RRA 1998 Senate Report p6

RRA 1998 Senate Report Page 6

Articles by Alvin Brown
Tax Preparation
Offer In Compromise
State Offers in Compromise
Levy
IRS Tax Liens
IRS Tax Liens - continued
IRS Tax Liens - continued 2
Levy - continued
Audit Techniques Guide
Congressional Contacts
Criminal Investigation
D.O.J Criminal Tax Manual
Tax Litigation
Penalty
Installment Agreements
Statute of Limitations
Frivolous Tax Argument
Interest Abatement
IRS Misconduct
IRS Abuses
Tax Fraud
Fraud Statutes
Bankruptcy
Tax Reform Legislation
Tax Shelters
Tax Court
Trust Fund Penalty
Legislation
Innocent Spouse Relief
Important Links

IRS Restructuring and Reform Act of 1998

Senate Report page6

2. Confidentiality of tax return information (sec. 3802 of the bill)

Present Law

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

Reasons for Change

The Committee believes that a study of the confidentiality provisions will be useful in assisting the Committee in determining whether improvements can be made to these provisions.

Explanation of Provision

The provision requires the Joint Committee on Taxation and Treasury to each conduct a separate study on provisions regarding taxpayer confidentiality. The studies are to examine present-law protections of taxpayer privacy, the need, if any, for third parties to use tax return information, whether greater levels of voluntary compliance can be achieved by allowing the public to know who is legally required to file tax returns but does not do so, and the interrelationship of the taxpayer confidentiality provisions in the Internal Revenue Code with those elsewhere in the United States Code (such as the Freedom of Information Act).

Effective Date

The findings of the studies, along with any recommendations, are required to be reported to the Congress no later than one year after the date of enactment.

TITLE IV. CONGRESSIONAL ACCOUNTABILITY FOR THE IRS

A. Century Date Change (sec. 4001 of the bill)

Present Law

No specific provision.

Reasons for Change

Operations of the IRS computer systems are critical to the viability of the Federal tax system.

Explanation of Provision

The bill provides that it is the sense of the Congress that the IRS should place resolving the century date change computing problems as a high priority. The bill also provides that the Commissioner shall expeditiously submit a report to the Congress on the overall impact of the bill on the ability of the IRS to resolve the century date change computing problems and the provisions of the bill that will require significant amounts of computer programming changes prior to December 31, 1999, in order to carry out the provisions. It is expected that this report will be submitted within 14 days of the date of Committee action on the bill.

Effective Date

The provision is effective on the date of enactment.

B. Tax Law Complexity Analysis (sec. 4002 of the bill)

Present Law

Present law does not require a formal complexity analysis with respect to changes to the tax laws.

Reasons for Change

The National Commission on Restructuring the IRS found a clear connection between the complexity of the Internal Revenue Code and the difficulty of tax law administration and taxpayer frustration. The Committee shares the concern that complexity is a serious problem with the Federal tax system. Complexity and frequent changes in the tax laws create burdens for both the IRS and taxpayers. Failure to address complexity may ultimately reduce voluntary compliance.

The Committee is aware that it may not be possible or desirable to eliminate all complexity in the tax system. There are many objectives of a tax system and particular tax provisions, and simplicity is only one. In some cases other policies, such as fairness, may outweigh concerns about complexity. Nevertheless, the Committee believes complexity of the tax system should be reduced whenever possible. Accordingly, the Committee believes it appropriate to introduce new procedural rules that will focus attention on complexity. The Committee also believes that the tax-writing committees should receive periodic input from the IRS regarding areas of the law that cause problems for taxpayers. This input will be valuable in developing future legislation.

Explanation of Provision

IRS report on complexity

The IRS is to report to the House Ways and Means Committee and the Senate Finance Committee annually regarding sources of complexity in the administration of the Federal tax laws. Factors the IRS may take into account include: (1) frequently asked questions by taxpayers; (2) common errors made by taxpayers in filling out returns; (3) areas of the law that frequently result in disagreements between taxpayers and the IRS; (4) major areas in which there is no or incomplete published guidance or in which the law is uncertain; (5) areas in which revenue agents make frequent errors in interpreting or applying the law; (6) impact of recent legislation on complexity; (7) information regarding forms, including a listing of IRS forms, the time it takes for taxpayers to complete and review forms, the number of taxpayers who use each form, and how the time required changed as a result of recently enacted legislation; and (8) recommendations for reducing complexity in the administration of the Federal tax system.

Complexity analysis with respect to current legislation

The bill requires the Joint Committee on Taxation (in consultation with the IRS and Treasury) to provide an analysis of complexity or administrability concerns raised by tax provisions of widespread applicability to individuals or small businesses. The analysis is to be included in any Committee Report of the House Ways and Means Committee or Senate Finance Committee or Conference Report containing tax provisions, or provided to the Members of the relevant Committee or Committees as soon as practicable after the report is filed. The analysis is to include: (1) an estimate of the number and type of taxpayers affected; and (2) if applicable, the income level of affected individual taxpayers. In addition, such analysis should include, if determinable, the following: (1) the extent to which existing tax forms would require revision and whether a new form or forms would be required; (2) whether and to what extent taxpayers would be required to keep additional records; (3) the estimated cost to taxpayers to comply with the provision; (4) the extent to which enactment of the provision would require the IRS to develop or modify regulatory guidance; (5) whether and to what extent the provision can be expected to lead to disputes between taxpayers and the IRS; and (6) how the IRS can be expected to respond to the provision (including the impact on internal training, whether the Internal Revenue Manual would require revision, whether the change would require reprogramming of computers, and the extent to which the IRS would be required to divert or redirect resources in response to the provision).

Effective Date

The provision requiring the Joint Committee on Taxation to provide a complexity analysis is effective with respect to legislation considered on or after January 1, 1999. The provision requiring the IRS to report on sources of complexity is effective on the date of enactment.

TITLE V. REVENUE OFFSETS

A. Employer Deduction for Vacation and Severance Pay (sec. 5001 of the bill and sec. 404 of the Code)

Present Law

For deduction purposes, any method or arrangement that has the effect of a plan deferring the receipt of compensation or other benefits for employees is treated as a deferred compensation plan (sec. 404(b)). In general, contributions under a deferred compensation plan (other than certain pension, profit-sharing and similar plans) are deductible in the taxable year in which an amount attributable to the contribution is includible in income of the employee. However, vacation pay which is treated as deferred compensation is deductible for the taxable year of the employer in which the vacation pay is paid to the employee (sec. 404(a)(5)).

Temporary Treasury regulations provide that a plan, method, or arrangement defers the receipt of compensation or benefits to the extent it is one under which an employee receives compensation or benefits more than a brief period of time after the end of the employer's taxable year in which the services creating the right to such compensation or benefits are performed. A plan, method or arrangement is presumed to defer the receipt of compensation for more than a brief period of time after the end of an employer's taxable year to the extent that compensation is received after the 15th day of the 3rd calendar month after the end of the employer's taxable year in which the related services are rendered (the "2-1/2 month" period). A plan, method or arrangement is not considered to defer the receipt of compensation or benefits for more than a brief period of time after the end of the employer's taxable year to the extent that compensation or benefits are received by the employee on or before the end of the applicable 2-1/2 month period. (Temp. Treas. Reg. sec. 1.404(b)-1T A-2).

