrictions to the credit over the years were for laudable purposes. However, the rules are so complex that the group of taxpayers to be benefited find them incomprehensible and are not effectively able to claim the credit to which they are entitled.

Recommended Changes 

We recommend that Congress adopt the following changes to the EITC:

A. Simplify definitions and the calculation.

B. Define "earned income" as taxable wages (Form 1040, line 7) and self-employment income (Form 1040, line 12).

C. Modify the "qualifying child" rules.

  1. Replace the "qualifying child" definition with the existing "dependent child" definition.
  2. Increase the incremental amount of credit provided for two children versus one child.
  3. Use the dependency exemption rather than the EITC to provide benefits for children.

D. Combine and expand the denial provision.

Deny the credit for taxpayers with: foreign earned income, alternative minimum tax liability, and AGI that exceeds earned income by $2,200 or more.

 

Contribution to Simplification

Instructions and computations would be greatly simplified. The error rate should be dramatically reduced.

 

INDIVIDUAL ALTERNATIVE MINIMUM TAX

 

Present Law

The tax laws give special treatment to certain types of income and allow special deductions for certain types of expenses. These laws enable some taxpayers with substantial economic income to significantly reduce their regular tax. The purpose of the alternative minimum tax (AMT) is to ensure that these taxpayers pay a minimum amount of tax on their economic income.

The AMT is one of the most complex provisions in the tax system. Each of the adjustments of IRC section 56, and preferences of IRC section 57, requires computation of the income or expense item under the separate AMT system. The supplementary schedules used to compute the necessary adjustments and preferences must be maintained for many years to allow the computation of future AMT as items "turn around."

Generally, the fact that AMT cannot always be calculated directly from information on the tax return makes the computation extremely difficult for taxpayers preparing their own returns. This complexity also calls into question the ability of the IRS to audit compliance with the AMT. The inclusion of adjustments and preferences from "pass through" entities also contributes to the complexity of the AMT system.

 

Recommended Change

Eliminate itemized deductions and personal exemptions as adjustments to regular taxable income in arriving at alternative minimum taxable income.

 

Contributions to Simplicity

The goal of fairness that is the basis for AMT has created hardship and complexity for many taxpayers who have not used preferences to lower their taxes but have mathematically been caught up in AMTís attempt to bring fairness. Many of these individuals are not aware of these rules and complete their return themselves, causing confusion and errors. Those individuals who are affected only by itemized deductions and personal exemption adjustments would no longer have to compute the AMT amount.

In addition, many of the AMT preferences could be eliminated by reducing for all taxpayers the regular tax benefits of present law AMT preferences (e.g., require longer lives for regular tax depreciation).

It is also worth noting that because state income taxes vary, taxpayers may incur AMT solely based on the state in which they live; other taxpayers with the same adjusted gross income (AGI), but who live in states with lower or no state income taxes, would not have any AMT.

In addition, itemized deductions are already penalized by the 3 percent AGI adjustment, 2 percent AGI miscellaneous itemized deduction adjustment, and the 50 percent disallowance for meals & entertainment. Similarly, the phase out of exemptions already affects high income taxpayers.

This change would increase simplicity and create fairness. Compliance would be improved.

 

"KIDDIE TAX"

 

Present Law

The 1986 Tax Reform Act introduced the so-called "kiddie tax" which taxes the unearned income of children under the age of 14 at the parents' bracket. While at first this seems to be a straightforward approach, it has evolved into a very complicated calculation. When first proposed in 1986, there was not a preferential tax rate for capital gains. The introduction of the maximum 28 percent capital gain rate has further complicated the situation. Under certain limited circumstances, parents can elect to include their childrenís income in their return. However, the election in not available for parents of a child with any earned income, unearned income in excess of $5,000, capital gains, withholding or estimated tax payments.

Instructions for utilization of Form 8615, "Tax for Children Under Age 14 Having Investment Income of More Than $1,200", cannot be contained on the reverse of the form. Instead, the IRS has issued Publication 929, a 22-page booklet which provides the "hidden worksheets" that allow the taxpayer, or the return preparer, to calculate the child's taxable income, as well as the tax.

In situations in which there are multiple siblings falling under this provision, the complexity expands. Similarly, if a child is subject to the alternative minimum tax (AMT), additional calculations are required. In the overwhelming majority of situations, the additional tax revenue generated by the kiddie tax appears to be insignificant when compared to the complexity of the calculations.

Also, the kiddie tax provision only considers the regular tax of section 1 and not the AMT of section 55. Therefore, the way the current rules are written, if a parent must pay AMT, the childrenís income is still taxed at the parentís regular marginal tax rate, while the parent is taxed at the AMT rate without taking into account the childrenís income or the childrenís regular tax liability. This results in taxpayers paying more tax than if the parent and childrenís incomes are both included in the parentís AMT calculation.

 

Recommended Change

The linkage of a childís taxable income to parentsí and other siblingsí taxable income should be repealed. Income (other than capital gains) subject to kiddie tax should be taxed at a separate rate schedule (e.g., fiduciary income tax rates). The childís capital gains would be taxed at the capital gains rates.

The election to include a childís income on the parentís return should be expanded to allow all income, regardless of its nature or amount, to be included. The election could apply whether or not the child has withholding or estimated payments. There could be a checkoff, similar to the current nominee interest checkoff, or column added to the Form 1040 Schedules B and D so as to indicate whether the item applies to another social security number, in order to avoid any matching problems.

 

Contribution to Simplicity

Removing the linkage to parentís and siblingís returns would allow childrenís returns to stand on their own. Issues regarding missing information on one return, matrimonial issues, and unintended AMT problems would be eliminated. The perceived loop-hole of shifting income to minors would remain closed since fiduciary income moves to higher tax brackets at lower income levels than individual income. Allowing across-the-board inclusion of a childís income on a parentís return could eliminate many childrenís returns and the associated compliance burdens for taxpayers and the government.

 

MILEAGE ALLOWANCE

 

Present Law

A standard mileage allowance, determined annually, is allowed employees in determining their expenses related to employment (31.5 cents per mile in 1997). For charitable contribution deduction purposes, a mileage allowance of 12 cents per mile is used. For medical expense deduction and moving expense deduction purposes, a taxpayer may deduct a standard mileage allowance of 10 cents per mile.

 

Recommended Change

Two mileage rates should be allowed: One for business (currently set at 31.5 cents), and another for all nonbusiness purposes (charitable, medical and moving expense). The rates would be adjusted for the cost of living, and would be rounded to the nearest cent.

 

Contribution to Simplicity

Taxpayers would no longer have to remember several different mileage allowances, at least three of which they are very likely to have to use in the same individual tax return. The tax system would, however, continue to distinguish between activities which are business related (where depreciation applies) and those which are personal in nature.

 

DIVORCE AND SEPARATION

 

Present Law

The tax issues involved with divorce and separation, occur in many areas of the tax law, such as sale of the principal residence, dependency exemption, disposition of the family business, innocent spouse rules, and tax liability of the parties.

 

Recommended Changes

The following recommendations are based on the belief that the tax law should be as unintrusive as possible in divorce and separation and that when individuals fail to make affirmative choices, the defaults imposed by law and regulation should be fair. In addition, the AICPA has commented on an allocated liability standard in comments to IRS Notice 96-19 relative to joint return and community property issues for divorce and separated taxpayers. The detailed recommendations are set forth in the attached Addendum A. The following is a listing of the specific recommendations.

 

The legislative recommendations are:

  1. Amending Internal Revenue Code (IRC) section 121, regarding the definition of principal residence for purposes of the exclusion on sale of residence incident to divorce;
  2. Amending IRC section 1034, regarding time period for acquisition of replacement residence by divorcing spouses;
  3. Amending IRC section 172, regarding characterization of alimony for net operating loss purposes;
  4. Amending IRC section 6013(e)(4), regarding AGI threshold for innocent spouse relief; and
  5. Enacting legislation regarding division of carryover tax attributes incident to a divorce.

 

The regulatory recommendations are:

 

  1. Additions to regulations under IRC sections 121 and 1034, regarding allocation of sales proceeds from sale of principal residence incident to divorce;
  2. Changes to Treasury Regulation section 1.154-4T, Q&A 4, regarding revocation of waiver of dependency exemption;
  3. Changes to Temporary Treasury Regulation section 1.1041-1T(c), Q&A 9, regarding stock redemptions incident to divorce;
  4. Changes to Temporary Treasury Regulation section 1.1041-1T(d), regarding spousal notes issued in a divorce;
  5. Changes to Temporary Treasury Regulation section 1.1041-1T(d), regarding tax consequences of transfers of partnership interests pursuant to a divorce and resultant debt relief;
  6. Changes to Treasury Regulation section 1.6013-5(b), regarding the criteria applying to the innocent spouse relief provisions;
  7. Issuance of a Published Ruling under IRC section 108(d)(3), regarding determination of insolvency for a married taxpayer; and
  8. Withdrawal of Revenue Ruling 87-112, regarding recognition of income on EE bonds transferred between spouses incident to divorce.

 

Contribution to Simplification

Many of the proposals simplify the tax law. These include the proposed changes to Temporary Treasury Regulation section 1.1041-1T(c), Q&A 9 and Temporary Treasury Regulation section 1041-1T(d), IRC section 1034 regarding time to replace a principal residence, IRC section 6012(e)(4) regarding the AGI threshold for innocent spouse relief, legislation regarding division of carryover tax attributes incident to a divorce to eliminate extensive tracing rules, and the proposed withdrawal of Revenue Ruling 87-112.

 

Other Issues

Other proposals in the domestic relations area address inequities more than simplification, such as the rules for allocation of sales proceeds on the sale of a principal residence and the revocation of a waiver of dependency exemption; however, because all of these domestic relations issues are so interrelated, they have been kept intact as one proposal instead of being treated as separate proposals.

 

INTEREST EXPENSE

  

Present Law

Under present law, an individual taxpayer must allocate interest expense among six possible categories (not including interest which must be capitalized): business (including passive), investment, qualified residence (acquisition related), qualified residence (home equity), personal, and interest attributable to acquiring or carrying tax-exempt securities. The determination of the treatment of an individualís interest expense is often difficult both because of the number of possible categories and the complexity of the allocation methods.

The current system is highly complex, which results in some degree of noncompliance (whether or not intentional). Further, it is susceptible to manipulation by sophisticated taxpayers, is difficult to administer by the IRS, is unfair in the sense that the same type of interest expense may be deductible by one taxpayer but not another, and may encourage uneconomic behavior.

 

Recommended Changes

A legislative proposal and the following regulatory proposals are set forth in detail in Addendum B.

 

  1. Regulation sections 1.163-8T(c)(1) and (j)(1) -- Proposal for primary reliance on securitization -- allocation of debt & interest expense
  2. Regulation sections 1.163-8T(c)(3)(i) and (ii) -- Proposal regarding third-party financing
  3. Regulation section 1.163-8T(c)(4)(iii)(B) -- Proposal regarding supplemental ordering rules and an example of multiple accounts
  4. Regulation section 1.163-8T(c)(4)(iv) -- Proposal regarding the optional method for determining date of reallocation
  5. Regulation section 1.163-8T(d)(4) -- Proposal for an example involving debt repayments with continuous borrowings
  6. Regulation sections 1.163-8T(f), (g), and (h) -- Proposal regarding passthrough entities
  7. Regulation section 1.163-8T(m)(1) -- Proposal for coordination with other provisions of interest on debt secured by a residence
  8. Regulation section 1.163-8T(m)(2) and Regulation section 1.163-10T(b) -- Proposal for coordination of the interest expense allocation rules with section 265
  9. Regulation section 1.163-10T(p)(3)(iii) -- Proposal regarding interest paid by the nonresident spouse on the marital residence
  10. Regulation section 1.163-10T(r) -- Proposal regarding interest on debt secured by a residence to effect transfer of property incident to a divorce

 

Contribution to Simplification

The proposals would reduce the taxpayersí compliance burden as well as the ability of taxpayers to manipulate the interest allocation rules. The proposals would also encourage taxpayers to enter into transactions based only on economic reasons.

 

SALE OF RESIDENCE

  

Present Law

Under the general rule, gain on the sale or exchange of a principal residence is includible in gross income and is subject to a maximum rate of 28 percent. However, section 1034 of the IRC provides that if an individual purchases a new principal residence within two years of selling the old residence, gain from the sale of the old residence (if any) is recognized only to the extent that the taxpayerís adjusted sales price exceeds the taxpayerís cost of purchasing the new residence.

Further, under section 121 of the IRC, in general, a taxpayer may exclude from gross income up to $125,000 of gain from the sale or exchange of a principal residence if the taxpayer (1) has attained age 55 before the sale and (2) has used the residence as a principal residence for three or more years of the five years preceding the sale. This election is allowed only once in a lifetime unless all previous elections are revoked. For this purpose, sales on or before July 26, 1978 are not counted against the once in a lifetime limit.

Only one spouse is required to satisfy those tests in order to be eligible for the exclusion, but that spouse alone must meet all the requirements. Married couples are entitled to only one $125,000 exclusion between them if they file jointly (provided neither has previously claimed it); if they file separately, they are entitled to only $62,500 each. Unmarried individuals are each entitled to exclusions of $125,000. The section 121 exclusion was increased from $100,000 to $125,000 in 1981. It has not been changed for the effects of inflation since that time.

