Legislative Update: Tax Increase Prevention and Reconciliation Act of 2005

Congress approved on May 11, 2006 a five-year $70 billion tax cut, the Tax Increase Prevention and Reconciliation Act of 2005, clearing it for the President.

Conferees are continuing to discuss a potential second tax bill that would extend certain expired provisions, such as the research credit, and that could include other changes. In a statement, Senate Finance Committee Chairman Charles Grassley (R-IA) said he and Ways and Means Committee Chairman Bill Thomas (R-CA) “have an understanding” concerning the expired provisions.

Below are preliminary descriptions of most of the provisions in the Conference Agreement. References to the bill section and corresponding page in the Conference Report are included at the end of each provision (click on the hyperlink for an electronic version).

I. Major Provisions

A. Extend Reduced Rates on Capital Gains and Dividends

The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the maximum income tax rate on net capital gains of individuals to 15%, and also applied this tax rate to qualified dividend income. For net capital gains or qualified dividend income that would otherwise be taxed at a rate below 25%, the maximum rate was reduced to 5%. Furthermore, in tax years beginning after 2007, the 5% rate was reduced to zero. Other special rates apply in certain situations.

These reduced rates are scheduled to expire for tax years beginning after 2008. The 15% rate would generally revert to 20%, the 5% rate (zero for 2008) would generally revert to 10%, and these reduced rates would no longer apply to qualified dividend income.

The Conference Agreement would extend the reduced rate structure for net capital gains and qualified dividend income for two years, i.e., to tax years beginning in 2009 and 2010. Thus, in those tax years, there would be a general maximum individual income tax rate of 15% on net capital gains and qualified dividend income, and any such income that would otherwise be taxed at a rate below 25% would effectively be exempt from tax.

Code (sec. 1(h))           Conference Report (p. 48)
Act (sec. 102)

B. Modify Individual AMT Provisions

The Conference Agreement would make revisions to the alternative minimum tax (AMT) for individuals, effective for tax years beginning in 2006, that are intended to limit the number of taxpayers that are subject to the AMT. The AMT is imposed in addition to the regular tax when a tax computed at 26% or 28% of alternative minimum taxable income (AMTI) is larger than the regular tax. AMTI is generally a broader tax base than that used to compute regular tax and notably lacks deductions for state and local taxes and for personal exemptions.

The Conference Agreement would provide an exemption of $62,550 on a joint return ($42,550 for an unmarried individual) in computing AMTI for 2006. An exemption of $58,000 ($40,250 for an unmarried individual) had been allowed for 2005, but the exemption was scheduled to decline for 2006 to its 2002 level of $45,000 ($33,750 for an unmarried individual).

Code (sec. 55)           Conference Report (p. 56)
Act (sec. 301)

Also, the Conference Agreement would reinstate for 2006 a provision that had been in effect for 2005 and several earlier years that allowed an individual to offset against its AMT liability several nonrefundable credits (the dependent care credit, the child tax credit, the adoption credit, and others).

Code (sec. 26)           Conference Report (p. 1)
Act (sec. 302)

C. Eliminate Income Limits for Rollovers to a Roth IRA from a Traditional IRA

Taxpayers with adjusted gross income (AGI) exceeding $100,000 may not convert assets from a traditional IRA to a Roth IRA.

Generally, any untaxed amounts rolled over are included in income in the year rolled over.

The Conference Agreement would eliminate the income limits on conversions of traditional IRAs to Roth IRAs. Thus, taxpayers could make conversions without regard to AGI.

The provision would be effective for tax years beginning after 2009. For conversions in 2010, the amount includable in income generally would be included ratably in 2011 and 2012, unless a taxpayer elects otherwise.

Code (sec. 408A)           Conference Report (p. 308)
Act (sec. 512)

D. Modify Wage Limitation for Section 199

The Conference Agreement would modify the section 199 deduction for qualified production activities that was enacted in 2004.

Under current law, the deduction from taxable income for a tax year for qualified production activities is limited to 50% of all W-2 wages paid by the taxpayer during the calendar year that ends in such tax year.

The Conference Agreement would modify the W-2 wage limitation so that taxpayers could only include amounts properly allocable to domestic production gross receipts. Thus, the wage limitation would be 50% of W-2 wages that are incurred in qualifying domestic production activities.