The Tax Court recently addressed the issue of when vacation pay and severance pay are considered deferred compensation in Schmidt Baking Co., Inc., 107 T.C. 271 (1996). In Schmidt Baking, the taxpayer was an accrual basis taxpayer with a fiscal year that ended December 28, 1991. The taxpayer funded its accrued vacation and severance pay liabilities for 1991 by purchasing an irrevocable letter of credit on March 13, 1992. The parties stipulated that the letter of credit represented a transfer of substantially vested interest in property to employees for purposes of section 83, and that the fair market value of such interest was includible in the employees' gross incomes for 1992 as a result of the transfer.⁵⁰ The Tax Court held that the purchase of the letter of credit, and the resulting income inclusion, constituted payment of the vacation and severance pay within the 2-1/2 month period. Thus, the vacation and severance pay were treated as received by the employees within the 2-1/2 month period and were not treated as deferred compensation. The vacation pay and severance pay were deductible by the taxpayer for its 1991 fiscal year pursuant to its normal accrual method of accounting.

Reasons for Change

The Committee believes that the decision in Schmidt Baking reaches an inappropriate and unintended result. To permit methods such as that used in Schmidt Baking to be considered payment or receipt would allow taxpayers to avoid the 2-1/2 month rule and inappropriately accelerate deductions. The Committee believes that the intent of the 2-1/2 rule was clearly to provide that a deduction for deferred compensation is not available for the current taxable year unless the compensation is actually paid to employees within 2-1/2 months after the end of the year. Moreover, previous legislative histories reflect Congressional intent and understanding that compensation actually paid beyond the 2-1/2 month period is deferred compensation.⁵¹

Further, the Committee is concerned that taxpayers may inappropriately extend the rationale of Schmidt Baking to other situations in which a deduction or other tax consequences are contingent upon an item being paid. The Committee does not believe that, as a general rule, letters of credit and similar mechanisms should be considered payment for any purposes of the Code.

Explanation of Provision

Under the bill, for purposes of determining whether an item of compensation is deferred compensation (under Code sec. 404), the compensation is not considered to be paid or received until actually received by the employee. In addition, an item of deferred compensation is not considered paid to an employee until actually received by the employee. The provision is intended to overrule the result inSchmidt Baking. For example, with respect to the determination of whether vacation pay is deferred compensation, the fact that the value of the vacation pay is includible in the income of employees within the applicable 2-1/2 month period would not be relevant. Rather, the vacation pay must have been actually received by employees within the 2-1/2 month period in order for the compensation not to be treated as deferred compensation.

It is intended that similar arrangements, in addition to the letter of credit approach used in Schmidt Baking, do not constitute actual receipt by the employee, even if there is an income inclusion. Thus, for example, actual receipt does not include the furnishing of a note or letter or other evidence of indebtedness of the taxpayer, whether or not the evidence is guaranteed by any other instrument or by any third party. As a further example, actual receipt does not include a promise of the taxpayer to provide service or property in the future (whether or not the promise is evidenced by a contract or other written agreement). In addition, actual receipt does not include an amount transferred as a loan, refundable deposit, or contingent payment. Amounts set aside in a trust for employees are not considered to be actually received by the employee.

The provision does not change the rule under which deferred compensation (other than vacation pay and deferred compensation under qualified plans) is deductible in the year includible in the gross income of employees participating in the plan if separate accounts are maintained for each employee.

While Schmidt Baking involved only vacation pay and severance pay, there is concern that this type of arrangement may be tried to circumvent other provisions of the Code where payment is required in order for a deduction to occur. Thus, it is intended that the Secretary will prevent the use of similar arrangements. No inference is intended that the result in Schmidt Baking is present law beyond its immediate facts or that the use of similar arrangements is permitted under present law.

The provision does not affect the determination of whether an item is includible in income. Thus, for example, using the mechanism in Schmidt Baking for vacation pay could still result in income inclusion to the employees, but the employer would not be entitled to a deduction for the vacation pay until actually paid to and received by the employees.

Effective Date

The provision is effective for taxable years ending after the date of enactment. Any change in method of accounting required by the bill is treated as initiated by the taxpayer with the consent of the Secretary of the Treasury. Any adjustment required by section 481 as a result of the change will be taken into account in the year of the change.

B. Modify Foreign Tax Credit Carryover Rules (sec. 5002 of the bill and sec. 904 of the Code)

Present Law

U.S. persons may credit foreign taxes against U.S. tax on foreign source income. The amount of foreign tax credits that can be claimed in a year is subject to a limitation that prevents taxpayers from using foreign tax credits to offset U.S. tax on U.S. source income. Separate foreign tax credit limitations are applied to specific categories of income.

The amount of creditable taxes paid or accrued (or deemed paid) in any taxable year which exceeds the foreign tax credit limitation is permitted to be carried back two years and forward five years. The amount carried over may be used as a credit in a carryover year to the extent the taxpayer otherwise has excess foreign tax credit limitation for such year. The separate foreign tax credit limitations apply for purposes of the carryover rules.

Reasons for Change

The Committee believes that reducing the carryback period for foreign tax credits to one year and increasing the carryforward period to seven years will reduce some of the complexity associated with carrybacks while continuing to address the timing differences between U.S. and foreign tax rules.

Explanation of Provision

The bill reduces the carryback period for excess foreign tax credits from two years to one year. The bill also extends the excess foreign tax credit carryforward period from five years to seven years.

Effective Date

The provision applies to foreign tax credits arising in taxable years ending after the date of enactment.

C. Clarify and Expand Mathematical Error Procedures (sec. 5003 of the bill and sec. 6213(g)(2) of the Code)

Present Law

Taxpayer identification numbers ("TINs")

The IRS may deny a personal exemption for a taxpayer, the taxpayer's spouse or the taxpayer's dependents if the taxpayer fails to provide a correct TIN for each person for whom the taxpayer claims an exemption. This TIN requirement also indirectly effects other tax benefits currently conditioned on a taxpayer being able to claim a personal exemption for a dependent (e.g., head-of-household filing status and the dependent care credit). Other tax benefits, including the adoption credit, the child tax credit, the Hope Scholarship credit and Lifetime Learning credit, and the earned income credit also have TIN requirements. For most individuals, their TIN is their Social Security Number ("SSN"). The mathematical and clerical error procedure currently applies to the omission of a correct TIN for purposes of personal exemptions and all of the credits listed above except for the adoption credit.

Mathematical or clerical errors

The IRS may summarily assess additional tax due as a result of a mathematical or clerical error without sending the taxpayer a notice of deficiency and giving the taxpayer an opportunity to petition the Tax Court. Where the IRS uses the summary assessment procedure for mathematical or clerical errors, the taxpayer must be given an explanation of the asserted error and a period of 60 days to request that the IRS abate its assessment. The IRS may not proceed to collect the amount of the assessment until the taxpayer has agreed to it or has allowed the 60-day period for objecting to expire. If the taxpayer files a request for abatement of the assessment specified in the notice, the IRS must abate the assessment. Any reassessment of the abated amount is subject to the ordinary deficiency procedures. The request for abatement of the assessment is the only procedure a taxpayer may use prior to paying the assessed amount in order to contest an assessment arising out of a mathematical or clerical error. Once the assessment is satisfied, however, the taxpayer may file a claim for refund if he or she believes the assessment was made in error.