A recent legislative proposal would repeal the section 121 exclusion and the section 1034 rollover rules and replace them with a $500,000 (married)/$250,000 (single) exclusion of gain on the sale of a home; the exclusion would be available once every two years.

 

Recommended Change

The AICPA supports the above exclusion proposal with a few modifications. We suggest a $500,000 exclusion apply per house. This would focus on the more appropriate issue - the residence, and not on the marital status of the taxpayer. Further, the exclusion proposal should apply if the residence is the principal residence of either spouse at the time of a divorce or legal separation or if the residence is sold pursuant to a divorce decree or legal separation. The $500,000 exclusion proposal, particularly with these modifications, would be a simple and broad solution to the many home sale tax problems in the present law that the current proposal seeks to correct.

 

Contribution to Simplification

The tax law should be changed to reduce complexities and inequities related to the sale of a residence by: elderly individuals selling their residences and entering continuing care retirement communities, individuals with differing marital statuses, individuals with inflation-based (non-economic) gains, individuals with losses, and individuals in different geographic areas.

 

INTEREST ON UNDERPAYMENTS AND OVERPAYMENTS

  

Present Law

Interest on underpayments is set at 3 percent above the short-term federal rate, compounded daily. Interest on overpayments is set at 2 percent above the short-term federal rate, simple interest. The rates are revised quarterly, rounded to the nearest full percent.

 

Recommended Change

Eliminate the 1 percent differential between underpayments and overpayments. The single interest rate would be revised just once annually, unless the Treasury Department determines that interest rates are very unstable. The interest rate would be compounded annually instead of daily. The effective date for the annual interest rate adjustment would be April 16.

 

Contribution to Simplicity

Because of daily compounding and quarterly rate changes, IRS interest calculations are unverifiable without a computer program. Even then, the IRS and outside computer programs often produce small unreconcilable differences. Calculating the interest on an underpayment of estimated tax has become so complicated, that the IRS offers to calculate it for taxpayers and bill them after returns are filed.

This recommended change will make interest calculations simple and verifiable. The April 16 effective date will make it even simpler for individuals.

 

Other Issues

Pros - This recommended change fulfills the policy goal of creating a disincentive for settlement delays through annually compounding.

Cons - If tax is owed for less than a full year, or if there are rate changes during the year, interest will be slightly higher using an effective annual rate, than a daily compounding rate. Restricting rate changes to once annually will yield different results than the current quarterly changes.

History - Interest on underpayments and overpayments was 6 percent until July 1, 1975. It was then raised to 9 percent, with IRC section 6621 requiring the Treasury Department to adjust the rate once every two years to equal the bank prime rate. Effective January 1, 1983, a change in the rate was required semi-annually, and IRC section 6622 was added to require daily compounding of interest on underpayments. Effective January 1, 1987, the change in the rate was required quarterly with 2 percent above the short term federal rate on overpayments and 3 percent above the short federal rate on underpayments.

The Tax Equity and Fiscal Responsibility Act of 1982 instituted quarterly interest rate changes because of dramatic monthly fluctuations the United States was experiencing at that time. When interest rates are relatively stable, the law should vary the rate less frequently.

The Tax Reform Act of 1986 added an interest rate differential for underpayments and overpayments out of concern that they relate closely to other interest rates in the economy. [However, other interest rates rarely include daily compounding (except as a sales gimmick on low rate savings accounts). So daily compounding and rate differential are two methods of accomplishing the same goal, and the daily compounding (being the more complicated) should be repealed as superfluous.]

 

HEALTH INSURANCE PREMIUM DEDUCTION

  

Present Law

Currently, self-employed persons may deduct from gross income 40 percent of amounts paid for health insurance for themselves, their spouses, and dependents. The Health Insurance Portability and Accountability Act of l996 provided an increase in the percentage deductible: 45 percent from l998-2002, 50 percent in 2003, 60 percent in 2004, 70 percent in 2005 and 80 percent in 2006. This tax deduction is limited for the self-employed to their earned income from their self-employment activity. Earned income is defined as net income from the activity minus one-half of the sum of the calculated self-employment tax and any self-employed retirement plan contributions. So if the earned income from the activity as defined above is a loss for the current year, no tax deduction will be allowed. Also, the deduction for health insurance is not taken into account when calculating the self-employment tax, so the benefit of this deduction is further reduced for the self-employed person. In contrast, incorporated businesses receive a 100 percent tax deduction for all health insurance premiums paid for owners and employees, there is no earned income limitation calculation, and the deduction is taken before the calculation on net income.

 

Recommended Change

Self-employed business owners should be treated the same as their corporate competitors. The health care deduction for the self-employed should be brought to l00 percent as quickly as possible.

 

Contribution to Simplification

If the 100 percent deduction for health insurance premiums for the self-employed is enacted the current phase-in rules will be eliminated and self-employed business owners will be treated the same as their corporate competitors.

 

DEPRECIATION

  

Present Law

Many methods are used to calculate depreciation.

 

Recommended Change

Use the straight line method to calculate all depreciation.

 

Contribution to Simplification

This change would raise revenue if existing entities were permitted to convert to the straight line method and would eliminate the necessity of referring to numerous depreciation tables to determine which is appropriate. In addition, if only the straight line method to calculate depreciation is allowed, less record keeping and preparation time would be required by taxpayers and tax practitioners.

 

REFUND CHECKS AND ADJUSTMENT NOTICES

  

Present Law

The IRS sends refund checks and adjustment notices in separate correspondence. For example, if a taxpayer has a refund coming of $1,000.00 and the IRS offsets some of this for back taxes or student loans, etc., the taxpayer gets a reduced refund check without any explanation why the refund is diminished. Sometimes the explanation never comes, but usually the adjustment notice arrives about two weeks after the refund check. In the meantime, the taxpayer is left to wonder why his or her refund is short.

 

Recommended Change

Send the refund check and adjustment notice in the same correspondence.

 

Contribution to Simplification

 There would be less stress and confusion for the taxpayer and an easing of the administrative burden on the IRS. Some postage may also be saved.

 

INTEREST CAPITALIZATION

 

Background

Under section 263A(f) of the IRC, interest expense attributable to the cost of constructing an asset is not currently deductible. It must be capitalized and added to the basis of the asset. Notice 88-99 provided rather detailed guidance on how the interest capitalization rules should apply to flow-through entities and related parties.

 

Present Law

The Notice 88-99 rules for related parties and flow-through entities are very complicated and difficult to follow. For flow-through entities, the rules are applied first at the partnership (S corporation) level and then at the partner (shareholder) level. There are two general sets of rules for flow-through entities, depending on whether the partnership or the partner is the producing entity.

If the partnership is the producer, and if the partnershipís accumulated production expenditures (APEs) exceed its own traced and avoided cost debt, the entire interest related to that traced and avoided cost debt is capitalized. The remaining APEs are subject to capitalization by any partner that has avoided cost debt. But a partner is not subject to these rules if both prongs of the following de minimis test are met:

  1. The partner owns no more than 20 percent of the partnership; and
  2. The partnerís share in the partnershipís APEs (reduced by the partnershipís traced and avoided cost debt allocable to such APEs) is no more than $250,000.

If the partner is the producer, and if the partnerís APEs exceed its own traced and avoided cost debt, then the entire interest related to that traced and avoided cost debt is capitalized. If the partnership incurs interest that is included in the distributive share of the partner (and is not allocated to the partnershipís own APEs), the partner capitalizes such flow-through interest as if it would have been capitalized had it been incurred directly by the partner. A partner is not subject to these rules, however, if both prongs of the following de minimis test are met:

  1. The partner owns no more than 20 percent of the partnership; and
  2. The interest expense that is included in the partnerís distributive share for its tax year is no more than $25,000.

 The related party rules are extremely complicated. Generally, if a member of the taxpayerís parent-subsidiary controlled group (related party) has interest on traced or avoided cost debt not capitalized with respect to its own APEs, the related party must capitalize the amount of interest that the taxpayer would have capitalized, using avoided cost principles as if the taxpayer itself had incurred the interest.

 

Proposed Simplifications

Financial Accounting Standard No. 34 (FAS) requires the capitalization of interest for financial accounting purposes and includes rules for related parties. Requiring conformity with FAS 34 would simplify these rules more than any of our other recommendations. However, if this cannot be accomplished, the following simplifications should be considered.

 

A. Liberalize De Minimis Rules

The presence of pass-through entities creates unbelievable complexity to the mechanical process of calculating capitalized interest. For example, if a partnership is undergoing the production activity and has excess production costs but has no "other eligible debt" within the entity, information must generally be provided to each partner as to the extent of his or her share of the partnershipís excess production costs. "Other eligible debt" outside the partnership must be identified, including debt in other partnerships, a portion of the interest on which must then be capitalized to the production activity of the first partnership.

It would make sense to establish de minimis rules that only require capitalization when it is substantial in nature. The de minimis limitation should be set at the producing entityís level (e.g., based upon a certain amount of the producing entityís APEs) rather than at the ownerís level. For example, section 460(e) provides that certain long-term contracts of less than $10 million are excepted from the requirement to capitalize certain direct and indirect cost, but they are not excepted from the interest capitalization requirement.

 

B. Simplify the Ordering Rules

When multiple corporations are related to a single producing corporation or when a single corporation is related to multiple producing corporations, complicated ordering rules apply under the deferred asset method. Attributing APEs or debt to related parties could be simplified by allowing taxpayers to adopt any reasonable ordering method and use it consistently. The IRS might consider publishing a list of ordering rules that it considers "reasonable" for this purpose. For example, ordering rules that allow the taxpayer to select the affiliate with the largest amount of eligible debt may be preferred by some groups and may be simpler to administer.

 

C. Interest Rates

The calculation of the applicable interest rate is extremely complicated, especially considering the interest rate differentials among the various outstanding debt obligations of the controlled members of the group. Allowing taxpayers to use the applicable Federal rate (AFR) (and not the AFR plus 3 percentage points) would substantially simplify this calculation. Currently, few taxpayers avail themselves of AFR plus 3 percent because the rate is too high.

 

D. Definition of Related Parties

Simplification would result by modifying which persons and producing taxpayers are "related persons." For example, 80 percent could be used instead of 50 percent in determining whether a related group of entities are considered to be related parties under the interest capitalization rules.

 

E. Consolidated Groups

In applying the interest capitalization rules to consolidated groups, simplification would result if the rules would follow FAS 34, which provides that, in applying the interest capitalization rules, intercompany indebtedness is eliminated. If this simplification is not adopted, other approaches would include:

  1. Provide that only intercompany indebtedness of the producing member is eligible debt.
  2. Provide an ordering rule that treats intercompany debt as eligible debt only after outside debt.
  3. Count debt only once, so that amounts that are lent more than once within the group are not doubled up.

 

F. Principal Purpose Test

To achieve maximum simplification while retaining a viable capitalization requirement, a partner (or S shareholder) should capitalize interest if the principal purpose of the partner (or S shareholder) for incurring the debt is the reduction of debt subject to interest capitalization at the partnership or S corporation level. This could be coupled with an antiabuse test.

 

DISTRIBUTIONS AFTER DEATH

 

This is one of six recommendations all designed to simplify minimum distribution requirements under IRC section 401(a)(9).

 

Present Law

Under current law, a participant in a retirement plan qualified under sections 401(a), 403(a) or 403(b), an individual retirement account or annuity under section 408, or a deferred compensation plan for employees of state or local governments or tax-exempt organizations is required to commence receiving distributions by the "required beginning date" (RBD) as that term is defined in section 401(a)(9)(C). When the participant dies, additional rules regarding post death distributions are triggered. These rules are complex, requiring extensive current regulations. One of the complexities is a difference under section 401(a)(9)(B) in the options available and the applicable rules for distributions that begin before or after a participantís death. Also, post-death distribution differs if they commence before or after the participantís RBD.

 

Recommended Change

Eliminate the distinction between distributions that begin before or after a participantís death. At death, distributions should be required to be paid over the life expectancy of the beneficiary and they should begin no later than one year after the decedentís death.

 

Contribution to Simplification

The current rules regarding distributions after death are extremely complex. The penalties for failure to make a minimum required distribution can run to 50 percent of the shortfall and/or tax disqualification of the plan. A consistent and simplified approach to post death distributions, in conjunction with other recommended changes we are suggesting, will simplify planning and reduce the pitfalls and penalties that taxpayers run afoul of in attempting to comply with the current rules.

 

DISTRIBUTIONS BEFORE RETIREMENT

 

This is one of six recommendations all designed to simplify minimum distribution requirements under IRC section 401(a)(9).

 

Present Law

Current law requires a trust or annuity for a retirement plan qualified under sections 401(a), 403(a) or 403(b) to begin making distributions to an employee by the "required beginning date" (RBD). The term RBD generally means April 1 of the calendar year following the later of:

  1. the calendar year in which the employee attains age 70 ½; or
  2. the calendar year in which the employee retires.

However, under section 401(a)(9)(C), effective for years beginning after December 31, 1996, (with narrow exceptions for certain Employee Stock Ownership Plans), an employee who is a "5-percent owner" (as that term is defined in section 416) must begin receiving distributions under the first option (age 70 ½) and cannot wait until retirement.