In addition, under current law, the W-2 wages allocable to a partner, or a shareholder of a passthrough entity, are limited to two times the qualified production activities income that actually is allocated to that person for the tax year.

As a simplification measure, the Conference Agreement would repeal this limitation on W-2 wages allocable to partners or shareholders. For purposes of the W-2 wage limitation, a shareholder, partner, or similar person that is allocated a share of qualified production activities income from a passthrough entity would be treated as being allocated W-2 wages from the entity in an amount determined under regulations prescribed by the Secretary -- even if this amount is more than twice the applicable percentage of qualified production activities income allocated to that person for the tax year.

Code (sec. 199)           Conference Report (p. 314)
Act (sec. 514)

E. Extend Temporary Section 179 Expensing Rules

The Conference Agreement would extend for two years several temporary changes to the section 179 expensing rules, originally enacted in 2003, so that they would apply in tax years beginning in 2008 and 2009. These provisions are:

• A $100,000 limitation on the amount of Section 179 property that a taxpayer may elect each year to expense, rather than depreciate. (This amount is indexed for inflation each year; the indexed limitation for 2006 is $108,000.) After 2009, this limitation would revert to $25,000, without any indexing.
• A $400,000 threshold on the annual amount of investment in Section 179 property a taxpayer can make before the annual limitation begins to be phased out. (This amount is indexed for inflation each year; the indexed limitation for 2006 is $430,000.) After 2009, this threshold would revert to $200,000, without any indexing.
• Authority allowing taxpayers to revoke or amend a Section 179 election, without the consent of the IRS.
• Inclusion of certain computer software as Section 179 property.

Code (sec. 179)           Conference Report (p. 54)
Act (sec. 101)

II. Corporate Tax Provisions

A. Modify Active Business Definition Under Section 355

The Conference Agreement would modify the tax-free distribution rules under section 355. The Conference Report states that the modification would simplify the active trade or business test for certain corporate distributions. By applying this test on an affiliated group basis, the provision would apply the same standard regardless of whether a business is owned by a holding company or directly owned. The Conference Report also states that this provision would allow corporations to avoid costly and inefficient internal restructurings prior to certain corporate distributions to their shareholders.

The Conference Agreement would change the rules to allow holding companies greater ease in satisfying the active trade or business requirement of section 355(b).

Under the Conference Agreement, a holding company would no longer be required to hold substantially all of its assets in the form of stock or securities in corporations engaged in an active trade or business, in order to satisfy the active trade or business requirement in a divisive reorganization. Instead, all members of a corporation’s “separate affiliated group” would be treated as one corporation, thereby permitting both the distributing corporation and the controlled corporation to satisfy the active trade or business requirement by reference to their respective affiliated groups. The term “separate affiliated group” means the affiliated group that would be determined under section 1504(a), if the distributing corporation or controlled corporation, as the case may be, was the common parent.

Thus, if the distributing corporation were a holding company and the parent of an affiliated group (generally defined under the section 1504(a)), and the affiliated group were engaged in an active trade or business, the distributing corporation would satisfy the active trade or business requirement. The same analysis would apply to the controlled corporation.

A special rule would apply for certain pre-enactment distributions. For distributions before the date of enactment, solely for the purposes of determining whether, after the date of enactment, the taxpayer continues to satisfy section 355(b)(2)(A) as a result of an acquisition, disposition, or other restructuring (a “restructuring”) after that date and before 2011, the provision would apply as if the distribution occurred on the date of such restructuring.

Code (sec. 355)           Conference Report (p. 65)
Act (sec. 202)

B. Limit Section 355 Tax-Free Treatment for Distributions Involving Disqualified Investment Companies

A new section 355(g) would target “cash rich” split-offs. Sections 355 and 356 would not apply to any distribution that is part of a transaction, or series of transactions, if:

• Either the distributing corporation or the controlled corporation is, immediately after the transaction (or series of transactions), a disqualified investment corporation (that is, either corporation is cash rich), and
• Any person holds, immediately after the transaction (or series of transactions), a 50% or greater interest in the vote or value of the stock of any disqualified investment corporation, but only if that person did not hold such an interest in the corporation immediately before the transaction (or series of transactions) (that is, the transaction effects a split-off to a 50% controlling shareholder).