Reasons for Change

The Committee believes that it is appropriate to provide additional guidance to the Internal Revenue Service with respect to the application of the TIN requirement. It will also improve compliance to allow the IRS to use date of birth data, from the Social Security Administration, to determine ineligibility for the dependent care credit, the child tax credit and the earned income credit. Once this determination is made, the Committee believes that the IRS should use the mathematical and clerical error procedure to correctly assess the tax due with respect to affected tax returns.

Explanation of Provision

The bill provides in the application of the mathematical and clerical error procedure that a correct TIN is a TIN that was assigned by the Social Security Administration (or in certain limited cases, the IRS) to the individual identified on the return. For this purpose the IRS is authorized to determine that the individual identified on the tax return corresponds in every aspect (including, name, age, date of birth, and SSN) to the individual to whom the TIN is issued. The IRS also is authorized to use the mathematical and clerical error procedure to deny eligibility for the dependent care tax credit, the child tax credit, and the earned income credit even though a correct TIN has been supplied if the IRS determines that the statutory age restrictions for eligibility for any of the respective credits is not satisfied (e.g., the TIN issued for the child claimed as the basis of the child tax credit identifies the child as over the age of 17 at the end of the taxable year).

Effective Date

The provision is effective for taxable years ending after the date of enactment.

D. Freeze Grandfather Status of Stapled REITs (sec. 5004 of the bill)

Present Law

In general

A real estate investment trust ("REIT") is an entity that receives most of its income from passive real estate related investments and that essentially receives pass-through treatment for income that is distributed to shareholders. If an electing entity meets the qualifications for REIT status, the portion of its income that is distributed to the investors each year generally is taxed to the investors without being subjected to a tax at the REIT level. In general, a REIT must derive its income from passive sources and not engage in any active trade or business.

Requirements for REIT status

A REIT must satisfy a number of tests on a year-by-year basis that relate to the entity's (1) organizational structure, (2) source of income, (3) nature of assets, and (4) distribution of income. These tests are intended to allow pass-through treatment only if there is a pooling of investment arrangement, if the entity's investments are basically in real estate assets, and its income is passive income from real estate investment, as contrasted with income from the operation of a business involving real estate. In addition, substantially all of the entity's income must be passed through to its shareholders on a current basis.

Under the organizational structure tests, except for the first taxable year for which an entity elects to be a REIT, the beneficial ownership of the entity must be held by 100 or more persons. Generally, no more than 50 percent of the value of the REIT's stock can be owned by five or fewer individuals during the last half of the taxable year.

Under the source-of-income tests, at least 95 percent of its gross income generally must be derived from rents, dividends, interest and certain other passive sources (the "95-percent test"). In addition, at least 75 percent of its income generally must be from real estate sources, including rents from real property and interest on mortgages secured by real property (the "75-percent test").

For purposes of these tests, rents from real property generally include charges for services customarily rendered in connection with the rental of real property, whether or not such charges are separately stated. Where a REIT furnishes non-customary services to tenants, amounts received generally are not treated as qualifying rents unless the services are furnished through an independent contractor from whom the REIT does not derive any income. In general, an independent contractor is a person who does not own more than a 35-percent interest in the REIT, and in which no more than a 35-percent interest is held by persons with a 35-percent or greater interest in the REIT.

To satisfy the REIT asset requirements, at the close of each quarter of its taxable year, an entity must have at least 75 percent of the value of its assets invested in real estate assets, cash and cash items, and government securities. Not more than 25 percent of the value of the REIT's assets can be invested in securities (other than government securities and other securities described in the preceding sentence). The securities of any one issuer may not comprise more than five percent of the value of a REIT's assets. Moreover, the REIT may not own more than 10 percent of the outstanding securities of any one issuer, determined by voting power.

A REIT is permitted to have a wholly-owned subsidiary subject to certain restrictions. A REIT's subsidiary is treated as one with the REIT.

The income distribution requirement provides generally that at least 95 percent of a REIT's income (with certain minor exceptions) must be distributed to shareholders as dividends.

Stapled REITs

In a stapled REIT structure, both the shares of a REIT and a C corporation may be traded, but are subject to a provision that they may not be sold separately. Thus, the REIT and the C corporation have identical ownership at all times.

In the Deficit Reduction Act of 1984 (the "1984 Act"), Congress required that, in applying the tests for REIT status, all stapled entities are treated as one entity (sec. 269B(a)(3)). The 1984 Act included grandfather rules, one of which provided that certain then-existing stapled REITs were not subject to the new provision (sec. 136(c)(3) of the 1984 Act). That grandfather rule provided that the new provision did not apply to a REIT that was a part of a group of stapled entities if the group of entities was stapled on June 30, 1983, and included a REIT on that date.

Reasons for Change

In the 1984 Act, Congress eliminated the tax benefits of the stapled REIT structure out of concern that it could effectively result in one level of tax on active corporate business income that would otherwise be subject to two levels of tax. Congress also believed that allowing a corporate business to be stapled to a REIT was inconsistent with the policy that led Congress to create REITs.

As part of the 1984 Act provision, Congress provided grandfather relief to the small number of stapled REITs that were already in existence. Since 1984, however, many of the grandfathered stapled REITs have been acquired by new owners. Some have entered into new lines of businesses, and most of the grandfathered REITs have used the stapled structure to engage in large-scale acquisitions of assets. The Committee believes that such unlimited relief from a general tax provision by a handful of taxpayers raises new questions not only of fairness, but of unfair competition, because the stapled REITs are in direct competition with other companies that cannot use the benefits of the stapled structure.

The Committee believes that it would be unfair to remove the benefit of the stapled REIT structure with respect to real estate interests that have already been acquired. On the other hand, the Committee believes that future acquisitions of interests in real property by these grandfathered entities, or improvements of property that are tantamount to new acquisitions, should not be accorded the benefits of the stapled REIT structure. Accordingly, the rules of the Committee bill generally apply with respect to real property interests acquired by the REIT or a stapled entity after March 26, 1998, pursuant to transactions not in progress on that date. Further, the Committee is concerned that the some of the benefit of the stapled REIT structure can be derived through mortgages and interests in subsidiaries and partnerships. Accordingly, the Committee bill provides rules for mortgages acquired after March 26, 1998, and indirect acquisitions of real property interests through entities after such date (with transition relief similar to that for direct acquisitions).

Explanation of Provision

Overview

Under the provision, rules similar to the rules of present law treating a REIT and all stapled entities as a single entity for purposes of determining REIT status (sec. 269B) apply to real property interests acquired after March 26, 1998, by an existing stapled REIT, a stapled entity, or a subsidiary or partnership in which a 10-percent or greater interest is owned by an existing stapled REIT or stapled entity (together referred to as the "stapled REIT group"), unless the real property interest is grandfathered as described below. Special rules apply to certain mortgages acquired by the stapled REIT group after March 26, 1998, where a member of the stapled REIT group performs services with respect to the property secured by the mortgage.

Rules for real property interests

In general

The provision generally applies to real property interests acquired by a member of the stapled REIT group after March 26, 1998. Real property interests that are acquired by a member of the REIT group after such date, and which are not grandfathered under the rules described below, are referred to as "nonqualified real property interests".