 

Recommended Change

If distributions are required to commence for certain owners before they retire, the ruleís application should be limited to 20 percent owners, where the present value of their accrued benefit exceeds $750,000.

 

Contribution to Simplification

Requiring distributions before retirement when an employee is still actively participating in a retirement plan adds unneeded complexity and expense to pension contribution and distribution calculations. In addition, the House Committee Report for Public Law No. 104-188, (Small Business Job Protection Act of 1996), the law that eliminated age 70 ½ as a distribution requirement for employees with less than a 5 percent ownership interest, stated simply that it is inappropriate to require all participants to commence distributions by age 70 ½ without regard to whether the participant is still employed by the employer. We concur with this statement and believe it should also be applied to many of the minority shareholder or owner employees who now fall outside its scope. If the objective of the law is to require employees to use the funds for retirement and not to build up an estate with tax deferred dollars, such a provision should be limited to those employees who are more likely to control their retirement date and who have built up significant tax deferred assets. We believe a cutoff of the rulesí application to employees with less than a 20 percent ownership interest or less than a $750,000 accrued plan benefit would meet that criteria.

 

PROHIBITION ON QUALIFIED PLAN LOANS

 

This is one of six recommendations all designed to simplify minimum distribution requirements under IRC section 401(a)(9).

 

Present Law

Current law imposes a 10 percent excise tax on prohibited transactions. One type of prohibited transaction is the lending of money or other extension of credit between a plan and a disqualified person. A plan participant is a disqualified person. However, the prohibited transaction rules generally exempt participant plan loans from the prohibited transaction tax. The exemption however does not extend to sole proprietors (including the individualís spouse, lineal descendants, brothers and sisters), or S corporation shareholders owning more than 5 percent of the stock (including the individualís spouse, lineal descendants, brothers and sisters). Further, current law states that a plan is not qualified if benefits provided under the plan are assigned or alienated. Participants who take plan loans and secure them with their account balance are considered to have assigned benefits unless the plan loan is exempt from the prohibited transaction tax. Because sole proprietors and certain S corporation shareholders and partners are not exempt from the prohibited transaction rules as they relate to loans, the making of a loan could also result in plan disqualification.

 

Recommended Change

Sole proprietors and subchapter S corporation shareholders and partners should be able to take loans from a qualified plan subject to the same rules available to other plan participants.

 

Contribution to Simplification

The inability of sole proprietors and certain partners and subchapter S corporation shareholders to borrow from qualified plans while allowing other types of plan participants to borrow from qualified plans creates an unnecessary state of confusion. While the law encourages these individuals to save for retirement through the providing of a tax deduction for plan contributions, it sets a trap for the unwary. Typically, those that get caught are small business persons who are unsophisticated or lack the financial means to receive sound professional advice. Besides the imposition of the 10 percent prohibited transaction tax, the plan could also be disqualified. These sanctions considered in the aggregate are extreme and harsh. The law, as it is written today, has two traps. First, individuals related to sole proprietors and certain S corporation shareholders and partners are also prohibited from taking plan loans. For example, an adult child who is not a shareholder in an S corporation, but who is an employee and a plan participant cannot take a plan loan simply because his or her father or mother owns the company. Second, when a shareholder in a regular corporation that has elected to be taxed as a subchapter S corporation has an outstanding loan, the loan will be considered to be a prohibited transaction on the effective date of the S corporation election unless it is repaid prior to the effective date. If the loan is not repaid, a prohibited transaction tax would be applicable as well as the possibility of plan disqualification. The lawís differing standard with regard to loans creates situations in which certain taxpayers taking loans find the consequences devastating. Because the ability to take loans exists for the vast majority of plan participants, it does not appear to be good tax policy to single out sole proprietors and certain partners and S corporation shareholders.

 

LIFE EXPECTANCY FOR PURPOSES OF THE MINIMUM DISTRIBUTION REQUIREMENTS

 

This is one of six recommendations all designed to simplify minimum distribution requirements under IRC section 401(a)(9).

 

Present Law

Under current law, a participant in a retirement plan qualified under sections 401(a), 403(a) or 403(b), an individual retirement account or annuity under section 408, or a deferred compensation plan for employees of state or local governments or tax-exempt organizations is required to commence receiving distributions by the "required beginning date" (RBD) as that term is defined in section 401(a)(9)(C). As a general rule, in calculating the required minimum distribution that must be made by the RBD and subsequent years, the participantís account balance (for defined contribution plans) must be divided by the life expectancy of the participant or the joint and last survivor life expectancy of the participant and his or her beneficiary. In determining life expectancy, section 401(a)(9)(D) provides that the life expectancy of the participant and the spouse may be redetermined annually. The regulations clarify that either the participantís or the spouseís life expectancy may be fixed at the time of the RBD or recalculated annually, but that any other beneficiaryís life expectancy must be fixed at the time of the RBD.

 

Recommended Change

Eliminate the ability to recalculate life expectancy annually.

 

Contribution to Simplification

The recalculated life expectancy method, which involves annual redetermination of life expectancy, is more complex than the fixed "term certain" method, which requires that life expectancy be determined once, at the RBD. This is particularly so if the life expectancy of each annuitant is determined under different methods. Furthermore, the recalculated method is a trap for the unwary in that once the participant or spouse using that method dies, their remaining life expectancy is 0. This requires the following yearís distribution to be significantly increased, or if that person is the second to die, a full distribution of the account balance. Eliminating the method simplifies the tax rules and tax planning by providing for an easy to calculate, predictable stream of distributions.

 

HALF-YEAR REQUIREMENTS

  

This is one of six recommendations all designed to simplify minimum distribution requirements under IRC section 401(a)(9).

 

Present Law

Section 401(a)(9) of current law requires distributions from various retirement plans to begin, under many scenarios, by April 1 of the calendar year following the calendar year in which the employee attains age 70 ½ . The retirement plans subject to this rule include:

· Qualified retirement plans under section 401(a) or 403(a);

· Individual retirement accounts and annuities under section 408;

· Tax deferred annuities under section 403(b); and

· Deferred compensation plans of state and local governments and tax-exempt organizations under section 457.

 

Failure to do so can result in a 50 percent penalty on the amount of the required distribution and/or disqualification of the plan.

 

In addition, section 72(1) imposes, subject to certain exceptions, a 10 percent additional tax on distributions from plans qualifying under sections 401(a), 403(a), 403(b) or 408 if the distribution is made before the plan participant attains age 59 ½ .

 

Recommended Change

Eliminate the various half-year requirements currently in use by reducing the age 70 ½ and 59 ½ requirements to ages 70 and 59, respectively.

 

Contribution to Simplification

The ½ year requirements are somewhat confusing to the unsophisticated taxpayer. Dropping the ½ year convention would make the requirements more user friendly.

 

DESIGN-BASED SAFE HARBOR FOR MINIMUM DISTRIBUTION REQUIREMENTS

 

This is one of six recommendations all designed to simplify minimum distribution requirements under IRC section 401(a)(9).

 

Present Law

The calculation of minimum required distributions under section 401(a)(9) is exceedingly complex requiring 42 pages in the current proposed regulations. The consequences of an insufficient or late distribution can be a 50 percent penalty on the amount of the distribution shortfall, and/or a tax disqualification of the plan.

 

Recommended Change

A design-based safe harbor should be considered. One possibility would be that a taxpayer commencing distributions at age 70 ½ could be allowed to elect to receive a minimum annual distribution of 10 percent of the account balance on the December 31 of the year he or she attains age 70 ½. Once determined, this amount would remain fixed and would be required to be received annually until the account is depleted.

 

Contribution to Simplification

A proposal similar to the one above would simplify the required calculations and reduce the chances of inadvertently running afoul of the penalty provisions.

 

DEFINED CONTRIBUTION KEOGH

  

Present Law

Under current law, contributions that do not exceed the lesser of 25 percent of compensation or $30,000 can be made to Keogh plans in a given year. The maximum compensation that can be considered for 1997 is $160,000. If a profit sharing Keogh plan is established, the maximum contribution that can be made is 15 percent of compensation. Therefore, considering the maximum compensation of $160,000, the maximum contribution to a Keogh profit sharing plan is $24,000. In order to contribute an additional $6,000 to a second plan, a money purchase pension Keogh plan would need to be established. This requires a separate plan document and trust as well as a separate accounting.

 

Recommended Change

Allow sole proprietors who have no employees to contribute the maximum contribution of $30,000 to a single profit sharing Keogh plan by increasing the percentage from 15 percent to 25 percent.

 

Contribution to Simplification

This change would eliminate the need for eligible individuals to establish two plans, two trusts and to keep two separate accountings. This would eliminate unnecessary administrative costs to both the Keogh plan holder as well as the bank, broker, insurance company or other investment company holding the assets. In addition, both the Internal Revenue Service and taxpayer would benefit from paper reduction by eliminating the need to file two Form 5500's each year.

 

THROWBACK RULES APPLICABLE TO DOMESTIC TRUSTS

 

Present Law

The throwback rules of Subchapter J of the IRC sections 665-669 generally treat a trust beneficiary who receives distributions of accumulated income as if the beneficiary had received the distributed amounts (including the taxes paid by the trust on them) in the year or years in which they were earned by the trust. The purpose of the throwback rules is to prevent avoidance of income taxes through the accumulation of income in one or more trusts at tax rates which are lower than the rates at which the trust beneficiary would have paid taxes with respect to the same income if it had been distributed.

 

Recommended Change

It is proposed that the throwback rules be repealed as far as they apply to domestic trusts. They would remain in the IRC and continue to apply to foreign situs trusts with U.S. beneficiaries. Because such foreign trusts would have paid no U.S. tax with respect to accumulations, the potential for abuse would still exist if the throwback rules did not still apply to foreign situs trusts. The throwback rules would still apply to multiple trusts, as provided in the legislation passed by Congress in 1992 and vetoed by President Bush.

 

Contribution to Simplification

The complex tax calculations imposed on the trust beneficiary and difficult record keeping burdens imposed on the fiduciary as a result of the throwback rules would be eliminated. The abuses sought to be corrected by these complex provisions arose as a result of the broad progressive rate schedule which made it profitable to use trusts as separate taxpayers rather than tax income and gain at an individualís top marginal rate. The rate compression put in place by the 1986 Tax Reform Act has rendered these provisions virtually obsolete in that most trusts are now taxed at rates equal to or greater than most individuals.

 

GIFT TAX RETURN EXCLUSION RULES

 

Present Law

Section 6019 requires a gift tax return be filed if a transfer is: (1) not excluded as a qualifying educational or medical expense (section 2503(e)), (2) in excess of the annual exclusion (section 2503(b)), or (3) to donees other than the donorís spouse (section 2523). Thus, a section 2522 charitable gift, which would result in no taxable gift and no gift tax, triggers a return filing requirement even if the charitable gift is the only transfer.

Currently, after excluding qualifying $10,000-per-donee annual transfers and transfers for educational and medical expenses, there are only two deductions to consider in computing taxable gifts. These are the deductions for (1) charitable gifts (section 2522) and (2) gifts to spouses (section 2523).

 

Recommended Change

Section 2522 charitable gifts should be statutorily exempted. Transfers qualifying as either exclusions from gift tax consideration or gifts to spouses are already statutorily exempted from any gift tax return filing requirement.

 

Contribution to Simplification

We believe many gift tax returns currently are required to be filed simply because a section 2522 charitable gift is made during the year. This results in unnecessary time and expense being incurred by both the taxpayer and the Internal Revenue Service.

 

UNIFIED CREDIT AND GENERATION-SKIPPING TRANSFER TAX EXEMPTION PORTABILITY BETWEEN SPOUSES

  

Present Law

Under current law, the $600,000 unified credit exemption equivalent amount and the $1 million Generation-Skipping Transfer Tax (GSTT) exemption of a first-to-die spouse will be wasted if such spouse does not make lifetime transfers and either (1) does not own enough property at the time of his or her death to utilize his or her unified credit and/or GSTT exemption or (2) bequeathed his or her entire estate to the surviving spouse.

However, portability between spouses of the unified credit exemption equivalent and the GSTT exemption amounts can be achieved by skillful drafting and "hedging" gifts.

Specifically, interspousal gifts can be made from the wealthier spouse, to the other spouse so that each spouse has at least $1 million of property. Depending upon the specific family circumstances, such a gift may raise concerns unless a qualified terminable interest property (QTIP) trust is used.

The will (or administrative trust) can then be drafted to avoid the loss of the benefit of the unified credit from overuse of the marital deduction by including a by-pass (credit shelter) trust bequest to the decedent's children (or other non-spousal beneficiary). Similarly, loss of the benefit of the GSTT exemption can be avoided with skillful drafting entailing the use of two marital trusts, one of which is a "Reverse QTIP" trust funded with the amount of the otherwise unused GSTT exemption.

Therefore, under current law, well-informed spouses can achieve portability of the unified credit exemption equivalent and the GSTT exemption through the use of lifetime interspousal gifts and transfers to non-spousal beneficiaries that may not have otherwise been made. Conversely. similarly situated uninformed spouses may pay unnecessary taxes when the exemptions are wasted.