For example, the provision would apply if a person that held 50% or more of the vote, but not the value, of a distributing corporation immediately before a split-off transaction holds 50% of the value of either the distributing or controlled corporation immediately following the transaction.

A “disqualified investment corporation” would be any distributing or controlled corporation, if the fair market value of the investment assets of the corporation were two-thirds or more of the fair market value of all assets of the corporation. (The Conference Agreement provides a one-year transition rule setting the fraction at three-fourths or more of the fair market value of all corporate assets.)

Investment assets generally would include cash, any stock or securities in a corporation, any interest in a partnership, any debt instrument or other evidence of indebtedness, any option, forward or futures contract, notional principal contract, or derivative, foreign currency, or any similar asset. There would be numerous exceptions. For example, investment assets would not include:

• Any assets that are held for use in the active and regular conduct of a lending or finance business, a banking business (provided that substantially all of the income of the banking business is derived from unrelated persons), or a regulated insurance business
• Securities held by a dealer in securities that are marked to market
• Stock or certain other securities issued by a 20% controlled entity of the distributing or controlled corporation -- instead, the distributing or controlled corporation would be treated as owning its ratable share of the assets of the 20% controlled entity
• An interest in a partnership, or any debt instrument issued by a partnership, if one or more of the trades or businesses of the partnership are taken into account in determining whether the active trade or business requirement is met with respect to the distribution

Code (sec. 355(g))           Conference Report (p. 65)
Act (sec. 507)

C. Modify Corporate Estimated Tax Payment Requirements

The Conference Agreement would make changes to the amounts and timing of estimated tax payments that corporations would pay at certain times over the next several years.

For a corporation with assets of at least $1 billion at the end of its preceding tax year:

• The amount of any required installment otherwise due in July, August, or September 2006 would be increased to 105% of such amount
• The amount of any required installment otherwise due in July, August, or September 2012 would be increased to 106.25% of such amount
• The amount of any required installment otherwise due in July, August, or September 2013 would be increased to 100.75% of such amount

In each case, the corporation would be permitted to reduce proportionately the next required installment.

• For all corporations, regardless of assets, 20.5% of the amount of any required installment otherwise due in September 2010 would not be due until October 1, 2010.
• For all corporations, regardless of assets, 27.5% of the amount of any required installment otherwise due in September 2011 would not be due until October 1, 2011.

For a calendar-year corporation, these revised payment requirements would generally apply to the third required installment of estimated tax for the year, due September 15.

Code (sec. 6655)           Conference Report (p. 320)
Act (sec. 401)

III. International Provisions

A. Repeal FSC/ETI Binding Contract Rule

The Conference Agreement would repeal the rules grandfathering certain binding contracts under the repealed foreign sales corporation (FSC) and Extraterritorial Income Exclusion (ETI) regimes.

Code (sec. 205)           Conference Report (p. 311)
Act (sec. 513)

B. Modify Section 911 Housing Exclusion

The Conference Agreement would make substantial changes to the exclusions currently available under section 911 to U.S. citizens and residents living abroad in respect of foreign earned income and housing expenses.

The Conference Agreement would:

• Accelerate the indexing of the maximum foreign earned income exclusion amount to begin in 2006, rather than in 2008. The indexed amount of the maximum exclusion for 2006 would be $82,400.
• Introduce a new method for calculating the housing expense exclusion. Under the Conference Agreement the base housing amount would be 16% of the maximum foreign earned income amount, multiplied by the number of days of qualifying foreign residence or presence.

The Conference Agreement would also limit the total amount that can be excluded as housing expenses. The maximum housing amount exclusion would be 30% of the maximum foreign earned income exclusion amount. This exclusion for 2006 would be $11,536, calculated as follows: ($82,400 x 30%) – ($82,400 x 16%).

• Introduce a “stacking rule” whereby individuals claiming the foreign earned income and/or housing expense exclusions would be subject to the same rates of U.S. tax as individuals working in the United States. In other words, the exclusions would no longer be treated as coming “off the top” of an individual’s income. This concept is similar to the “exemption with progression” method applied under certain income tax treaties in relation to relief from double taxation.

The Conference Agreement would grant authority to the Treasury to issue regulations or other guidance providing for adjustment of the 30% limitation on the housing expense exclusion to reflect geographic differences in housing costs in relation to housing costs in the United States. It is anticipated that such adjustments could be made upwards or downwards on an annual basis.