The provision treats activities and gross income of a stapled REIT group with respect to nonqualified real property interests held by any member of the stapled REIT group as activities and income of the REIT for certain purposes in the same manner as if the stapled REIT group were a single entity. This treatment applies for purposes of the following provisions that depend on a REIT's gross income: (1) the 95-percent test (sec. 856(c)(2)); (2) the 75-percent test (sec. 856(c)(3)); (3) the "reasonable cause" exception for failure to meet either test (sec. 856(c)(6)); and (4) the special tax on excess gross income for REITs with net income from prohibited transactions (sec. 857(b)(5)).

Thus, for example, where a stapled entity leases nonqualified real property from the REIT and earns gross income from operating the property, such gross income will be subject to the provision. The REIT and the stapled entity will be treated as a single entity, with the result that the lease payments from the stapled entity to the REIT would be ignored. The gross income earned by the stapled entity from operating the property will be treated as gross income of the REIT, with the result that either the 75-percent or 95-percent test might not be met and REIT status might be lost. Similarly, where a stapled entity leases property from a third party after March 26, 1998, and uses that property in a business, the gross income it derives will be treated as income of the REIT because the lease would be a nonqualified real property interest.

Grandfathered real property interests

Under the provision, all real property interests acquired by a member of the stapled REIT group after March 26, 1998, are treated as nonqualified real property interests subject to the general rules described above, unless they qualify under one of the grandfather rules. An option to acquire real property is generally treated as a real property interest for purposes of the provision. However, a real property interest acquired by exercise of an option after March 26, 1998, is treated as a nonqualified real property interest, even though the option was acquired before such date.

Under the provision, grandfathered real property interests include properties acquired by a member of the stapled REIT group after March 26, 1998, pursuant to a written agreement which was binding on March 26, 1998, and all times thereafter. Grandfathered properties also include certain properties, the acquisition of which were described in a public announcement or in a filing with the Securities and Exchange Commission on or before March 26, 1998.

A real property interest does not generally lose its status as a grandfathered interest by reason of a repair to, an improvement of, or a lease of, the real property. Thus, if a REIT leases a grandfathered real property to a stapled entity, a renewal of the lease does not cause the property to lose its grandfathered status, whether the renewal is pursuant to the terms of the lease or otherwise. Similarly, if a REIT owns a grandfathered real property interest that is leased to a third party and, at the expiration of that lease, the REIT leases the property to a stapled entity, the interest would remain a grandfathered interest. Finally, if a stapled entity leases a grandfathered property interest from a third party and the property is repaired or improved, the interest would remain a grandfathered interest except as described below.

An improvement of a grandfathered real property interest will cause loss of grandfathered status and become a nonqualified real property interest in certain circumstances. Any expansion beyond the boundaries of the land of the otherwise grandfathered interest occurring after March 26, 1998, will be treated as a non-qualified real property interest to the extent of such expansion. Moreover, any improvement of an otherwise grandfathered real property interest (within its land boundaries) that is placed in service after December 31, 1999, is treated as a separate nonqualified real property interest in certain circumstances. Such treatment applies where (1) the improvement changes the use of the property and (2) its cost is greater than (a) 200 percent of the undepreciated cost of the property (prior to the improvement) or (b) in the case of property acquired where there is a substituted basis, the fair market value of the property on the date that the property was acquired by the stapled entity or the REIT. There is an exception for improvements placed in service before January 1, 2004, pursuant to a binding contract in effect on December 31, 1999, and at all times thereafter. The rule treating improvements as nonqualified real property interests could apply, for example, if a member of the stapled REIT group constructs a building after December 31, 1999, on previously undeveloped raw land that had been acquired on or before March 26, 1998.

Ownership through entities

If a REIT or stapled entity owns, directly or indirectly, a 10-percent-or-greater interest in a corporate subsidiary or partnership (or other entity described below) that owns a real property interest, the above rules apply with respect to a proportionate part of the entity's real property interest, activities and gross income. Thus, any real property interest acquired by such a subsidiary or partnership that is not grandfathered under the rules described above is treated as a nonqualified real property interest held by the REIT or stapled entity in the same proportion as its ownership interest in the entity. The same proportion of the subsidiary's or partnership's gross income from any nonqualified real property interest owned by it or another member of the stapled REIT group will be treated as income of the REIT under the rules described above. However, an interest in real property acquired by a grandfathered 10-percent-or-greater partnership or subsidiary is treated as grandfathered if such interest would be a grandfathered interest if held directly by the REIT or stapled entity. Thus, for example, if a REIT contributes a grandfathered real property interest to a partnership 10 percent or more of which is owned on March 26, 1998, the interest will not cease to be a grandfathered interest.⁵²

Similar rules attributing the proportionate part of the subsidiary's or partnership's real property interests and gross income will apply when a REIT or stapled entity acquires a 10-percent-or-greater interest (or in the case of a previously-owned entity, acquires an additional interest) after March 26, 1998, with exceptions for interests acquired pursuant to binding written agreements or public announcements described above. Transition relief can apply to both an entity's assets and the interest in the entity under the above rules. Thus, if on March 26, 1998, and at all times thereafter, a stapled entity has a binding written contract to buy 10-percent or more of the stock of a corporation and the corporation also has a binding written contract to buy real property, no portion of the property will be treated as a nonqualified real property interest as a result of the transaction.

Under the above rules, gross income of a REIT or stapled entity with respect to a nonqualified real property interest held by a 10-percent-or-greater partnership or subsidiary is subject to the rules for nonqualified real property interests only in proportion to the interest held in the partnership or subsidiary. For example, assume that a stapled entity has a contract to manage a nonqualified real property interest held by a partnership in which the stapled entity owns an 85-percent interest. Under the above rules, for purposes of applying the gross income tests, 85 percent of the partnership's activities and gross income from the property are attributed to the REIT. As a result, 85 percent of the stapled entity's income from the management contract is ignored under the single-entity analysis described above. The remaining 15 percent of the management fee is not treated as gross income of the REIT because it is not income from a nonqualified real property interest held or deemed held by the REIT or a stapled entity.

Grandfathered real property interests that are deemed owned by a REIT or a stapled entity under the rules for 10-percent-or-greater interests will not be treated as acquired after March 26, 1998, if the REIT or a stapled entity subsequently becomes the actual owner. For example, assume a REIT has a 50-percent interest in a partnership that distributes a grandfathered real property interest to the REIT in complete liquidation of its interest. The 50-percent interest that was previously deemed owned by the REIT will continue to be grandfathered; the remaining 50-percent interest will be a nonqualified real property interest because it was acquired by the REIT after March 26, 1998.

Mortgage rules

Under the provision, special rules apply where a member of the stapled REIT group holds a mortgage (that is not an existing obligation under the rules described below) that is secured by an interest in real property, and a member of the stapled REIT group engages in certain activities with respect to that property. The activities that have this effect under the provision are activities that would result in impermissible tenant service income (as defined in sec.856(d)(7)) if performed by the REIT with respect to property it held. In such a case, all interest on the mortgage that is allocable to that property and all gross income received by a member of the stapled REIT group from the activity will be treated as impermissible tenant service income of the REIT, which is not qualifying income under either the 75-percent or 95-percent tests. For example, assume that the REIT makes a mortgage loan on a hotel owned by a third party which is operated by a stapled entity under a management contract. Unless an exception applies, both the management fees earned by the stapled entity and the interest earned by the REIT will be treated as impermissible tenant services income of the REIT.

