Revenue Offsets and Miscellaneous Provisions

Discharge of Indebtedness of an S Corporation (Override of Gitlitz)

The Act overrides the result in Gitlitz v. Commissioner, 531 U.S. 236 (2001). The Act provides that discharge of indebtedness income that is excluded from the income of an S corporation cannot be used to increase a shareholder's basis in S corporation stock, effective for discharges of indebtedness occurring after October 11, 2001. A transitional rule exempts discharges made before March 1, 2002, pursuant to a plan of reorganization filed on or before October 11, 2001.

In Gitlitz, the U.S. Supreme Court allowed excluded discharge of indebtedness income to be taken into account for purposes of determining an S corporation shareholder's basis.

KPMG Observation

S corporation shareholders may continue to recognize an increase in the basis of their S corporation shares for income attributable to discharges of indebtedness that occurred on or before October 11, 2001. Taxpayers who hold or held shares in an S corporation whose debt was relieved prior to October 12, 2001, should review their basis calculations, as they may still benefit from the decision in Gitlitz.

Limitation on Use of the Nonaccrual Experience Method of Accounting

The nonaccrual experience method of accounting allows accrual basis taxpayers to exclude from gross income certain income from services that, based on the taxpayer's experience, it does not expect to collect. Temporary regulations¹ mandate the use of a specific formula to determine the amount that is not expected to be collected.

The Act limits the use of the nonaccrual experience method of accounting to amounts to be received for the performance of qualified personal services: health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. The nonaccrual experience method also may be used by accrual method taxpayers with average annual gross receipts of $5 million or less.

Taxpayers that are no longer eligible to use the method are required to change their method of accounting for the first tax year ending after the date of enactment² (e.g., calendar year 2002). Any adjustment necessitated by such change will be taken into income over a period of up to four years beginning with the tax year in which the change is required.

The Act also provides greater flexibility in determining the amount that, on the basis of experience, will not be collected. The Secretary of the Treasury is directed to issue regulations allowing taxpayers to adopt, or change to, any computation or formula that clearly reflects the taxpayer's experience.

KPMG Observation

The provision modifying the nonaccrual experience method provides opportunities for taxpayers that continue to be eligible to use the method.

In many cases, the nonaccrual experience formula mandated in the temporary regulations underestimates the amount of service receivables a taxpayer will not collect. This is particularly true where receivables can be outstanding for significant periods of time. As a result, many taxpayers that were eligible to use the nonaccrual experience method did not elect to do so. Accrual method taxpayers that provide qualified personal services should now consider whether an election to adopt the nonaccrual experience method is advantageous. Taxpayers that previously adopted the nonaccrual experience method should review their records to determine if a different formula would be more beneficial.

Electronic Delivery of Forms 1099

The Act allows Forms 1099 to be furnished electronically to a taxpayer if the taxpayer consents to electronic transmission. The provision is effective on the date of enactment (March 9, 2002).

KPMG Observation

Unless the Secretary of the Treasury authorizes a different procedure, it is expected that the recipient will be required to consent affirmatively to the use of an electronic Form 1099.

The provision could reduce the federal income tax reporting costs of banks and financial institutions. Banks and other financial institutions have been required to provide their customers with a Form 1099 in paper form. Providing paper Forms 1099 can be costly, especially since they are required for even very small payments of income.

Interest Rate Used in Determining Additional Required Contributions to Defined Benefit Plans and Pension Benefit Guaranty Corporation (PBGC) Variable Rate Premiums

The Act expands the permissible range of the statutory interest rate used in calculating an underfunded defined benefit plan's current liability for purposes of applying the additional contribution requirements on account of the underfunding.

KPMG Observation

Defined benefit plans have minimum funding requirements that determine the amount of contributions or additional contributions required for a plan year. The interest rate used to determine a plan's current liability and the PBGC premiums for such plans are based on interest rates on 30-year Treasury securities.

However, Treasury stopped issuing 30-year Treasury securities in 2001, and the extrapolated interest rate that has been used instead has been very low, forcing plan sponsors to make contributions larger than if a market rate of interest were used.

The Act allows a higher interest rate to be used (up to 120 percent, instead of 115 percent, of the extrapolated 30-year Treasury security rate) in plan years beginning in 2002 or 2003. Special rules are provided for determining quarterly contribution requirements for plan years beginning in 2002 and again in 2004 (when the expanded range ceases to apply).

Also, the Act raises the interest rate used in 2002 and 2003 to determine the amount of unfunded vested benefits for PBGC variable rate premiums purposes from 85 percent to 100 percent of the extrapolated interest rate on 30-year Treasury securities for the month preceding the month in which the plan year begins.

Exclusion from Income for Qualified Foster Care Payments

The definition of "qualified foster care payments" is expanded to include payments by a placement agency that is licensed or certified by a state or local government (or an entity designated by such government) to make payments to providers of foster care. Also, the definition of a "qualified foster care individual" is expanded to include an individual placed by a qualified foster care placement agency, regardless of the individual's age at placement.

This provision is effective for tax years beginning after 2001.

Deduction for Classroom Materials

The Act provides an annual above-the-line deduction for up to $250 of expenses paid or incurred by an eligible educator for certain books, supplies, computer equipment, and supplementary materials used by the educator in the classroom. The expense must otherwise qualify as a trade or business expense.

An "eligible educator" is an individual who is a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide in a school for at least 900 hours during the school year. The deduction is allowed only to the extent that the expenses exceed the amount excludable under certain other tax provisions relating to educational expenses.

The exclusion is effective for tax years beginning after 2001.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

¹ Treas. Reg. section 1.448-2T(e).

² Date of enactment is March 9, 2002.