Code (sec. 911)           Conference Report (p.316)
Act (sec. 515)

C. Modify Controlled Foreign Corporations Treatment

Extend the Active Financing Income Exceptions

The Conference Agreement would extend, for tax years beginning in 2007 and 2008, two active financing exceptions from subpart F foreign personal holding company income (FPHCI). The special rules in section 954(h) for income derived in the active conduct of banking, financing, or similar businesses, and in sections 954(i) and 953(e) for income derived in the active conduct of insurance business, would apply in tax years beginning before 2009.

Code (sec. 954(h), 954(i), 953(e))           Conference Report (p. 44)
Act (sec. 103(a))

Look-Through Treatment of Payments Between Related CFCs

The Conference Agreement would create a temporary “CFC look-through” exception from subpart F FPHCI for dividends, interest, rents, and royalties received by a controlled foreign corporation (CFC) from another CFC that is a related person within the meaning of section 954(d)(3). To the extent those items are attributable or properly allocable (under rules similar to section 904(d)(3)(C) and (D)) to income of the related person that is not subpart F income, they would not be treated as FPHCI. Regulations could be issued to prevent abuse. The provision would apply for tax years of CFCs beginning after 2005 and before 2009.

Code (sec. 954(c)(6))           Conference Report (p. 47)
Act (sec. 103(b))

D. Apply Earnings Stripping Rules to Partners That Are C Corporations

The Conference Agreement would limit the deductibility of interest paid to certain related persons by codifying portions of proposed Treasury regulation section 1.163(j)-2(e). The provision would attribute partnership interest income, interest expense, and liabilities to corporate partners for purposes of applying the earnings stripping rules of section 163(j) to those corporate partners. The provision would apply except to the extent provided in regulations. Also, regulations could reallocate shares of partnership indebtedness or distributive shares of partnership interest income or interest expense. The provision would apply to tax years beginning on or after date of enactment.

Code (sec. 163(j))            Conference Report (p. 265)
Act (sec. 501)

E. Expand Eligibility for Tonnage Tax Election

Certain corporations engaged in shipping operations may elect a “tonnage tax” in lieu of corporate income tax on taxable income from certain shipping activities. The tax is based on the net tonnage of the corporation’s qualifying vessels.

A “qualifying vessel” is a self-propelled (or a combination of self-propelled and non-self-propelled) U.S. vessel of not less than 10,000 deadweight tons used exclusively in the United States foreign trade (meaning the transportation of goods or passengers between the United States and a foreign place or between foreign places).

The Conference Agreement would reduce the tonnage limit from 10,000 to 6,000 deadweight tons.

Code (sec. 1355)           Conference Report (p.75)
Act (sec. 205)

F. Modify Treatment of Distributions Attributable to FIRPTA to RICs, and Prevention of Avoidance Through Wash Sales

Application to RICs

The Conference Agreement would amend a temporary portion of the definition of “qualified investment entity” in section 897(h)(4) that potentially subjects a foreign person holding an interest in such entities to taxation under the rules of section 897 and to withholding under the rules of section 1445 (the FIRPTA rules). The provision would clarify that the term “qualified investment entity” includes “any regulated investment company” (RIC) that is a U.S. real property holding company (i.e., 50% or more of its value is attributable to U.S. real property interests, including investments in real property holding companies) (USRPHC) without regard to certain exceptions. Thus, included as U.S. real property interests of a RIC for determining whether the RIC is a USRPHC are (1) regularly traded stock, even if the RIC owns less than 5% of such stock, and (2) interests in any domestically controlled RIC or real estate investment trust (REIT) that is a USRPHC.

Code (sec. 897(h))           Conference Report (p. 284)
Act (sec. 504)

Distributions Attributable to FIRPTA Gains

The Conference Agreement would amend section 897(h) to address certain distributions through tiers of RICs or real estate investment trusts (REITs) (collectively referred to as qualified investment entities). Under current law, a distribution from a qualified investment entity that is attributable to a disposition of a USRPI is subject to FIRPTA tax and withholding if made to a foreign interest holder. Under the Conference Agreement, a distribution from one qualified investment entity to another of an amount attributable to a disposition of a USRPI would be treated as if it were from the disposition of a USRPI by that other qualified investment entity, so that a distribution by that other entity would continue to be subject to the FIRPTA rules. A RIC would continue to be subject to FIRPTA, even after 2007, if a REIT made a distribution to the RIC that was attributable to gain from the sale of a USRPI.