An exception to the above rules is provided for mortgages the interest on which does not exceed an arm's-length rate and which would be treated as interest for purposes of the REIT rules. An exception also is available for mortgages that are held by a member of the stapled REIT group on March 26, 1998, and at all times thereafter, and which are secured by an interest in real property on that date, and at all times thereafter (the "existing mortgage exception"). The existing mortgage exception ceases to apply if the mortgage is refinanced and the principal amount is increased in such refinancing.

In the case of a partnership or subsidiary in which the REIT or a stapled entity owns a 10-percent-or-greater interest, a proportionate part of the entity's mortgages, interest and gross income from activities would be attributed to the REIT or the stapled entity, subject to rules similar to those for nonqualified real property interests. Thus, if a REIT or a stapled entity acquires a 10-percent-or-greater interest in a partnership or corporation after March 26, 1998, no mortgage held by the partnership or subsidiary at such time would qualify for the existing mortgage exception. Similarly, if a REIT or stapled entity owns a 10-percent-or-greater interest in a partnership or subsidiary on March 26, 1998, and the REIT or the stapled entity subsequently acquires a greater interest, a portion of each of the partnership's or subsidiary's mortgages that is the same as the proportionate increase in the ownership interest would fail to qualify for the existing mortgage exception.

Under the provision's priority rules, the mortgage rules do not apply to any part of a real property interest that is owned or deemed owned by the REIT or a stapled entity under the rules for real property interests described above. Thus, for example, if the REIT makes a mortgage loan on real property owned by a stapled entity, the mortgage rules would not apply. If the property is a nonqualified real property interest, the interest on the mortgage would be ignored under the single-entity analysis described above, and the gross income of the stapled entity from the property would be treated as income of the REIT. Similarly, assume that a stapled entity owns 75 percent of the stock of a subsidiary and has a management contract to operate a hotel owned by the subsidiary. Assume also that the REIT makes a mortgage loan for the hotel. Under the real property interest rules, 75 percent of the hotel is treated as owned by the stapled entity. Thus, if the hotel is a nonqualified real property interest, 75 percent of the subsidiary's gross income from the hotel is treated as income of the REIT and 75 percent of the income on the management contract is ignored under the single-entity analysis. With respect to the remaining 25-percent interest in the subsidiary, the real property interest rules do not apply, but the mortgage rules would treat 25 percent of the mortgage interest and 25 percent of management contract income as impermissible tenant services income of the REIT.

Other rules

For purposes of both the real property interest and mortgage rules, if a stapled REIT is not stapled as of March 26, 1998, and at all times thereafter, or if it fails to qualify as a REIT as of such date or any time thereafter, no assets of any member of the stapled REIT group would qualify under the grandfather rules. Thus, all of the real property interests held by the group would be nonqualified real property interests and none of the mortgages held by the group would qualify for the existing mortgage exception.

For a corporate subsidiary owned by a stapled entity, the 10-percent ownership test would be met if a stapled entity owns, directly or indirectly, 10 percent or more of the corporation's stock, by either vote or value.⁵³ For this purpose, any change in proportionate ownership that is attributable solely to fluctuations in the relative fair market values of different classes of stock is not taken into account. For interests in partnerships, the ownership test would be met if either the REIT or a stapled entity owns, directly or indirectly, a 10-percent or greater interest in the partnership's assets or net profits. Interests in other entities, such as trusts, are treated in the same manner as 10-percent-or-greater interests in partnerships or corporations if the REIT or a stapled entity owns, directly or indirectly, 10 percent or more of the beneficial interests in the entity.

Under the provision, terms used that are also used in the stapled stock rules (sec. 269B) or the REIT rules (sec. 856) have the same meanings as under those rules.

The Secretary of the Treasury is given authority to prescribe such guidance as may be necessary or appropriate to carry out the purposes of the provision, including guidance to prevent the double counting of income and to prevent transactions that would avoid the purposes of the provision.

Effective Date

The provision is effective for taxable years ending after March 26, 1998.

E. Make Certain Trade Receivables Ineligible for Mark-to-Market Treatment

(sec. 5005 of the bill and sec. 475 of the Code)

Present Law

In general, dealers in securities are required to use a mark-to-market method of accounting for securities (sec. 475). Exceptions to the mark-to-market rule are provided for securities held for investment, certain debt instruments and obligations to acquire debt instruments and certain securities that hedge securities. A dealer in securities is a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business, or who regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in certain types of securities with customers in the ordinary course of a trade or business. A security includes (1) a share of stock, (2) an interest in a widely held or publicly traded partnership or trust, (3) an evidence of indebtedness, (4) an interest rate, currency, or equity notional principal contract, (5) an evidence of an interest in, or derivative financial instrument in, any of the foregoing securities, or any currency, including any option, forward contract, short position, or similar financial instrument in such a security or currency, or (6) a position that is an identified hedge with respect to any of the foregoing securities.

Treasury regulations provide that if a taxpayer would be a dealer in securities only because of its purchases and sales of debt instruments that, at the time of purchase or sale, are customer paper with respect to either the taxpayer or a corporation that is a member of the same consolidated group, the taxpayer will not normally be treated as a dealer in securities. However, the regulations allow such a taxpayer to elect out of this exception to dealer status.⁵⁴ For this purpose, a debt instrument is customer paper with respect to a person if: (1) the person's principal activity is selling nonfinancial goods or providing nonfinancial services; (2) the debt instrument was issued by the purchaser of the goods or services at the time of the purchase of those goods and services in order to finance the purchase; and (3) at all times since the debt instrument was issued, it has been held either by the person selling those goods or services or by a corporation that is a member of the same consolidated group as that person.

Reasons for Change

Congress enacted the mark-to-market rules of section 475 to provide a more accurate reflection of the income of securities dealers. The Committee does not believe that these provisions were intended to be used by taxpayers whose principal activity is selling goods and services to obtain a deduction for loss in value of their receivables at a time earlier than otherwise would be permitted.

Explanation of Provision

The provision provides that certain trade receivables are not eligible for mark-to-market treatment. A trade receivable is covered by the provision if it is a note, bond or debenture arising out of the sale of goods by a person the principal activity of which is selling or providing non-financial goods and services and it is held by such person or a related person at all times since it was issued.

Under the provision, a receivable meeting the above definition is not treated as a security for purposes of the mark-to-market rules (sec. 475). Thus, such receivables are not marked-to-market, even if the taxpayer qualifies as a dealer in other securities. Because trade receivables cease to meet the above definition when they are disposed of (other than to a related person), a taxpayer who regularly sells trade receivables is treated as a dealer in securities as under present law, with the result that the taxpayer's other securities would be subject to mark-to-market treatment unless an exception to section 475 applies (such as that for securities identified as held for investment).