 

Recommended Change

Allow the surviving spouse to utilize the unused unified credit exemption equivalent and GSTT exemption of the first-to-die spouse. This change would (1) result in similarly situated married persons being taxed in the same manner; (2) be consistent with the policy of treating spouses as a single economic unit; and (3) eliminate the need for lifetime hedging gifts and trusts that are created solely to ensure utilization of these examinations.

Under this recommended change, if the first-to-die spouse bequeaths his or her entire estate to the surviving spouse, a one-time (all or nothing) election could be made so that no estate tax would be imposed due to the marital deduction and the surviving spouse would be entitled to a $1.2 million unified credit exemption equivalent amount. Similarly, the surviving spouse would be entitled to a $2 million GSTT exemption where the entire estate of the first-to-die spouse is bequeathed to the surviving spouse.

 

Contribution to Simplicity

Simplicity would be achieved in two main areas. First, this change would eliminate the incentive to make lifetime hedging gifts between spouses that would not be desired for non-tax reasons. Second, this change would eliminate the need for some trusts that are created solely for tax purposes. Specifically, a by-pass (credit shelter) trust would not need to be established unless there was a non-tax reason for deflecting part of the decedent's estate from the surviving spouse. Similarly, there would be no need to establish a "Reverse QTIP" trust in order to utilize the first-to-die spouse's GSTT exemption; only one marital trust would be required.

 

Other Issues

Assuming that not all spouses are fully advised as to the techniques for avoiding loss of the unified credit exemption equivalent amount and/or the GSTT exemption, the proposal will involve some loss of revenue. However, revenue could be increased due to the fact that an estate tax may be imposed on the growth (during the time period between the deaths of the spouses) on the property that would otherwise have been transferred to a by-pass (credit shelter) trust.

Additionally, the portability of the unified credit exemption equivalent amount and the GSTT exemption amount also furthers the Congressional purpose of neutrality between spouses in common law property states with spouses in community property states. Spouses in community property jurisdictions are more likely to hold property in approximately equal amounts so that the credit and exemption benefit loss is less likely.

 

ESTATE TAX INCLUSION PERIOD REGULATIONS

  

Present Law

The $1 million Generation-Skipping Transfer Tax (GSTT) exemption may be allocated to lifetime gifts. For purposes of determining the amount of the allocation, the value of the property is determined as of close of the "estate tax inclusion period" (ETIP). An ETIP exists during the period in which the transferred property would have been includible in the transferorís gross estate had the transferor or the transferorís spouse retained an interest in the transferred property.

 

Recommended Change

Eliminate the complex (and universally misunderstood) ETIP regulations. The ETIP regulations should be replaced with a simplified rule that provides that an allocation of the GSTT exemption becomes final when a completed transfer is made. This would be a more understandable rule.

 

Contribution to Simplification

The ETIP regulations were designed to prevent taxpayers from "leveraging" the $1 million GSTT exemption by allocating the exemption prior to making a completed transfer. Leveraging of the GSTT exemption occurs when more than one dollar of transfer is exempted from the GSTT for each dollar of GSTT exemption used. The regulations are designed to prevent special tax planning that rarely occurs in the real world. Because the regulations are extremely complex and generally misunderstood, the effect of the regulations is to cause innocent taxpayers to make ineffective allocations of their GSTT exemption. These regulations cause significant uncertainty in determining, and thus planning for, a transferorís GSTT liability and are a trap for the unwary.

 

CHARITABLE LEAD ANNUITY TRUST RULES

 

Present Law

The inclusion ratio for a charitable lead annuity trust is determined under a special rule. This rule was enacted by Congress out of concern that the application of the general rule governing the computation of the applicable fraction would permit leveraging of the Generation Skipping Transfer Tax (GSTT) exemption. Leveraging of the GSTT exemption occurs when more than one dollar of transfer is exempted from the GSTT for each dollar of GSTT exemption used. Generally, in computing the denominator of the applicable fraction, the value of the property transferred to a charitable lead annuity trust is reduced by any estate or gift tax charitable deduction allowed on the transfer. The effect of this reduction of the denominator is to increase the applicable fraction, thereby reducing the inclusion ratio and the applicable rate of GSTT tax. However, in computing the charitable deduction, taxpayers must use present value assumptions that assume the trust earns a fixed rate of return based on the applicable federal rate during the month of the transfer or the applicable federal rate during either of the two previous months. The purpose of these rules is to prevent taxpayers from benefitting in the event the trust earns a greater return than that assumed in computing the applicable federal rate.

 

Recommended Change

Revoke section 2642(e) which imposes special rules solely on charitable lead annuity trusts. Under section 2642(e), the "applicable fraction" and "inclusion ratio" for a charitable lead annuity trust cannot be determined until the end of the trustís lead period (which may be many years in the future). As a result, a transferor cannot determine the correct amount of his or her GSTT exemption to allocate to the trust until the end of the lead period. Further, unlike other trusts, if the transferor over allocates his or her GSTT exemption to a charitable lead annuity trust, the excess amount is not restored to the transferor. The special rules should be eliminated in favor of more simple rules which use the applicable federal rate on the date the trust is established. If leveraging occurs, it will benefit both the charity and the noncharitable beneficiaries. As a result, the benefit will not cause an extraordinary benefit to the taxpayer.

 

Contribution to Simplification

The special rule for charitable lead annuity trusts is designed to prevent a very carefully designed, but rarely used, device to leverage the benefit of the $1 million GSTT exemption. Generally, taxpayers will not engage in transfers to charitable organizations for the sole purpose of benefitting themselves or their families. As a result, it is unlikely that this special rule would be used by taxpayers or tax practitioners. By designing a special rule to prevent a possible tax abuse that rarely, if ever, occurs in the "real world," Congress has unnecessarily caused the rules with regard to the allocation of the GSTT exemption to be unreasonably complex.

 

INCOME TAXATION OF POWERS OF APPOINTMENT

  

Present Law

Generally, the lapse of a general power of appointment is a taxable event for transfer tax purposes [IRC sections 2041(b)(2) and 2514(e)]. However, such a lapse is not subject to estate or gift tax to the extent the value of the property subject to the power in any calendar year does not exceed the greater of $5,000 or five percent of the value of the property from which an exercise of the power could have been satisfied. This "5 or 5 exception" is common in moderate-size trusts to give income beneficiaries access to small amounts of corpus without transfer tax consequences and without having to justify the distribution to the trustee based on some subjective criteria (such as health, maintenance, or support).

While the transfer tax consequences of a lapse of a power of appointment are relatively straightforward, the income taxation of such lapses are complex and confusing, and as a result, are often not reflected on income tax returns. While a holder of a general power of appointment is taxed under the grantor trust provisions of IRC section 678 for income tax purposes, there is no exception for trust beneficiaries whose withdrawal powers are limited to the $5,000 or 5 percent criteria ("5 or 5 power"). The mere holding of a 5 or 5 power subjects a portion of trust income to tax at the beneficiary level, regardless of whether the power is ever exercised, and that portion of the trust income continues to be taxed to the beneficiaries even in years after such 5 or 5 power is allowed to lapse. In many situations, the 5 or 5 power lapses annually, which over a period of years would cause the holder to be treated as owner of a progressively larger share of trust property for income tax purposes. This seems inconsistent with the underlying purpose of the 5 or 5 power.

In addition, current IRC section 678(a)(2) contains several troublesome ambiguities that add uncertainty to the income taxation of powers of appointment. The reference to a previous "partial" release of a power creates confusion, since there is no indication as to the purpose of the word "partial," and raises the question of whether a partial release is to be treated any differently than a complete release. The same paragraph also refers to retained "control," which may be misleading in certain situations. Finally, IRC section 678(d), which refers to the income tax effect of a disclaimer of a general power of appointment, is unnecessarily vague with respect to when such a disclaimer must be made and does not conform to the requirements of IRC section 2518, the transfer tax statute governing qualified disclaimers.

 

Recommended Change

To correct the deficiencies and ambiguities in the current law, to promote compliance, and to simplify administration, the following changes should be made to IRC section 678:

1. Subsection (a)(2) should be amended as follows:

(2) such person has previously partially released or otherwise modified such a power and after the release or modification retains such interest or control as would, within the principles of sections 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner thereof.

2. There should be added a new subsection (d) which will read as follows:

(d) Exception for five or five powers. Subsection (a) shall not apply with respect to a power the lapse of which would not be treated as a release of such power under chapters 11 and 12 of this subtitle by virtue of section 2041(b)(2) and 2514(e).

3. Present subsection (d) should be renumbered as subsection (e) and should be amended as follows:

(e) Effect of renunciation or disclaimers. Subsection (a) shall not apply with respect to a power which has been renounced or disclaimed within a reasonable time after the holder of the power first became aware of its existence to the extent the power holder has made a qualified disclaimer thereof within the meaning of section 2518 of chapter 12 of this subtitle.

4. Present subsection (e) should be renumbered as subsection (f).

 

Contribution to Simplification

The recommended changes to IRC section 678 eliminate ambiguities and difficult computations, as follows:

1. Recommended change #1 eliminates troublesome ambiguities in the current statute. Elimination of the word "partial" in IRC section 678(a)(2) eliminates the possibility that a partial release of a power of appointment is to be treated any differently than a complete release of such a power. Changing retained "control" to retained "interest or control" clarifies that a power holder who retains only a right to income while releasing the power will continue to be treated as an owner, even if he or she cannot control dispositions of trust property.

2. The addition of proposed new IRC section 678(d) would eliminate the need for the trustee to allocate a fraction of each item of income, deduction, and credit to the power holder in years in which a 5 or 5 power is allowed to lapse and in subsequent years.

3. Recommended change #3 conforms the income tax rules to the transfer tax rules concerning qualified disclaimers and eliminates the ambiguity of the current statute as to when a disclaimer of a power of appointment is to be effective.

 

Other Issues

1. Effective date: The proposed changes should apply to powers created on or after the date of enactment.

2. Transition: Holders of a general power of appointment on the date of enactment would be able to elect to apply the revised provisions as of the first day of the first tax year beginning after the date of enactment.

3. Revenue impact: There should be only a de minimis revenue impact resulting from the proposed legislative changes. The net effect will likely be a small revenue increase resulting from taxation of income under the compressed trust and estate tax rate structure instead of under the individual income tax rates.

 

PROPERTY TRANSFERRED INTO A TRUST AT GRANTORíS MARGINAL RATE

  

Present Law

Section 644 seeks to prevent the use of trusts to avoid tax on capital gain at high marginal rates by providing that if appreciated property is given to a trust and the trust sells the property within 2 years, that appreciation will be taxed at the grantorís highest marginal tax rate.

 

Recommended Change

Section 644 should be repealed.

 

Discussion

In the case of the section 644 rules taxing gains in a trust at the grantorís marginal rate, it is difficult to obtain all the necessary tax return information from the grantor to complete the trustís return. There is no realistic possibility of using trusts for lower brackets. The capital gains rates are approximately the same, so trusts are no longer a low bracket accumulation device. Section 644 does not accomplish anything as this was passed when there was progressivity in the trust tax rates. Since there are now compressed tax rates, trusts pay 28 percent on income over $1,600. Therefore, the government is not receiving any additional revenue due to this provision.

 

Contribution to Simplification

The repeal of section 644 will eliminate the computations and problems in completing trustsí tax returns.

 

GENERATION-SKIPPING TRANSFER TAX

  

Present Law

Every generation skipping transfer is potentially subject to tax, with record keeping required whenever a donor makes a taxable transfer to a grandchild, with possible calculations included on the estate and gift tax return Forms 706 and 709. There is a $1 million per-donor lifetime exclusion from the tax that is accounted for on the forms. Definitions and computations are complex, and although the tax rarely applies, record keeping is required. The tax is intended to discourage generation skipping to avoid transfer taxes, and results in some additional gift and estate taxes.

Taxpayers make generation skipping transfers for personal reasons, such as strong feelings for grandchildren, and for tax avoidance reasons, to avoiding successive applications of transfer taxes as wealth is passed down through the generations. Because of the high level of the Generation Skipping Transfer Tax (GSTT), a $1 million per-donor exclusion, and the natural tendency to provide for oneís children first and hope that they will provide for future generations, there is little generation skipping tax paid, but the tax may serve its purpose of preventing dynastic succession of wealth. Generally, generation skipping for tax avoidance is only an issue for the very wealthy, although all income levels might wish to leave property to grandchildren for personal reasons.

 

Recommended Change

The Generation Skipping Transfer Tax should be repealed.

 

Contribution to Simplification

Record keeping for generation skipping transfers would be eliminated, entire sections of Forms 706 and 709 would be eliminated, and 22 IRC sections would be eliminated. These are particularly difficult IRC sections, with complex computations and definitions. Record keeping towards the $1 million exclusion could be eliminated. Those who make generation skipping transfers for personal reasons should not have the severe sanction of the GSTT. There would be natural curbs on abuse, with the inclination to care for children, and the unlikelihood of an overwhelming relationship being developed with an infant great grandchild. Rarely would anyone seek to give more than the $1 million allowed under present law ($2 million for a married couple).