Also, the Conference Agreement would expand an exception from FIRPTA taxation under section 897(h)(1) that applies to distributions from a REIT to foreign shareholders owning no more than 5% of stock of the REIT. The exception from FIRPTA taxation also would include distributions by RICs to foreign shareholders owning no more than 5% of stock of the RIC, and such distributions would be treated as dividend distributions subject to dividend withholding if made to foreign shareholders, but not if made to other RICs or REITs. The provision also would clarify that RICs and REITs must withhold under section 1445 on distributions attributable to sales of USRPIs.

Code (sec. 897(h))           Conference Report (p. 287)
Act (sec. 505)

Treatment of Certain Wash Sale Transactions

Under the Conference Agreement, a foreign person that:

• Disposes of stock of a domestically controlled RIC or REIT during the 30-day period preceding a distribution (including certain substitute payments) that would be taxable under section 897(h)(1),
• Does not actually receive that distribution, and
• Is treated as acquiring a substantially identical stock interest during a 61-day period,

generally would be treated as if it had disposed of a U.S. real property interest and would be taxable on an amount equal to that distribution that would have been taxable to the foreign person under section 897(h)(1) had it not sold the stock. A person would be considered to have acquired a substantially identical interest if it entered into a contract or acquired an option to acquire such an interest, or if a related party acquired the interest.

No person would be required to withhold tax under section 1445 with respect to the deemed disposition of a U.S. real property interest because of this special rule.

Code (sec. 897(h))           Conference Report (p. 287)
Act (sec. 506)

IV. Other Business Provisions

A. Impose Withholding on Government Payments

The Conference Agreement would impose a 3% withholding tax on certain payments made by government entities to persons providing property or services, regardless of whether the government entity making the payment is the recipient of the property or services. This requirement would apply to the U.S. government, every state and political subdivision thereof, and instrumentalities (including multi-state agencies).

Exemptions from the withholding requirement would apply to state political subdivisions (or instrumentalities) with less than $100 million in reportable annual expenditures. Also, certain payments through a public assistance program and other enumerated categories of payments would be exempt.

The Conference Agreement would provide that the payments are treated as the payment of wages by an employer to an employee.

Effective for payments made after 2010.

Code (sec. 3402)           Conference Report (p. 305-307)
Act (sec. 511)

B. Increase Amortization of Geological and Geophysical Costs for Major Integrated Oil Companies to 5 Years

The Energy Policy Act of 2005 requires a taxpayer to amortize over a 24-month period any geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the United States, beginning in the year paid or incurred. Generally, under prior law, such expenses were capitalized to the property.

The Conference Agreement would require “major integrated oil companies” to amortize such expenses over a five-year period, rather than a 24-month period, effective for amounts paid or incurred after the date of enactment.

A “major integrated oil company” would be defined as a producer of crude oil that had gross receipts in excess of $1 billion in its last tax year ending during 2005 and, for the tax year, has an average daily worldwide production of at least 500,000 barrels and an ownership interest in a crude oil refiner of 15% or more.

Code (sec. 167(h))           Conference Report (p. 282)
Act (sec. 503)

C. Clarify Taxation of Certain Settlement Funds

A qualified settlement fund that receive payments from a person to extinguish a tort liability of the person is treated as a separate taxable entity; payments by the person to the qualified fund pursuant to a court order are deemed to satisfy the economic performance requirement for the person to take a deduction for satisfying the liability, even if the fund does not make a payout until later.

The Conference Agreement would provide an exception to the statutory rule that a qualified settlement fund is in all cases subject to federal income tax. The exception would apply only to qualified settlement funds established in a consent decree entered by a U.S. District Court judge for the sole purpose of resolving claims under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA, i.e., the Superfund) and only if, among other things, the fund is controlled by the government entity involved and, upon termination, any amounts remaining in the fund will be disbursed to the government entity.