Effective Date

The provision generally is effective for taxable years ending after the date of enactment. Adjustments required under section 481 as a result of the change in method of accounting generally are required to be taken into account ratably over the four-year period beginning in the first taxable year for which the provision is in effect. However, where the taxpayer terminates its existence or ceases to engage in the trade or business that generated the receivables (except as a result of a tax-free transfer), any remaining balance of the section 481 adjustment is taken into account entirely in the year of such cessation or termination (see sec. 5.04(c) of Rev. Proc. 97-37, 1997-33 I.R.B. 18).

F. Add Vaccines Against Rotavirus Gastroenteritis to the List of Taxable Vaccines (sec. 5006 of the bill and sec. 4132 of the Code)

Present Law

A manufacturer's excise tax is imposed at the rate of 75 cents per dose (sec. 4131) on the following vaccines routinely recommended for administration to children: diphtheria, pertussis, tetanus, measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, and varicella (chicken pox). The tax applied to any vaccine that is a combination of vaccine components equals 75 cents times the number of components in the combined vaccine.

Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury Compensation Trust Fund to finance compensation awards under the Federal Vaccine Injury Compensation Program for individuals who suffer certain injuries following administration of the taxable vaccines. This program provides a substitute Federal, "no fault" insurance system for the State-law tort and private liability insurance systems otherwise applicable to vaccine manufacturers. All persons immunized after September 30, 1988, with covered vaccines must pursue compensation under this Federal program before bringing civil tort actions under State law.

Reasons for Change

Rotavirus gastroenteritis is a highly contagious disease among young children that can lead to life-threatening diarrhea, cramps, vomiting, and can result in death. In the United States , more than 50,000 children are hospitalized and more than 100 die annually from rotavirus gastroenteritis. The Food and Drug Administration's ("FDA") advisory committee has favorably reviewed a vaccine against the disease and the Centers for Disease Control have voted to recommend the vaccine for inoculation of children, subject to final FDA approval. The Committee believes American children will benefit from wide use of this new vaccine. The Committee believes that, by including the new vaccine with those presently covered by the Vaccine Injury Compensation Trust Fund, greater application of the vaccine will be promoted. The Committee, therefore, believes it is appropriate to add the vaccine against rotavirus gastroenteritis to the list of taxable vaccines.

Explanation of Provision

The bill adds any vaccine against rotavirus gastroenteritis to the list of taxable vaccines.

Effective Date

The provision is effective for vaccines sold by a manufacturer or importer after the date of enactment. For sales on or before the date of enactment for which delivery is made after the date of enactment, the delivery date is deemed to be the sale date.

TITLE VI. TAX TECHNICAL CORRECTIONS

TECHNICAL CORRECTIONS TO THE TAXPAYER RELIEF ACT OF 1997

A. Amendments to Title I of the 1997 Act Relating to the Child Credit 1. Stacking rules for the child credit under the limitations based on tax liability (sec. 6003(a) of the bill, sec. 101(a) of the 1997 Act, and sec. 24 of the Code)

Present Law

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

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

Nonrefundable credits may not be used to reduce tax liability below a taxpayer's tentative minimum tax. Certain credits not used as result of this rule may be carried over to other taxable years, while others may not. Special stacking rules apply in determining which nonrefundable credits are used in the current year. Generally, the stacking rules require that nonrefundable personal credits be considered first ⁵⁵ , followed by other credits, business credits, and the investment tax credit. Refundable credits, which are not limited by the minimum tax, are not stacked until after the nonrefundable credits.

Explanation of Provision

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

Effective Date

The provision is effective for taxable years beginning after December 31, 1997.

2. Treatment of a portion of the child credit as a supplemental child credit (sec. 6003(b) of the bill, sec. 101(b) of the 1997 Act, and sec. 32(n) of the Code)

Present Law

A portion of the child credit may be treated as a supplemental child credit. The supplemental child credit is treated as provided under the earned income credit and the child credit amount is reduced by the amount of the supplemental child credit.

Explanation of Provision

The bill clarifies that the treatment of a portion of the child credit as a supplemental child credit under the earned income credit (sec. 32) and the offsetting reduction of the child credit (sec. 24) does not affect the total tax credits allowed to the taxpayer or any other tax credit available to the taxpayer. Rather, it simply reduces the otherwise allowable nonrefundable child credit dollar-for-dollar by the amount treated as a supplemental child credit. The bill also clarifies that the amount of the supplemental child credit under section 32(n) is the lesser of (1) the amount by which the taxpayer's total nonrefundable personal credits (as limited by the tax liability limitation of section 26(a)) are increased by reason of the child credit, or (2) the "negative" tax liability of the taxpayer, defined as the excess of taxpayer's total tax credits, including the earned income credit over the sum of the taxpayer's regular income taxes and social security taxes. For purposes of this calculation, subsection 32(n) is not taken into account. The bill also clarifies that the earned income credit rules (e.g., the phaseout of the earned income credit) generally do not apply to the supplemental child credit.

Effective Date

The provision is effective for taxable years beginning after December 31, 1997.

B. Amendments to Title II of the 1997 Act Relating to Education Incentives 1. Clarifications to HOPE and Lifetime Learning tax credits (sec. 6004(a) of the bill, sec. 201 of the 1997 Act, and secs. 25A and 6050S of the Code)

Present Law

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

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

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

Explanation of Provision

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

Effective Date

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

2. Education IRAs (sec. 6004(d) of the bill, sec. 213 of the 1997 Act, and sec. 530 of the Code)

Present Law

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

Until a distribution is made from an education IRA, earnings on contributions to the account generally are not subject to tax.⁵⁶

In addition, distributions from an education IRA are excludable from gross income to the extent that the distribution does not exceed qualified higher education expenses incurred by the beneficiary during the year the distribution is made (provided that a HOPE credit or Lifetime Learning credit is not claimed with respect to the beneficiary for the same taxable year). The earnings portion of an education IRA distribution not used to pay qualified higher education expenses is includible in the gross income of the distributee and generally is subject to an additional 10-percent tax.⁵⁷ However, the additional 10-percent tax does not apply if a distribution is made of excess contributions above the $500 limit (and any earnings attributable to such excess contributions) if the distribution is made on or before the date that a return is required to be filed (including extensions of time) by the contributor for the year in which the excess contribution was made. In addition, section 530 allows tax-free rollovers of account balances from an education IRA benefiting one family member to an education IRA benefiting another family member. Section 530 is effective for taxable years beginning after December 31, 1997.

Explanation of Provision

Consistent with the legislative history to the 1997 Act, the bill provides that any balance remaining in an education IRA will be deemed to be distributed within 30 days after the date that the designated beneficiary reaches age 30 (or, if earlier, within 30 days of the date that the beneficiary dies). The bill further clarifies that, in the event of the death of the designated beneficiary, the balance remaining in an education IRA may be distributed (without imposition of the additional 10-percent tax) to any other (i.e., contingent) beneficiary or to the estate of the deceased designated beneficiary. If any member of the family of the deceased beneficiary becomes the new designated beneficiary of an education IRA, then no tax will be imposed on such redesignation and the account will continue to be treated as an education IRA.

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

The bill clarifies that, in order for taxpayers to establish an education IRA, the designated beneficiary must be a life-in-being. The bill also clarifies that, under rules contained in present-law section 72, distributions from education IRAs are treated as representing a pro-rata share of the principal (i.e., contributions) and accumulated earnings in the account.⁵⁸

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

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

Effective Date

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

3. Treatment of cancellation of certain student loans (6004(f) of the bill, sec. 225 of the 1997 Act, and sec. 108(f) of the Code)

Present Law

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

Explanation of Provision

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

Effective Date

The provision is effective as of August 5, 1997, the date of enactment of the 1997 Act.