 

SECTION 2642(c)

 

Present Law

Lifetime gifts that are excludable in computing the gift tax also are excludable in computing the Generation Skipping Transfer Tax (GSTT) if such gifts are direct skips. However, a lifetime direct skip to a trust that is for the benefit of an individual and that qualifies for the annual exclusion will be subject to GSTT unless the trust requires that: (1) the income or corpus may be distributed during the life of the individual only to that individual and (2) if the individual dies before the trust is terminated, the asset held in the trust must be included in the individualís gross estate.

 

Recommended Change

If complete repeal of GSTT is not possible, then repeal retroactively section 2642(c), which disallows the $10,000 annual exclusion for GSTT purposes for certain transfers in trust. Section 2642(c) has caused much confusion among practitioners and in many cases requires a gift tax return to be filed solely for purposes of allocating GSTT exemption.

 

Contribution to Simplification

The additional requirements placed on transfers in trust (e.g., income or corpus may be distributed during the life of the individual only to that individual and if the individual dies before the trust is terminated, the asset held in the trust must be included in the individualís gross estate) were imposed as an afterthought by Congress to prevent subsequent generation skipping transfers from a trust from benefitting from a zero inclusion ratio, as well as to prevent the annual exclusion from shielding appreciation in trust assets from transfer taxes. This position has caused considerable confusion. More importantly, however, the position is not supportable under the general provisions of the transfer tax system. In essence, this provision penalizes individuals who establish trusts for their grandchildren, rather than providing the grandchildren with outright gifts. Arguably, it may be more beneficial to establish a trust arrangement when giving a significant amount of assets to a younger generation family member to ensure that the transferred assets are handled in a responsible manner. Since tax policy has become interwoven with social policy, it seems more sensible to have it support the transfer of assets in a responsible manner.

 

ALLOCATION TO A SINGLE TRUST

 

Present Law

Transferors that allocate the $1 million Generation Skipping Transfer Tax (GSTT) exemption to transfers in trust must allocate the exemption to the entire trust. Because an allocation cannot be to a specific share of a single trust, two or more trusts must be created so that the allocation can be made to cause at least one trust to be exempt from GSTT.

 

Recommended Change

If complete repeal of GSTT is not possible, then allow a transferor to allocate his or her GSTT exemption to a specific share of a single trust (rather than to the entire trust). This would enable separate shares of a single trust to be treated as either exempt from GSTT or not exempt from GSTT based on the transferorís allocation of GSTT exemption thereto. Currently such treatment requires the use of two trusts (e.g., an exempt trust and a nonexempt trust). This change should apply to both inter vivos trusts and testamentary trusts.

 

Contribution to Simplification

The requirement that the GSTT exemption must be allocated to a single trust creates unreasonable complexity and favors taxpayers who can afford to hire special advisors to carefully structure their estate planning. The National Office of the Internal Revenue Service has taken a very narrow view of the allocation of the GSTT exemption, is based on a literal reading of the statute. It is doubtful that when the GSTT legislation was drafted such a narrow view was anticipated. As a result, considerable progress toward tax simplification could be made if the GSTT exemption could be allocated to a specific share of a single trust.

 

EARNINGS AND PROFITS

 

Present Law

Under present law, a comprehensive definition of earnings and profits (E&P) does not exist in the IRC, the Treasury Regulations or in any single judicial decision. The definition of E&P is developed by carefully reading a long list of IRC provisions, cases, regulations, rulings and non-authoritative writings. Uncertainty as to the definition of E&P appears to be a major contributor to compliance gaps relative to current tax law and creates unnecessary complexity in this area.

Currently there are two methods to calculate E&P, the taxable income approach (which may not be difficult to apply, but may become tedious in its application) and the residual value or balance sheet approach (which is premised on the residual value of E&P after corporate separations). Overlaid on these methods are concepts of the overall method of accounting and various operating rules concerning distributions. These operating rules are complicated where a corporation has a deficit in either current or accumulated E&P. Finally, many of the provisions of the IRC which address E&P issues are narrow in scope, impact unique tax entities or describe the results of highly specialized transactions.

 

Recommended Change

Replace the current construct of E&P with a single statutory definition under section 312 of the IRC and allow an election in the calculation of E&P. Those corporations which cannot or elect not to calculate E&P using a specified "fresh start" approach should be permitted to use retained earnings of the corporation as of the date of enactment of the statute.

 

Contribution to Simplification

This would provide a single statutory method of computing E&P under section 312 on a going forward basis that both the government and taxpayer can comprehend.

 

OWNERSHIP ATTRIBUTION RULES

  

Present Law

The purpose of the attribution rules is to identify circumstances where ownership of stock is deemed to exist due to the presumed relationship between the actual owner and the person to whom the stock is being attributed. Since the underlying policy objective is essentially the same for each set of attribution rules, this is an area in which substantial simplification can be accomplished with minimal disruption.

Currently, there are nine IRC sections that contain specific rules for stock attribution. Additionally, there are numerous references to these nine attribution sections elsewhere in the IRC. Many of these references modify the nine IRC sections resulting in additional variations of the attribution rules.

The proliferation of stock attribution rules has occurred because, frequently, when a new provision has been enacted, the drafters have tried to identify and address the exact relationships that would be covered. Each search for the ideal set of attribution rules seemingly ignored the wide variety of already-existing statutory attribution rules. As each new set of attribution rules became law, its own set of regulations, administrative pronouncements, and case law ensued.

 

Recommended Change

Repeal all existing stock attribution rules. In their place, a single set of stock attribution rules will provide significant simplification and improved administration of the tax law by both taxpayers and the IRS. The proposal is divided into three primary parts: 1) family attribution, 2) entity attribution, and 3) option attribution.

Family attribution: An individual is considered to own stock owned by his or her spouse, children, grandchildren, parents and grandparents.

Entity attribution: The owner of a partnership, corporation, estate or trust is deemed to own proportionally whatever stock the entity owns. An entity is deemed to own proportionally whatever stock the entity owns. An entity is deemed to own proportionally whatever stock is owned by its shareholders, partners or beneficiaries. In certain situations, entity attribution does not exist unless the owner owns more than 50 percent of the entity.

Option attribution: The general rule is that options will be treated as having been exercised unless a safe harbor test is satisfied. The safe harbor tests are similar to rules recently promulgated in Regulation section 1.1504-4. This recommended change is significantly different than current attribution rules where options are always treated as exercised even though there is little likelihood the options will ever be exercised.

 

Contribution to Simplification

One of the primary goals of a tax system is certainty. Currently, taxpayers and their advisors must deal with so many variations in the attribution rules that many relevant IRC sections must be consulted to ensure proper reporting. Moreover, with so many sections modifying various basic IRC sections, it is difficult to even know if all relevant provisions have been addressed.

One recently enacted example of this complexity is the related party definition of section 197(f)(9)(C). This provision states that a person is related to any person if the related person bears a relationship to such person specified in sections 267(b) or 707(b)(1), or the related person and such person are engaged in trades or businesses under common control within the meaning of section 41(f)(1)(A) and (B). If the reference to the three different IRC sections is not confusing enough, the provision further states that "20 percent" is substituted for "50 percent" in applying sections 267(b) and 707(b)(1). Section 267(b)(3), in turn, provides that two corporations that are members of a controlled group as defined in section 267(f) are related. Section 267(f), in turn, refers to but modifies section 1563. Does this mean that the substitution of 20 percent for 50 percent should be extended to section 267(f), and subsequently to section 1563? The usage of multiple attribution sections makes this provision virtually incomprehensible. Such a result is unnecessary and not good tax policy. Enacting just one set of stock attribution rules would greatly reduce this type of complexity.

The proposed single attribution IRC section would provide for one set of family, entity-to-owner, owner-to-entity, and option attribution rules. Developing one IRC section with one set of attribution rules will not only simplify the IRC, it will provide more certainty for taxpayers and their advisors in the planning and reporting of transactions. In addition, such a change will provide the IRS with a much more administrable set of rules.

A single set of stock attribution rules may not result in the ideal set of relationships for each and every situation. The advantage, however, of a single set of attribution rules is a manageable system that both the government and taxpayers can comprehend. In addition, we believe that it would not compromise any substantial purpose of the rules in the process. This proposal does not introduce complex new concepts, but rather utilizes already established attribution concepts. Likewise, this proposal does not address the definitions of control or related parties. The objective of this proposal is to accomplish simplification and standardization by providing a single set of understandable stock attribution rules.

 

SAFE HARBOR PROVISIONS FOR CORPORATE ESTIMATED TAX PAYMENTS

  

Present Law

The Omnibus Budget Reconciliation Act of 1987 (the Act) consolidated the corporate estimated tax rules into one section of the IRC, similar to the provision enacted for individuals by the Deficit Reduction Act of 1984. Corporations generally are required to make estimated tax payments in an amount equal to the lesser of (1) 100 percent of the tax shown on the return for the taxable year, or (2) 100 percent of the tax shown on the return of the corporation for the preceding taxable year. The Act deleted the exception that allowed a corporation to avoid a penalty for underpayment of estimated taxes in the current year if its estimated tax payments were computed by applying the current yearís tax rates to the facts shown on the return of the corporation for, and the law applicable to, the preceding year. This change effectively prevented corporations from using the lower corporate rates enacted in the Tax Reform Act of 1986 without picking up the new broader tax base.

Except for its first installment, a large corporation must base its estimated tax payments on current yearís facts using current year tax rates, and may not use 100 percent of its prior-year tax liability to avoid a penalty for underpayment of estimated taxes. A large corporation generally is defined as any corporation (or predecessor corporation) that had taxable income (with certain modifications) of $1 million or more during any of the three taxable years immediately preceding the taxable year involved.

The exception based on 100 percent of the prior yearís tax is not available to any corporation whose preceding taxable year consisted of less than 12 months, or whose prior yearís tax return did not show a tax liability.

 

Recommended Change

Corporations, other than large corporations, would be permitted to base their estimated tax payments for the current year on 100 percent of the tax shown on the return for the preceding year, notwithstanding that the preceding taxable year consisted of less than 12 months, or that the prior year return showed no tax liability. Large corporations would continue to be permitted to base only their first installment on 100 percent of the prior yearís tax liability.

 

Contribution to Simplification

The accurate computation of estimated tax payments is difficult for many corporations that paid no tax in the previous year. These corporations are often small companies that do not have the staff and resources required to accurately compute the companyís taxable income on a quarterly basis. The payment of 100 percent of the prior yearís tax is limited to corporations not meeting the definition of a "large corporation," whose prior year tax returns showed a tax liability and covered a period of 12 months. Thus, a corporation that incurred only a $1 tax liability in the preceding year can avoid making estimated tax payments, while a corporation that paid no tax the preceding year must make estimated tax payments based on current yearís income if it expects to incur a tax liability in the current year. The proposed change would eliminate an unnecessary recordkeeping burden for small companies that incurred no tax liability in their preceding taxable year.

 

COLLAPSIBLE CORPORATION RULES

  

Present Law

The IRC recharacterizes the gain recognized upon the sale or liquidation of stock of a "collapsible corporation" as ordinary income. A collapsible corporation is a corporation formed or availed of principally for the manufacture, construction or production of property, or the purchase of certain property, with a view to the sale or liquidation of the stock prior to the realization of at least 2/3 of the taxable income to be derived from such property. The statute is replete with an array of assumptions and exceptions.

 

Recommended Change

The collapsible corporation rules of section 341 should be repealed.

 

Contribution to Simplification

The repeal of section 341 would eliminate a relic of the tax code originally enacted in 1950 and rendered largely obsolete as a result of the Tax Reform Act of 1986 (the Act).

The collapsible corporation rules of section 341 are cited by many commentators as an example of unneeded complexity due to their ambiguity, even after many years of existence, and their overreaching breadth. Although originally designed to apply to abusive transactions in the film and real estate industries, section 341 was drafted so broadly that many closely-held corporations are potentially collapsible corporations.

Before the collapsible corporation rules were enacted, the law accommodated the abuse targeted by section 341 in that the then present, General Utilities doctrine provided the buyers of collapsible corporations a variety of means of liquidating the subject corporation without the incidence of corporate level taxation of the future stream of business earnings. The Act eliminated all vestiges of General Utilities thereby assuring corporate level taxation upon the sale or liquidation of corporate assets. Buyers today would undoubtedly discount purchase price attributable to future corporate level taxation of the target corporation. The absence of any material abuse potential calls for the repeal of an overly complex relic of the past.

The current tax preference bestowed investorsí capital gains attributable to capital assets held for at least one year is diametrically at odds with the collapsible corporation rules which attempt to recharacterize capital gain as ordinary income. Any policy in favor of tax preferences for risk capital greatly outweighs any resemblance of a continuing policy in favor of the collapsible corporation rules.

In the advent of multiple choices of non-taxable business entities other than corporations available to closely-held business owners (e.g., partnerships, S corporations and limited liability companies) the collapsible corporation rules are truly a trap for the unwary.