Code (sec. 468B)           Conference Report (p. 63)
Act (sec. 201)

D. Modify Treatment of Loans to Qualified Continuing Care Facilities

Generally, certain loans with below-market interest rates are treated as loans bearing interest at the market rate, accompanied by imputed payments in accordance with the substance of the transaction (for example as a gift, compensation, a dividend, or interest). An exception to the imputation rule is provided for any calendar year for a below-market loan made by a lender to a qualified continuing care facility pursuant to a continuing care contract, if the lender or the lender’s spouse attains age 65 before the end of the year. The exception applies to the extent the aggregate outstanding loans by the lender to any qualified continuing care facility do not exceed $163,300 (for 2006).

The Conference Agreement would modify these rules. A “continuing care contract” would be defined as a written contract between an individual and a qualifying continuing care facility under which:

• The individual or spouse may use a qualified continuing care facility for their life,
• The individual or spouse will be provided with housing in an independent living unit, and in an assisted living facility or a nursing facility, and
• The individual will be provided with assisted living or nursing care as the health of the individual or spouse requires.

The Conference Agreement would define an “assisted living facility” as a facility that assists with daily living activities. In the case of cognitive impairment, an “assisted living facility” would mean a facility that protects the health or safety of an individual. The Agreement would provide that a “nursing facility” is a facility that offers care requiring the utilization of licensed nursing staff.

No dollar cap on aggregate outstanding loans would apply under the Conference Agreement. In addition, the Agreement would require the lender or lender’s spouse to be age 62 by the close of the year.

Code (sec. 7872(g))           Conference Report (p. 199)
Act (sec. 209)

E. Allow Amortization of Song Rights

The Conference Agreement would allow a taxpayer to elect to amortize over a five-year period any costs (otherwise required to be capitalized) of creating or acquiring a musical composition (including any accompanying words), or any copyright with respect to such a musical composition. The election would apply to all such musical properties placed in service by the taxpayer during the same year. The election would not be available in certain cases in which a different tax treatment is provided under current law, such as for deductible creative expenses incurred by artists, for certain costs of compositions or copyrights produced by the artist’s personal efforts, or for certain copyrights acquired as part of the purchase of a trade or business that must be amortized over 15 years. If the election is not made, the Conference Report states that the taxpayer could recover the costs under any method allowable under prior law, including the income-forecast method.

Code (sec. 167(g)/263A)           Conference Report (p. 79)
Act (sec. 207)

F. Provide Capital Gains Treatment for Certain Self-Created Musical Works

The Conference Agreement would allow a taxpayer to treat the sale or exchange of a musical composition created by the taxpayer’s personal efforts, or a copyright on such works, as the sale or exchange of a capital asset. Without this election, in most cases gain on the sale would be treated as ordinary income. The election would also be available to a taxpayer whose basis in the composition, or copyright, is determined in whole or in part by reference to the basis of the creator, such as when the composition was received as a gift.

The Conference Agreement would clarify that the new rule does not allow a taxpayer making a charitable contribution of such a composition or copyright to deduct more than the taxpayer’s adjusted basis in the property, as under present law.

Code (sec. 1221/170)           Conference Report (p. 73)
Act (sec. 204)

G. Impose Reporting Requirement for Interest on Tax-Exempt Bonds

The Conference Agreement would require information reporting of interest paid on tax-exempt bonds, effective for payment made after 2005.

Code (sec. 6049)           Conference Report (p. 276)
Act (sec. 502)

V. Tax-Exempt Financing

A. Expand Qualified Veteran's Mortgage Bond Program

The Conference Agreement provides that, in the case of qualified veteran's mortgage bonds issued by Alaska, Oregon, and Wisconsin, the requirement that each mortgagor – veteran must have served before 1977 would be repealed and the eligibility period would be reduced from 30 to 25 years. The Agreement also would impose new volume limitations on the issuance of these bonds by Alaska, Oregon, and Wisconsin; the limitations would be phased in beginning in 2006.

Code (sec. 143)           Conference Report (p. 71)
Act (sec. 203)

B. Modify Certain Arbitrage Rules for Certain Funds

The Conference Agreement would codify and extend the current IRS position on how the tax-exempt bond arbitrage rules apply to a portion of the Texas Permanent University Fund.

Act (sec. 206)           Conference Report (p. 77)

C. Modify Small Issue Bonds–Accelerate Effective Date for Increase in Capital Expenditure Limit

The Conference Agreement would accelerate an increased capital expenditure limitation for qualified small issue bonds.