4. Deduction for student loan interest (sec. 6004(b) of the bill, sec. 202 of the 1997 Act, and sec. 221 of the Code)

Present Law

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

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

Explanation of Provision

The bill clarifies that the student loan interest deduction may be claimed only by a taxpayer who is legally obligated to make the interest payments pursuant to the terms of the loan.

Effective Date

The provision is effective for interest payments due and paid after December 31, 1997, on any qualified education loan.

5. Enhanced deduction for corporate contributions of computer technology and equipment (sec. 6004(e) of the bill, sec. 224 of the 1997 Act, and sec. 170(e)(6) of the Code)

Present Law

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

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

The legislative history of the provision states that the special tax treatment for contributions of computer and other equipment was to be effective for contributions made during a three-year period in taxable years beginning after December 31, 1997, and before January 1, 2001.⁵⁹ However, as a result of a drafting error, the statutory provision does not apply to contributions made during taxable years beginning after December 31, 1999.

Explanation of Provision

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

In addition, the bill clarifies that the requirements set forth in section 170(e)(6)(B)(ii)-(vii) apply regardless of whether the donee is an educational organization or a tax-exempt charitable entity. Similarly, the rule in section 170(e)(6)(ii)(I) regarding subsequent contributions by private foundations is clarified to permit contributions to either educational organizations or tax-exempt charitable entities described in section 170(e)(6)(B)(i).

Effective Date

The provision is effective as of August 5, 1997, the date of enactment of the 1997 Act.

6. Qualified State tuition programs (sec. 6004(c) of the bill, sec. 211 of the 1997 Act, and sec. 529 of the Code)

Present Law

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

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

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

Explanation of Provision

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

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

Effective Date

The provision s are effective for distributions made after December 31, 1997.

7. Qualified zone academy bonds (sec. 6004(g) of the bill, sec. 226 of the 1997 Act, and sec. 1397E of the Code)

Present Law

Certain financial institutions (i.e., banks, insurance companies, and corporations actively engaged in the business of lending money) that hold "qualified zone academy bonds" are entitled to a nonrefundable tax credit in an amount equal to a credit rate (set monthly by the Treasury Department⁶⁰ ) multiplied by the face amount of the bond (sec. 1397E). The credit rate applies to all such bonds issued in each month. A taxpayer holding a qualified zone academy bond on the credit allowance date (i.e., each one-year anniversary of the issuance of the bond) is entitled to a credit. The credit is includible in gross income (as if it were an interest payment on the bond), and may be claimed against regular income tax and AMT liability.

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

A total of $400 million of "qualified zone academy bonds" may be issued in each of 1998 and 1999. The $400 million aggregate bond cap will be allocated each year to the States according to their respective populations of individuals below the poverty line.⁶¹ Each State, in turn, will allocate the credit to qualified zone academies within such State. A State may carry over any unused allocation into subsequent years.

Explanation of Provision

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

Effective Date

The provision s are effective for obligations issued after December 31, 1997.

C. Amendments to Title III of the 1997 Act Relating to Savings Incentives 1. Conversions of IRAs into Roth IRAs (sec. 6005(b) of the bill, sec. 302 of the 1997 Act, and secs. 408A and 72(t) of the Code)

Present Law

A taxpayer with adjusted gross income of less than $100,000 may convert a present-law deductible or nondeductible IRA into a Roth IRA at any time. The amount converted is includible in income in the year of the conversion, except that if the conversion occurs in 1998, the amount converted is includible in income ratably over the 4-year period beginning with the year in which the conversion occurs.⁶² Amounts includible in income as a result of the conversion are not taken into account in determining whether the $100,000 threshold is exceeded. The 10-percent tax on early withdrawals does not apply to conversions of IRAs into Roth IRAs.

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

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

Explanation of Provision

Distributions of converted amounts

Distributions before the end of the 4-year spread

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

Under the bill, application of the 4-year spread will be elective. The election will be made in the time and manner prescribed by the Secretary. If no election is made, the 4-year rule will be deemed to be elected. An election, or deemed election, with respect to the 4-year spread cannot be changed after the due date for the return for the first year of the income inclusion (including extensions).

The following example illustrates the application of these rules.

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

Application of early withdrawal tax to converted amounts

The bill modifies the rules relating to conversions to prevent taxpayers from receiving premature distributions (i.e., within 5 years) while retaining the benefit of the nonpayment of the early withdrawal tax. Under the bill, if converted amounts are withdrawn within the 5-year period beginning with the year of the conversion, then, to the extent attributable to amounts that were includible in income due to the conversion, the amount withdrawn will be subject to the 10-percent early withdrawal tax.⁶³

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

Application of 5-year holding period

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

Ordering rules

Ordering rules will apply to determine what amounts are withdrawn in the event a Roth IRA contains both conversion amounts (possibly from different years) and other contributions. Under these rules, regular Roth IRA contributions will be deemed to be withdrawn first, then converted amounts (starting with the amounts first converted). Withdrawals of converted amounts will be treated as coming first from converted amounts that were includible in income. As under present law, earnings will be treated as withdrawn after contributions. For purposes of these rules, all Roth IRAs, whether or not maintained in separate accounts, will be considered a single Roth IRA.

Corrections

In order to assist individuals who erroneously convert IRAs into Roth IRAs or otherwise wish to change the nature of an IRA contribution, contributions to an IRA (and earnings thereon) may be transferred in a trustee-to-trustee transfer from any IRA to another IRA by the due date for the taxpayer's return for the year of the contribution (including extensions). Any such transferred contributions will be treated as if contributed to the transferee IRA (and not to the transferor IRA). Trustee-to-trustee transfers include transfers between IRA trustees as well as IRA custodians, apply to transfers from and to IRA accounts and annuities, and apply to transfers between IRA accounts and annuities with the same trustee or custodian.

Effect of death on 4-year spread

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

Calculation of AGI limit for conversions

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

Effective Date

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

2. Penalty-free distributions for education expenses and purchase of first homes (sec. 6005(c) of the bill, secs. 203 and 303 of the 1997 Act, and sec. 402 of the Code)

Present Law

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

Explanation of Provision

Under present law, participants in employer-sponsored retirement plans can avoid the early withdrawal tax applicable to such plans by rolling over hardship distributions to an IRA and withdrawing the funds from the IRA. The bill modifies the rules relating to the ability to roll over hardship distributions from employer-sponsored retirement plans (including section 403(b) plans) in order to prevent such avoidance of the 10-percent early withdrawal tax. The bill provides that distributions from cash or deferred arrangements and similar arrangements made on account of hardship of the employee are not eligible rollover distributions. Such distributions will not be subject to the 20-percent withholding applicable to eligible rollover distributions.

Effective Date

The provision is effective for distributions after December 31, 1998.