 

ADJUSTED CURRENT EARNINGS ADJUSTMENT

 

Present Law

Under present law, adjusted current earnings (ACE) is determined on a separate basis from alternative minimum taxable income (AMTI) after all other AMTI adjustments have been made (other than the accumulated minimum tax net operating loss (AMTNOL) deduction). ACE is essentially a redetermination of pre-ACE AMTI and is calculated by substituting up to 11 separate categories of differing ACE treatments for AMTI treatments. These different ACE treatment relate to: 1) depreciation, 2) items that are included in earnings and profits but not in pre-adjustment AMTI, 3) items that are deductible in determining pre-adjustment AMTI but are not deductible in determining earnings and profits, 4) intangible drilling costs, 5) amortization of circulation expenses and organization costs, 6) LIFO, 7) installment sales, 8) losses in exchange of debt pools, 9) depletion, 10) ownership changes and 11) basis adjustments. After ACE is determined, 75 percent of the difference between ACE and pre-adjustment AMTI is added to (or, as limited, subtracted from) pre-adjustment AMTI to result in AMTI (before deduction for AMTNOL).

 

Recommended Changes

The separate ACE adjustment of section 56(g) should be repealed. The ACE system should cease as of the taxable year ending on or after the effective date of this recommended legislation and ACE treatment for all items should no longer exist.

 

Contribution to Simplification

The ACE system introduces unwarranted complexity and duplication to the calculation of the alternative minimum tax (AMT). ACE, as a separate system, has its own treatment of specified items that differs from AMTI and taxable income. This introduces a third set of calculations necessary to determine federal tax liability; taxable income, AMTI and ACE. Since ACE is both a separate system and an adjustment to AMTI, there are two distinct treatments which must be tracked for many items to determine the amount of AMT. Asset basis affected by differing ACE treatment must be separately tracked for ACE as well as AMTI. Obviously, ACE, as a third system, greatly increases the compliance burden and cost. In addition, the parallel system concept makes the determination of ACE as burdensome as determining AMTI. Both systems require a separate redetermination of taxable income using their particular methods. It particularly seems pointless to have a third system, ACE, which itself is merely an adjustment to the second system. Such a complicated and redundant system is both costly and unnecessary to achieve the goal of AMT. The original goal of ACE, as a backstop to AMTI to ensure that corporations with significant earnings pay some tax, can be achieved by the removal of the ACE adjustment and the introduction of certain ACE components directly into AMTI.

 

SMALL BUSINESS EXCEPTION

 

Present Law

Under current law, alternative minimum tax (AMT) applies to all corporations regardless of size. The AMT system is a complex tax system which requires a complete recalculation of taxable income. This complexity adds unnecessary expense and encourages noncompliance, especially for small businesses.

 

Recommended Changes

Any corporation with average gross receipts for the prior three years not greater than $10 million should be excluded from the AMT rules. If the moving three-year average of gross receipts exceeds $10 million, the AMT rules would apply.

A small business exception to AMT should be extended to other forms of small business ownership, including partnerships, S-corporations and sole proprietorships.

 

Contribution to Simplification

Elimination of small corporations from the AMT calculation would advance the cause of simplification by reducing the compliance burden to small corporate businesses. This would eliminate much additional recordkeeping and associated costs currently required to calculate the AMT. The AICPA is willing to assist in developing a small business exception to AMT for noncorporate taxpayers.

 

PERSONAL HOLDING COMPANY TAX AS APPLIED TO CONSOLIDATED RETURNS

 

Present Law

The personal holding company rules penalize closely held corporations for excessive passive earnings in the absence of an actual or deemed distribution of such earnings to their shareholders. The rules are designed to prevent individuals from "incorporating their pocketbook" in order to defer shareholder taxation of the earnings until distributed. Generally, if a corporation has five or fewer shareholders owning more than 50 percent of its stock ("shareholder test") and at least 60 percent of the adjusted gross ordinary income of the corporation is from enumerated personal holding company income sources ("income test") the corporation is a personal holding company. The penalty is imposed in the form of an additional corporate tax equal to the highest individual tax rate, currently 39.6 percent, imposed on undistributed personal holding company income.

The testing for personal holding company status differs when an affiliated group of corporations files a consolidated tax return. Each corporation must engage in a separate company test in order to determine whether the group applies the income test on a separate company basis or a consolidated basis. Generally, separate company income testing is required if any member of the affiliated group has 10 percent or more of its adjusted ordinary income from sources outside the affiliated group and at least 80 percent of it is personal holding company income.

 

Recommended Change

The separate company income testing to determine whether a consolidated group measures for personal holding company on a separate company or consolidated basis should be stricken from the personal holding company rules. The income test should expressly be made a consolidated test.

 

Contribution to Simplification

The current rule creates an undue burden which is both bad policy and a proverbial trap for the unwary. Consolidated tax return principles would be further enhanced and better understood by taxpayers if the personal holding company income test were also done on a consolidated basis. In other words, the 60 percent adjusted gross income determination would be done on a consolidated basis without regard to intercompany items. The current rule which requires separate company computations for each affiliated group member would be rendered obsolete.

 

ACCUMULATED EARNINGS TAX CREDIT LIMITS

 

Present Law

Under present law, the accumulated earnings tax penalizes both public and private C corporations for unreasonably accumulating earnings at the corporate level. The proving or disputing of unreasonable accumulated earnings is very subjective and requires the examining of a myriad of factors including the current and projected reasonable business needs, the type of assets and income a corporation owns, and the amount of accumulated earnings and profits a corporation has earned over its lifetime.

A lifetime deduction (actually labeled a credit in section 535(c)(2) for any corporation or group of affiliated corporations) is $250,000. If the corporation is classified as a personal service corporation, the lifetime limit is $150,000. The $250,000 limit was enacted in 1981 and has not been adjusted for inflation in over fifteen years.

 

Recommended Change

The $250,000 and $150,000 credit limits would be raised to $450,000 and $270,000, respectively, to reflect the inflation factor for the last fifteen years. These credit limits should be adjusted at the beginning of each year following the year of enactment to reflect the change in inflation for the prior year.

The Consumer Price Index Annual Change for the period 1982 through 1996 is approximately four percent per year, which on a compounded basis yields an inflation index of 180 percent.

This proposed change to section 525(C)(2) would better reflect the economic realities of business.

 

Contribution to Simplification

This recommended change will help many small businesses avoid a significant trap for the unwary. Primarily, this change would exempt many marginally profitable companies from a very subjective tax provision. It would also eliminate the need for many small companies to prove their reasonable business needs to IRS agents on audit and avoids the computing of the complicated Bardahl formula on an annual basis.

 

EXCEPTION TO MARKET DISCOUNT RULES FOR TAX-EXEMPT OBLIGATIONS

  

Present Law

The Omnibus Budget Reconciliation Act of 1993 extended the market discount rules to tax-exempt bonds purchased after April 30, 1993. As a result, any market discount recognized on tax-exempt bonds is taxable as ordinary income. To the extent that a market discount bond is disposed of at a gain, the portion of the gain that represents accrued market discount is treated as ordinary income instead of capital gain.

 

Proposed Change

Restore the exception to the market discount rules for tax-exempt obligations purchased after April 30, 1993.

 

Contribution to Simplification

Under current law, investors who realize a gain upon disposition of a tax-exempt bond are required to perform a series of complex calculations to determine if a portion of the gain is taxable as ordinary income instead of capital gain. Investors must first analyze all sales at a gain and determine which lots were purchased at a discount. If purchased at a discount, further analysis is required to determine if the discount is OID (original issue discount) which is tax free, market discount which is taxable, or a combination of the two. Finally, calculations to accrue the discount must be performed, and the gain then bifurcated into its ordinary and capital portions. To accurately perform these calculations requires original issue information which is not readily available unless the bond is purchased at original issue, and the use of discount accretion schedules best developed with a computer program. The amounts of market discount resulting from this complex law are generally quite small.

One reason for these small amounts of market discount recognition on tax-exempt bonds is that the law has reduced liquidity in the tax-exempt bond market. In a period of falling bond prices when market discount is created, sophisticated institutional investors are not motivated to sell to new buyers when a bond is worth less to the new buyer on an after-tax basis than to the current holder. As a result, large portions of this trillion dollar market do not readily turn over and secondary market trades tend to price nearer par. A second reason for small amounts of market discount being recognized on tax-exempt bonds is that smaller retail investors are generally unaware of the existence of these rules resulting in considerable noncompliance in this area. Even if an individual investor is aware of these provisions, the complexities involved make it difficult to comply.

Finally, this law has imposed additional burdens on the mutual fund industry besides the complexities noted above. Because funds are required to distribute ordinary taxable income even though market discount amounts are small, a tax-free fund may find itself in the position of needing to declare a dividend of a small fraction of a cent per share. Often the cost of processing and mailing out the dividend information exceeds the total required amount of the dividend. Furthermore, extending the market discount rules to tax-free funds has inadvertently imposed additional burdens on funds seeking to comply with the excise tax distribution requirements of section 4982. For purposes of these rules, capital gains are measured on a November 1 - October 31 basis. However, ordinary taxable income under these rules must generally be measured on a January 1 - December 31 basis. These different measurement periods for capital gains and market discount create difficulties for funds in determining, declaring and distributing the proper amount at year end in order to avoid an excise tax liability.

 

POLICY ACQUISITION EXPENSES FOR REINSURANCE TRANSACTIONS

  

Present Law

Section 848, enacted as part of the Omnibus Budget Reconciliation Act of 1990, requires insurance companies to increase their taxable income by capitalizing and amortizing certain policy acquisition expenses. The amount required to be capitalized is determined on an accrual basis as a specified percentage of net premiums for certain contracts, not to exceed the insurance company's general deductions for that taxable year. Section 848(d)(4)(B) provides that the Secretary shall prescribe such regulations as may be necessary to ensure that premiums and other amounts with respect to reinsurance agreements, under which one insurance company takes on part or all of the risk of another insurer, are treated consistently by both companies.

Under the regulations for section 848, the two insurers who are parties to a reinsurance agreement are each required to net all amounts attributable to the agreement. For any particular year, one party will have a net positive amount subject to capitalization (the "Income Insurer"); and the other will have a net negative amount (the "Deduction Insurer"). The regulations do not allow the Deduction Insurer to reduce its taxable income for its net negative amount unless it can "demonstrate" that the Income Insurer included the corresponding amount in calculating its taxable income. Such a demonstration cannot be easily done, since the amount included by the Income Insurer may be limited to the amount of its general deductions that are attributable to the reinsurance agreement and the companies do not have access to each otherís books and records.

The regulations do allow the Deduction Insurer to use all of its negative amount if both insurers make an irrevocable election under Treasury Regulation section 1.848-2(g)(8) to determine the amounts to be capitalized without regard to the general deductions limitation. This regulation requires that the parties making the election agree to exchange information pertaining to the amount of net consideration under the reinsurance agreement each year to ensure consistency. Exchanging and reconciling confidential tax information imposes a significant time and expense burden on both parties, particularly on reinsurance companies with thousands of reinsurance agreements with hundreds of other companies. Prior to the issuance of these regulations in 1992, insurance companies entering into reinsurance agreements were not required to exchange information from their respective tax returns.

 

Proposed Change

Amend section 848(d)(4)(B) to provide that an insurance company will be able to use all of its negative amount if it has obtained a representation from the other party to the reinsurance agreement that it will include, in its calculation of taxable income, the full amount attributable to the agreement without regard to the general deduction limitation. In connection with such amendment, provide that parties to reinsurance agreements who have previously made an election under Treasury Regulation section 1.848-2(g)(8) may revoke their elections.

 

Contribution to Simplicity

Removing the requirement that parties to a reinsurance agreement agree on the amount attributable to the agreement that must be capitalized would streamline tax compliance. Requiring taxpayers to exchange confidential tax return information could create continuing problems if tax return information is adjusted on audit by the IRS. Overall tax compliance would be much simpler if the companies were not required to interact with each other after the original basic transaction was completed.

 

Other Considerations

Treasuryís failure to provide clarification regarding the "demonstration" requirement in Treasury Regulation section 1.848(d)(4)(B) has, in effect, forced taxpayers to make the election under Treasury Regulation section 1.848-2(g)(8) which requires the parties to exchange information each year for each reinsurance agreement so as to ensure that they use consistent amounts. Meeting this requirement has proven to be extremely time consuming and nearly impossible in many cases. While the amounts involved are determined on an accrual basis, there are a number of reasons why the insurers might appropriately reach different totals. The parties may close their books at different times and/or may use different methods to estimate certain reserves. Questions may arise as to when bills or claims were received or accrued. Information may not be received until after tax returns have been completed. The requirement for consistency on an agreement by agreement basis is further complicated when the same parties have several agreements.

 

LIFE-NONLIFE CONSOLIDATION

 

Present Law

Prior to 1981, life insurance companies were not allowed to join in filing a consolidated tax return with affiliated corporations who were not life insurance companies. Sections 1503(c)and 1504(c)(2), enacted as part of the Tax Reform Act of 1976, allow life insurance companies which have been members of an affiliated group for at least 5 years to file consolidated tax returns with affiliated nonlife insurance corporations, but restrict the amount of loss available for offset against life insurance company income.

 

Proposed Change

Repeal sections 1503(c), 1504(b) and 1504(c)(2), thereby allowing life insurance companies the same consolidation privilege as is granted most other corporations under the IRC.

 

Contribution to Simplicity

The elimination of these provisions, and the regulations that support them, would reduce the additional calculations needed to prepare the consolidated tax return and the record keeping necessary to track eligible and ineligible loss carryforwards, and eliminate the need for taxpayers to use various tax planning techniques and strategies in order to ensure full utilization of consolidated losses within the carryforward period. In addition, it would reduce a financial reporting problem of justifying the deferred tax asset associated with loss carryforwards.

 

Other Issues

The distinction between the taxation of life insurance companies and other corporations has, for all practical purposes, disappeared. Life insurance companies are now taxed on their entire income, both investment and underwriting. In addition, life insurance companies, like all other corporations, are subject to the alternative minimum tax provisions which ensure that corporations pay at least some tax on their financial reporting income. As a result, there is a no longer a logical or fair rationale for treating life insurance companies different from other corporations.

 

CONSISTENT APPLICATION OF POLICY INTEREST RATES

 

Present Law

Under section 812(b)(2)(A), the required interest portion of policy interest is determined using the greater of the prevailing State assumed rate or the applicable Federal interest rate whereas the excess interest portion under section 808(d)(1)(B) uses only the prevailing State assumed rate. This inconsistency may cause an overlap or shortfall in the amount of policy interest.

 

Proposed Change

Change section 808(d)(1)(B) to read "the greater of the prevailing State assumed rate or the applicable Federal interest rate" in computing excess interest.

 

Contribution to Simplicity

This would eliminate the need for taxpayers to maintain separate interest rate files for reserves and excess interest. It would also eliminate the overlap between the required interest and excess interest portions of policy interest.

 

REPORTING OF FOREIGN INCOME TAXES PAID BY REGULATED INVESTMENT COMPANIES UNDER SECTION 853

 

Present Law

IRC section 853 provides that if a Regulated Investment Company (RIC) meets certain requirements, it may elect to pass through the benefit of a foreign tax credit or deduction to its shareholders. If a RIC makes this election, it must send shareholders a written notice of such election within 60 days of its year end. Regulation section 1.853-3 requires the notice to designate the portion of foreign taxes paid to each separate country and the portion of the RICs dividend that represents income derived from sources in each separate country.

 

Proposed Change

The rationale for the requirement to provide information for each separate country was to enable shareholders to properly calculate their foreign tax credit limitation under section 904. Prior to 1976, section 904 required the allowable foreign tax credit to be computed on a separate country basis. The Tax Reform Act of 1976 amended section 904 to provide an overall limitation instead of separate country limitations. Since taxpayers are required to compute their foreign tax credit based on an overall limitation, it should no longer be necessary for RICs to specify the amount of income from each separate country and the amount of tax paid to each separate country. Therefore, the Regulations under section 853 should eliminate the requirement for RICS to provide information to shareholders on a separate country basis and should require RICs to provide information on an overall basis in accordance with requirements for computing the foreign tax credit limitation under section 904.

 

Contribution to Simplification

Current regulations require RICs to provide shareholders with information that is no longer needed to prepare their income tax returns. Compiling and providing this information is a time consuming and costly process. Modification of the regulations to conform with current law would reduce compliance and administrative costs and complexity.

 

SAFE HARBOR PERMITTING RICs TO AVOID PFIC TREATMENT

 

Present Law

Section 1291 of the IRC imposes a tax at the highest corporate rate on "excess distributions" received by a U.S. taxpayer from a "Passive Foreign Investment Company" (PFIC). An excess distribution includes gains on the disposition of PFIC stock as well as dividends which exceed the prior three yearsí average. A PFIC is any foreign corporation for which 75 percent or more of its gross income is passive income or 50 percent of its assets produce passive income. This rule was introduced by the Tax Reform Act of 1986 as an anti-abuse provision to prevent U.S. taxpayers from forming foreign corporations or investing in foreign corporations for passive investment purposes but only paying capital gains tax upon disposition of their holding and resulting in a possible tax deferral for many years. Unlike previous anti-abuse provisions which applied when there was substantial ownership of the foreign corporation, the PFIC provisions apply to any ownership interest.

 

Proposed Change

Exempt Regulated Investment Companies (RICs) from PFIC provisions because any tax deferral obtained by shareholders of a RIC is clearly not of the abusive nature Congress intended to eliminate. Shareholders of a publicly traded RIC lack control of the foreign corporation to create an abusive scheme and the tax diversification rules already limit the portion of the RICs assets which may be invested in a single foreign company, minimizing the potential for deferral.

 

Contribution to Simplification

RICs would be relieved of the onerous burden of determining if the foreign corporations they invest in are PFICs. Even if the proposed exemption were subject to special rules further limiting the potential for abuse (see alternative below), there would still be significant simplification.

 

The burden for RICs can be clearly distinguished from that of other taxpayers:

· RICs actively buy and sell securities so that the number of securities requiring identification may vary from several hundred for a fund or several thousand for a fund complex. In addition, this turnover limits the length of any tax deferral.

· The tax rules require a determination of the assets and income of the foreign company based on financial records prepared in accordance with U.S. tax rules. Virtually none of the foreign entities in which U.S. RICs invest provide such information. In addition, sources of information on foreign companies are substantially less than that reported for U.S. companies.

· The tax rules result in erroneously labeling foreign corporations as PFICs when in fact such companies are clearly not within the scope which Congress intended the PFIC legislation to cover. For example, companies in the start-up phase and active companies which are service, finance or finance-related entities may fail the asset test - a large problem for a RIC which may invest in many such entities. Start-up companies rarely qualify for the relief under IRC section 1297(b) because the start-up period is generally more than 1 year.

 

Various legislative and regulatory proposals have been set forth to provide relief for RICs. Such proposals provide for a "mark-to-market" regime which simplifies recording by permitting RICs to recognize income currently based on the increase in market value of their PFIC holdings. These proposals provide no relief from the burden of identification.

 

Alternative Proposal

Exempt a stockholding of a RIC from PFIC treatment if the RIC owns less than 10 percent of the outstanding stock of such company and less that 5 percent of the RICs assets are invested in the holding.

 

INTEREST ON LOANS ON NON-ACCRUAL

  

Institutions which use the accrual method of accounting typically have an ongoing policy of not accruing into income interest on loans which they deem to be nonperforming, but which have not yet been written off as bad debts. Nonperforming loans are those loans which, as a result of the inability of the borrower to meet the contractual terms of the loans, are delinquent and are placed on a non-accrual basis.

Loan accounts are most commonly placed on non-accrual status when payments have not been received after a predetermined number of days (e.g., 30, 60, 90 days, etc.). A loan account may also be placed on non-accrual status as a result of a specific event.

 

Present Law

Under present law, the IRS will not accept regulatory guidelines for determining when interest accruals should be discontinued on nonperforming loans. Taxpayers must continue the accrual of interest on nonperforming loans until either: a) uncollectibility of interest has been established under the guidelines of Revenue Ruling 80-361; or, b) the loan has been charged-off.

Revenue Ruling 80-361 generally states that income is includible in gross income when all events have occurred so that the right to receive such income and the amount thereof can be determined with reasonable accuracy. A fixed right does not exist if an income item is uncollectible or there is no reasonable expectation of payment. Therefore, taxpayers must examine each loan on a case by case basis to determine whether a reasonable expectation of repayment exists, irrespective of whether payments are delinquent. This subjective determination of interest collectibility has led to many disagreements between taxpayers and the IRS.

To the extent a loan has been charged off, interest accrual is not further required. In addition, if accrued interest on a nonperforming loan has previously been recognized in taxable income, and the loan subsequently becomes partially or wholly worthless, relief is available to the taxpayer via the bad debt deduction rules found in section 166.

Due to the somewhat subjective nature of determining worthlessness, bad debts are a frequent item of controversy between the IRS and taxpayers. To help alleviate this controversy, taxpayers have been granted the opportunity to rely on regulatory standards for purposes of determining their tax bad debt deductions. These rules, found in Regulation sections 1.166-2(d)(3) and (4), generally allow a taxpayer to claim a tax bad debt deduction for chargeoffs of loans which were classified as "loss" for regulatory purposes. If all associated requirements are met, these chargeoffs are considered valid bad debt deductions and are not subject to IRS examination. However, these bad debt conformity rules do not extend to interest accruals.

 

Proposed Change

Due to the close relationship governing collection of principal and interest on nonperforming loans, as well as the ability of taxpayers to rely on regulatory classifications in determining the appropriate bad debt deduction, it is recommended that book-tax conformity be established for interest accruals on nonperforming loans. Due to the subjective nature of determining the collectibility of interest on nonperforming loans, use of regulatory guidelines by both the IRS as well as taxpayers should serve to reduce or eliminate controversy between the two parties on this issue.

 

Contribution to Simplification

Interest on non-accrual is one of the most time consuming components of an IRS audit. In the same manner that the conformity election was introduced to reduce the burden on the taxpayer and the IRS with respect to the audit of an institution's bad debt deduction, similar treatment of interest on non-accrual will provide comparable benefits. The risk of taxpayer abuse in this area is unlikely. Failure to accrue income for book purposes directly impacts regulatory capital by reducing the amount of current income. As a result, an institution is unlikely to manipulate it's book accrual of interest income to achieve a tax benefit.

 

SHORT-SHORT TEST FOR REGULATED INVESTMENT COMPANIES

 

Present Law

A regulated investment company (RIC) is treated, in essence, as a conduit for Federal income tax purposes. If a corporation qualifies as a RIC, it is allowed a deduction for dividends paid (or deemed paid) to its shareholders (section 852(b)). Thus, no corporate level tax is payable on earnings of a RIC distributed (or deemed distributed) to its shareholders. In order for a corporation to qualify as a RIC, a corporation must elect such status and must satisfy certain tests (section 851(b)). In particular, a corporation must derive less than 30 percent of its gross income from the sale or disposition of certain investments (including stock, securities, options, futures, and forward contracts) held less than 3 months (the "short-short test") (section 851(b)(3)).

 

Proposed Change

Repeal the short-short test.

 

Contribution to Simplification

The short-short test restricts the investment flexibility of RICs. The test can, for example, limit a RICs ability to "hedge" its investment (e.g., to use options to protect against adverse market moves). The test also burdens a RIC with significant record keeping, compliance, and administration costs. The RIC must keep track of the holding periods of assets and the relative percentages of short-term and long-term gain that it realizes throughout the year.

 

MARK-TO-MARKET ACCOUNTING

 

Section 475 requires taxpayers that are dealers in securities to use the mark-to-market method (MTM) of accounting for any security held for sale. Many banks and thrifts are dealers in securities as a result of loan sales.

 

Present Law

Effective for taxable years ending on or after December 31, 1993, section 475(a) requires a dealer in securities to mark its securities to market for federal income tax purposes at the end of every taxable year. Any resulting gain or loss is included in taxable income for that year. Section 475(c) defines a dealer in securities as any taxpayer who:

A. regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business; or,

B. regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.

 

Section 475 was originally intended to restrict the perceived abuse by securities dealers in using the "Lower of Cost or Market" (LOCOM) method of accounting to recognize unrealized depreciation in market value of their securities inventory while not reporting unrealized appreciation in such securities. As a result, a bank will frequently be classified as a dealer for purposes of the MTM rules as a result of loan sales.

The IRS has issued guidance in the form of revenue rulings, notices and proposed and temporary regulations to address the myriad of issues section 475 raises. Despite this guidance, compliance with section 475 has proven difficult and administratively burdensome. Accordingly, the following suggestions are submitted to address some areas where simplification can be achieved without undermining the intent of section 475.

 

Proposed Change

A. Valuation Issues

A great deal of uncertainty surrounds the valuation of securities required to be marked to market under section 475(a). Unless such uncertainties are removed through published guidance, taxpayers and IRS will undoubtedly engage in protracted valuation disputes. Such disputes will be costly for both taxpayers and the government. Accordingly, we strongly encourage the publication of clear and easy to comply with administrative guidance for computing the fair market value of each class of securities under section 475(c)(2). In the absence of such clear and easy to comply with guidance, e.g., one which employs widely accepted methodologies using generally available objective rates, the regulations should clarify that fair values determined in conformity with generally accepted accounting principles (GAAP) are accepted as presumptively correct fair market values for section 475(a). (Note: The IRC section 475 definition of securities differs from and is generally more expansive than the GAAP definition of securities in FASB Statement No. 115.)

B. Identification

To ease the administrative burdens of identification, taxpayers should be allowed flexibility in implementing systems of identification. The requirement under proposed regulations to cite which subparagraph of section 475(b)(1) supports exemption from MTM is unnecessary and burdensome. Inasmuch as the terms "held for investment" and "not held for sale" have the same meaning, the regulations should provide that any system that clearly identifies which securities are held for sale and which are not should be sufficient. For example, if the majority of a taxpayer's securities are held for sale, a system that clearly identifies those securities that are not held for sale should be acceptable. Conversely, if the majority of a dealer's securities are not held for sale, a system that clearly identifies those securities that are held for sale should be sufficient.

C. U.S. Branches of International Banks

The regulations should clarify that, for the purpose of determining whether a taxpayer is a dealer, the activities and assets of a foreign bank doing business in the U.S. that do not produce income effectively connected with its conduct of a trade or business in the U.S. are irrelevant. Thus, if a foreign bank is a dealer in securities (under principles of section 475) in its home country or elsewhere in the world, but is not a dealer with regard to its U.S. trade or business, such bank should be exempt from the MTM requirements for its U.S. effectively connected assets. Focusing solely on the U.S. effectively connected assets in applying section 475 not only comports with the drafters' intent, but will also eliminate difficult enforcement problems associated with examining activities and assets that do not produce effectively connected income.