3. Limits based on modified adjusted gross income (sec. 6005(b) of the bill, sec. 302(a) of the 1997 Act, and sec. 72(t) of the Code)

Present Law

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

Explanation of Provision

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

Effective Date

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

4. Contribution limit to Roth IRAs (sec. 6005(b) of the bill, sec. 302 of the 1997 Act, and sec. 408A(c) of the Code)

Present Law

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

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

Explanation of Provision

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

Effective Date

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

5. Contribution limitations for active participants in an IRA (sec. 6005(a) of the bill, sec. 301(b) of the 1997 Act, and sec. 219(g) of the Code)

Present Law

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

   Taxable years beginning in:        

Phase-out
 
Range

      1997                            $40,000 to $50,000

      1998                            $50,000 to $60,000

      1999                            $51,000 to $61,000

      2000                            $52,000 to $62,000

      2001                            $53,000 to $63,000

      2002                            $54,000 to $64,000

      2003                            $60,000 to $70,000

      2004                            $65,000 to $75,000

      2005                            $70,000 to $80,000

      2006                            $75,000 to $85,000

      2007                            $80,000 to $100,000

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

Explanation of Provision

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

Effective Date

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

D. Amendments to Title III of the 1997 Act Relating to Capital Gains 1. Individual capital gains rate reductions (sec. 6005(d) of the bill, sec. 311 of the 1997 Act, and sec. 1(h) of the Code)

Present Law

The 1997 Act provided lower capital gains rates for individuals. Generally, the 1997 Act reduced the maximum rate on the adjusted net capital gain of an individual from 28 percent to 20 percent and provided a 10-percent rate for the adjusted net capital gain otherwise taxed at a 15-percent rate. The "adjusted net capital gain" means the net capital gain determined without regard to certain gain for which the 1997 Act provided a higher maximum rate of tax. The 1997 Act generally retained a 28-percent maximum rate for the long-term capital gain from collectibles, certain long-term capital gain included in income from the sale of small business stock, and the net capital gain determined by including all capital gains and losses properly taken into account after July 28, 1997, from property held more than one year but not more than 18 months and all capital gains and losses properly taken into account for the portion of the taxable year before May 7, 1997. In addition, the 1997 Act provided a maximum rate of 25 percent for the long-term capital gain attributable to real estate depreciation ("unrecaptured section 1250 gain"). Beginning in 2001 and 2006, lower rates of 8 and 18 percent will apply to certain property held more than five years.

The amounts taxed at the 28- and 25- percent rates may not exceed the individual's net capital gain and also are reduced by amounts otherwise taxed at a 15-percent rate.

Under the provisions of the 1997 Act, net short-term capital losses and long-term capital loss carryovers reduce the amount of adjusted net capital gain before reducing amounts taxed at the maximum 25- and 28-percent rates.

The 1997 Act failed to coordinate the new multiple holding periods with certain provisions of the Code.

Explanation of Provision

Under the bill, the "adjusted net capital gain" of an individual is the net capital gain reduced (but not below zero) by the sum of the 28-percent rate gain and the unrecaptured section 1250 gain.

"28-percent rate gain" means the amount of net gain attributable to collectibles gains and losses, an amount of gain equal to the gain excluded from gross income on the sale of certain small business stock under section 1202,⁶⁴ long-term capital gains and losses properly taken into account after July 28, 1997, from property held more than one year but not more than 18 months, the net short-term capital loss for the taxable year and the long-term capital loss carryover to the taxable year. Long-term capital gains and losses properly taken into account before May 7, 1997, also are included in computing 28-percent rate gain.

"Unrecaptured section 1250 gain" means the amount of long-term capital gain (not otherwise treated as ordinary income) which would be treated as ordinary income if section 1250 recapture applied to all depreciation (rather than only to depreciation in excess of straight-line depreciation) from property held more than 18 months (one year for amounts properly taken into account after May 6, 1997, and before July 29, 1997).⁶⁵ The unrecaptured section 1250 depreciation is reduced (but not below zero) by the excess (if any) of amount of losses taken into account in computing 28-percent gain over the amount of gains taken into account in computing 28-percent rate gain.

The bill contains several conforming amendments to coordinate the multiple holding periods with other provisions of the Code. Inherited property (sec. 1223 (11) and (12)) and certain patents (sec. 1235) are deemed to have a holding period of more than 18 months, allowing the 10-and 20-percent rates to apply. Amounts treated as ordinary income by reason of section 1231(c) will be allocated among categories of net section 1231 gain in accordance with IRS forms or regulations. The bill clarifies that the amount treated as long-term capital gain or loss on a section 1256 contract is treated as attributable to property held for more than 18 months.

Under the bill, in applying section 1233(b) where the substantially identical property has been held more than one year but not more than 18 months, any gain on the closing of the short sale will be considered gain from property held not more than 18 months, and the substantially identical property will have be treated as held for one year on the day before the earlier of the date of the closing of the short sale or the date the property is disposed of. In applying section 1233(d) where, on the date of the short sale, the substantially identical property has been held more than 18 months, any loss on the closing of the short sale will be treated as a loss from the sale or exchange of a capital asset held more than 18 months. Finally, in applying section 1092(f), any loss with respect to the option shall be treated as a loss from the sale or exchange of a capital asset held more than 18 months, if at the time the loss is realized, gain on the sale or exchange of the stock would be treated as gain from the sale or exchange of a capital asset held more than 18 months.⁶⁶

The bill reorders the rate structure under sections 1(h)(1) and 55(b)(3) without any substantive change.

The bill makes minor technical changes, including a provision to reduce the minimum tax preference on certain small business stock to 28 percent, beginning in 2006.⁶⁷

Effective Date

The provision applies to taxable years ending after May 6, 1997.

2. Rollover of gain from sale of qualified stock (sec. 6005(f) of the bill, sec. 313 of the 1997 Act, and sec. 1045 of the Code)

Present Law

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

Explanation of Provision

Under the bill, a partnership or an S corporation can roll over gain from qualified small business stock held more than six months if (and only if) at all times during the taxable year all the interests in the partnership or S corporation are held by individuals, estates⁶⁸ , and trusts with no corporate beneficiaries.

Effective Date

The provision applies to sales on or after August 5, 1997, the date of enactment of the 1997 Act.

3. Exclusion of gain on the sale of a principal residence owned and used less than two years (sec. 6005(e)(1) and (2) of the bill, sec. 312(a) of the 1997 Act, and sec. 121 of the Code)

Present Law

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

Explanation of Provision

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

In addition, the bill provides that if a married couple filing a joint return does not qualify for the $500,000 maximum exclusion, the amount of the maximum exclusion that may be claimed by the couple is the sum of each spouse's maximum exclusion determined on a separate basis.

Effective Date

The provision is effective as if included in section 312 of the 1997 Act.

4. Effective date of the exclusion of gain on the sale of a principal residence (sec. 6005(e)(3) of the bill, sec. 312(d)(2) of the 1997 Act, and sec. 121 of the Code)

Present law

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

Explanation of Provision

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

Effective Date

The provision is effective as if included in section 312 of the 1997 Act.

E. Amendments to Title IV of the 1997 Act Relating to Alternative Minimum Tax 1. Election to use AMT depreciation for regular tax purposes (sec. 6006(b) of the bill, sec. 402 of the 1997 Act, and sec. 168 of the Code)

Present Law

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

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

Explanation of Provision

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

Effective Date

The provision is effective for property placed in service after December 31, 1998.