 

Contribution to Simplification

Issues related to the MTM method of accounting will likely dominate the IRS's significant issue list in the next decade. As a result, taxpayers and examining agents will be spending countless hours ensuring compliance with the rules. Enactment of these proposals put forth to simplify the application of the MTM rules will greatly ease the compliance burden on taxpayers without undermining the intent of section 475. Similarly, providing guidance on valuing assets under section 475 is necessary to ensure compliance by the broad spectrum of taxpayers required to use the MTM method of accounting.

 

TRANSLATION OF FOREIGN TAXES AT AVERAGE EXCHANGE RATES

  

Present Law

IRC section 902 allows a U.S. corporate shareholder to claim a foreign tax credit for qualifying foreign income taxes paid or accrued by a foreign subsidiary from which it receives a dividend. The amount of credit allowed is calculated based on the foreign subsidiary's earnings and profits (E&P) and foreign taxes.

The Tax Reform Act of 1986 (the Act) changed the translation rules applied for credits under section 902. Under existing law, E&P of a foreign subsidiary are calculated and maintained in the functional currency, whereas foreign income taxes paid (section 986) by the subsidiary are translated into U.S. dollars at the rate of exchange on the date paid and are maintained as a dollar pool of taxes. When the dividend is paid, the dividend and E&P pool are both translated into U.S. dollars at the dividend date exchange rate, and the section 902 credit is calculated based on such amounts and on the U.S. dollar pool of foreign taxes.

When income is included by a U.S. shareholder under section 951 (subpart F), the income is first computed in the foreign subsidiary's functional currency and then translated into U.S. dollars at the weighted average exchange rate for the year of inclusion. Foreign taxes paid by the subsidiary are translated into a dollar pool on the date paid under section 986. The deemed paid foreign tax credit available to corporate shareholders is computed under section 960 using the dollar amounts of dividend, E&P and foreign taxes.

Under current law, foreign taxes paid directly by U.S. individuals and corporations also must be translated into U.S. dollars on the date paid under section 986 for the purpose of computing the section 901 tax credit.

 

Recommended Change

It is recommended that, in the computation of the deemed paid foreign tax credit under sections 902 (including foreign tax credits allowed with respect to section 1248 dividends), 960 and 901, U.S. individuals and corporations be allowed to translate foreign taxes into U.S. dollars at the average exchange rate for the year and that the section 986 translation rule adopted by the 1986 Act be repealed.

 

Contribution to Simplicity

The rules adopted in the Tax Reform Act of 1986 require U.S. taxpayers to spend significantly greater time calculating deemed paid foreign tax credits. Foreign subsidiaries, like U.S. companies, make tax payments at various times of the year to comply with local estimated tax payment rules and to cover other underpayments and deficiencies. In some countries, taxes must be paid monthly. Thus, the existing rule greatly increases the information gathering and calculation time required of U.S. individuals and companies, and increases the amount of IRS time spent auditing the calculations. Since exchange rates fluctuate unpredictably, there is no way to predict whether the recommended change would produce more or less revenue than existing law; however, the revenue loss, if any, would be insignificant in relation to the simplification of our tax law provided by this change.

 

PASSIVE FOREIGN INVESTMENT COMPANY/CONTROLLED FOREIGN CORPORATION OVERLAP

 

Present Law

Current law taxes a U.S. shareholder on its pro rata share of the passive income of a controlled foreign corporation (CFC) under the subpart F provisions. A foreign company is a CFC if more than 50 percent of its vote or value is owned by U.S. shareholders.

The Tax Reform Act of 1986 added the passive foreign investment company (PFIC) regime. A PFIC is a foreign corporation in which over 50 percent of the assets or over 75 percent of the gross income is passive. In addition, any foreign corporation that has once met the tests for being a PFIC is forever treated as a PFIC. These provisions, in general, tax U.S. shareholders on their pro rata share of the earnings of a PFIC. A U.S. shareholder of a PFIC will be taxed on its share of earnings either when the PFIC is sold or has an excess distribution (with an imputed interest component added for the tax deferral) or currently, if the shareholder elects out of the PFIC regime. As the IRC sections related to PFICs are separate from the CFC provisions, a PFIC does not have to be controlled by U.S. shareholders to be subject to current taxation of its earnings.

 

Recommended Change

A PFIC that is also a CFC should be treated as a non-PFIC with respect to its 10 percent U.S. shareholders.

 

Contribution to Simplicity

A PFIC that is also a CFC is subject to the subpart F as well as the PFIC provisions. This overlap is unnecessary and duplicative and represents a trap for the unwary. Both provisions are designed to prevent U.S. shareholders from parking easily movable cash and investments in low-taxed foreign jurisdictions. Presumably, the PFIC provisions were intended to extend CFC-like rules to noncontrolled foreign corporations; however, their reach is not so restricted.

The PFIC provisions frequently strike unintended targets. For example, a newly organized foreign company whose plant is under construction for longer than 12 months will meet the PFIC income test if it has even one dollar of interest earned on its working capital (since the newly organized operation would have no gross income except for interest). Since this company met a PFIC test in one year, it forever carries the PFIC taint (unless it elects to be taxed currently). Upon the sale of the company, the U.S. shareholder will have to pay the resulting tax on the imputed interest in addition to the gain on the sale of stock. To avoid this harsh result, U.S. shareholders must carefully scrutinize each foreign corporation, including operating companies, each year to determine whether any meet either of the PFIC tests. While this is a onerous task for holders of non-controlled foreign corporations, it is an unnecessary burden on holders of CFCs who must also make detailed and complex subpart F calculations. Because the PFIC provisions are duplicative and do not constitute good tax policy in relation to CFCs, these provisions should be made inapplicable to PFICs that are also CFCs with respect to their 10 percent U.S. shareholders.

 

DIVIDENDS FROM ALL "10/50" COMPANIES IN ONE FOREIGN TAX CREDIT LIMITATION BASKET

  

Present Law

IRC section 904(d) provides that a separate foreign tax credit computation must be performed for dividends from each "noncontrolled section 902 corporation." A noncontrolled section 902 corporation (also known as a "10/50" company) is any foreign corporation with respect to which the U.S. shareholder meets the stock ownership requirements of section 902. However, a controlled foreign corporation (CFC) is not treated as a 10/50 company with respect to any distribution out of earnings for periods during which the corporation was a CFC. IRC section 902 requires that the foreign company be no lower than the third tier, that each shareholder company in the chain own at least 10 percent of its subsidiary company, and that the U.S. parent must own indirectly at least 5 percent of the applicable foreign company. A foreign company is a CFC if more than 50 percent of its vote or value is owned by U.S. shareholders. For example, a foreign corporation which is owned exactly 50 percent by a U.S. shareholder is a "10/50" company and dividends cannot be combined with dividends from other foreign companies in the foreign tax credit computation.

 

Recommended Change

It is recommended that the rule be changed to combine dividends from all "10/50" companies in one foreign tax credit limitation basket.

 

Contribution to Simplicity

While the current "10/50" provisions were partly intended to mitigate the compliance burden resulting from having to gather the underlying financial data of non-controlled foreign companies, in many cases, it has actually increased the compliance burden by requiring the taxpayer to make separate foreign tax credit calculations for each "10/50" company.

Each "10/50" company of the U.S. taxpayer is generally subject to a local effective tax rate comparable to the taxpayerís other "10/50" companies. Therefore, only insignificant tax revenues would be lost by allowing taxpayers to average the earnings and taxes of all "10/50" companies by combining them in a single foreign tax credit computation. The significant reduction in the compliance burden of U.S. taxpayers justifies this result.

 

HIGH TAX KICK OUT RULE

 

Present Law

The Tax Reform Act of 1986 (the Act) revised the foreign tax credit provisions by requiring the limitation on the amount of creditable tax to be calculated with respect to separate categories, or "baskets", of income [section 904(d)]. Among other things, foreign source passive income must be separated from a taxpayer's other types of income. This segregation was enacted to prevent a taxpayer from manipulating investments and averaging foreign tax credits on operating income, which generally are imposed at relatively high foreign tax rates, with foreign tax credits on passive types of income such as portfolio interest, dividends, etc. These latter types of income often can be invested in a way that allows for a low foreign tax. By segregating passive foreign source income and active foreign income into separate baskets in applying the foreign tax credit limitation, the tax law prevents cross-crediting of foreign taxes between operating and investment income.

In establishing the passive/active segregation, the Act included a mechanical rule which excludes "high taxed" passive income and the associated foreign income taxes from the passive basket [sections 904(d)(2)(A)(iii)(III) and 904(d)(2)(F)]. This rule, which is generally referred to as the "high tax kick out" rule provides that passive income that is subject to an effective foreign tax rate equal to or greater than the maximum U.S. tax rate may not be included in the passive basket. That is, it is "kicked out" of the passive basket and will then generally fall into the taxpayer's general (active) basket. For example, if foreign investment interest income is received by a corporate taxpayer, the income will be in the passive basket if the effective foreign tax rate is less than 35 percent, but the income will be included in the active basket if the effective foreign tax rate is 35 percent or more. In calculating the effective foreign tax rate, foreign principles of taxation are applied to determine how much tax is imposed on income, but the effective rate is based on U.S. principles of allocating deductions and of grouping items of income.

 

Recommended Changes

The high tax kick out rule should be repealed.

 

Contribution to Simplicity

The high tax income exception of sections 904(d)(2)(a)(iii)(III) and 904(d)(2)(F) is technically one of the more difficult provisions of the foreign tax credit limitation to apply. It creates many interpretative issues as to which items of income may be grouped. Also, it creates unnecessary work for taxpayers and adds to the time required for an IRS agent to audit a U.S. taxpayer. For example, many companies with foreign operations earn small amounts of investment income on cash available during temporary or seasonal operating fluctuations. This interest generally is subject to the same foreign tax as operating income. Where passive income is earned in an operation and subject to foreign tax, it is obviously not a result of manipulation for tax avoidance purposes. Congress does not wish to create a "business needs" exception to allow passive income to be categorized as operating income. At the same time, however, to re-characterize passive income as operating income based on an arbitrary tax rate is conceptually incorrect and not necessary to preclude manipulation of the credit rules. It is believed that repeal of this provision will lose very little revenue. The provision does, however, add significantly to the complexity of our laws and should be eliminated.

 

UNIFORM CAPITALIZATION RULES

 

Present Law

With respect to inventory property produced by the taxpayer or acquired for resale, section 263A requires certain costs to be capitalized to inventory for all taxpayers with average annual gross receipts of more than $10,000,000 for the 3-taxable year period prior to the taxable year. In addition, section 263A requires the capitalization of interest costs during the construction period of long-lived assets. Since this law constitutes a method of accounting, these uniform capitalization rules (UNICAP) must be used in determining the earnings and profits of all foreign corporations, even those not conducting any business in the U.S.

The gross receipts of all subsidiaries, foreign and domestic, within a controlled group are aggregated for purposes of determining whether the $10,000,000 threshold is exceeded. If the aggregate of gross receipts exceeds the threshold, then the UNICAP rules must be applied to each domestic and foreign entity in the controlled group (Rev. Rul. 89-26 1989-1 C.B. 87).

 

Recommended Change

Remove the requirement that UNICAP be applied to foreign corporations that conduct no business in the U.S.

 

Contribution to Simplicity

Elimination of a UNICAP inventory adjustment in this situation would greatly relieve the administrative burden in determining the earnings and profits of foreign subsidiaries. The foreign UNICAP adjustment has a minimal effect relative to adjustments in the domestic context because: (1) post-1986 E&P is accounted for in one pool, thereby diluting the effect of the adjustment, and (2) the effect is recognized for foreign tax credit purposes only when the CFC distributes a dividend (or as Subpart F income) as opposed to being reflected in each year's taxable income.

Exemption from the application of UNICAP also removes a burden from U.S. multinationals vis-a-vis the UNICAP requirements for foreign based multinationals who are not required to apply UNICAP to foreign subsidiaries that do not conduct business in the U.S.

In addition, this proposal is expected to have little or no revenue impact for the following reasons. The effect of UNICAP on foreign subsidiaries is to increase the amount of earnings and profits of the foreign subsidiary. The increase in earnings and profits has the effect of lowering the effective foreign tax rate, thereby increasing a taxpayer's capacity to utilize foreign tax credits where the taxpayer is in an excess foreign tax credit position. Since most U.S. multinationals are in an excess foreign tax credit position, the revenue generated by the UNICAP rules is small in relation to the bookkeeping burden required in order to comply with the rules, even assuming that the simplified U.S. ratio method is used. In addition, the effect of UNICAP under present law is to increase the amount of general limitation (active) income, thereby increasing a taxpayer's capacity to recognize active income on the sale of a CFC under section 1248. Finally, the current revenue impact of applying UNICAP at the foreign subsidiary level may be minimal because of the offsetting effects in the allocation and apportionment of expenses at the U.S. parent level, perhaps causing no significant change in the amount of tax revenue collected by the Treasury Department. Therefore, the repeal of UNICAP, as it applies to foreign persons, is justified as an appropriate means of achieving simplification.