Qualified small issue bonds are tax-exempt state and local bonds used to finance private business manufacturing activities or the acquisition of land and equipment by certain farmers. There are limits on the amount of financing that may be provided. The maximum amount of allowable capital expenditures for an eligible business in the same municipality or county is generally $10 million under current law. For bonds issued after September 30, 2009, current law allows up to $10 million of capital expenditures to be disregarded, effectively increasing from $10 million to $20 million the maximum amount of allowable capital expenditures by an eligible business in the same municipality or county.

The Conference Agreement would accelerate the application of the $20 million capital expenditure limit from bonds issued after September 30, 2009 to bonds issued after December 31, 2006.

Code (sec. 144(a)(4))           Conference Report (p.191)
Act (sec. 208)

D. Modify Loan and Redemption Requirements on Pooled Financings

The Conference Agreement would impose new loan and redemption requirements on pooled financing bonds as a condition of tax exemption.

The provision would impose the following requirements on pooled financing bonds.

• Strengthened reasonable expectation requirement. In addition to meeting the current three-year reasonable expectation requirement, the issuer would be required to “reasonably expect” that at least 30% of the net proceeds of a pooled financing bond would be lent to the ultimate borrowers within one year after the date of issuance.
• Redemption requirement. Outstanding bonds would need to be redeemed with proceeds that had not been lent to borrowers within the expected loan origination periods.
• Written loan commitment requirement. Pre-issuance written loan commitments would be required to identify the ultimate potential borrowers of at least 30% of the net proceeds of the pooled financing bond issue.
• Arbitrage rebate small issuer exception. The provision would eliminate the rule that disregards pooled financing bonds for purposes of the small issuer exception to the arbitrage rebate rules.

Code (sec. 149(f))           Conference Report (p. 272)
Act (sec. 508)

VI. Other Individual Provisions

A. Increase in Age of Minor Children Whose Unearned Income is Taxed as if Parent’s Income

The unearned income of a child under age 14 generally is taxed at the parent’s tax rate (the “kiddie tax”). The Conference Agreement would raise the age to which the kiddie tax provisions apply to a child under 18 years -- except for a child who is married and files a joint tax return for the tax year. Effective for tax years beginning after 2005.

Code (sec. 1(g))           Conference Report (p. 268)
Act (sec. 510)

B. Impose Offers-In-Compromise Partial Payment Requirement

The Conference Agreement would require a payment of 20% of the amount being offered to the IRS in any lump sum offer-in-compromise (five or fewer installments) to accompany such offer. All other offers would need to be accompanied by the first proposed installment.

Failure to comply with the proposed offer while it is being considered could be treated as a withdrawal of the offer. If the offer is not rejected within 24 months of the date of submission, it would be deemed to have been accepted.

The provision would be effective for offers submitted 60 days on or after the date of enactment.

Code (sec. 7122)           Conference Report (p. 231)
Act (sec. 509)

VII. New Tax Shelter Penalty

The Conference Agreement would impose an excise tax on certain tax-exempt entities that become a party to a transaction that is a prohibited tax shelter transaction, defined as (1) a listed transaction under section 6707A(c)(2) or (2) a prohibited reportable transaction. A prohibited reportable transaction would be any confidential transaction or any transaction with contractual protection (as defined in regulations) that is a reportable transaction under section 6707A(c)(1).

Under the provision, a tax-exempt entity is:

• A section 501(c) or section 501(d) organization
• A section 170(c) entity (not including the United States)
• An Indian tribal government under section 7701(a)(40)
• A non-exempt trust described in section 4979(e)(1) through (3)
• A qualified tuition program described in section 529
• An eligible deferred compensation plan described in section 457(b) maintained by an employer described in section 4457(e)(1)(A), or
• Certain tax-favored accounts and annuities described in section 4973

Generally, the excise tax for the tax year (and any subsequent tax year) would be determined at the highest unrelated business income tax rate times the greater of (1) the entity’s net income (after taking into account any other tax imposed with respect to the transaction) that is attributable to the transaction, or (2) 75% of the proceeds received by the entity that are attributable to the transaction.

Special rules apply if a transaction is not a listed transaction at the time certain entities -- those described in section 501(c), section 501(d), section 170(c) (not including the United States), or an Indian tribal government under section 7701(a)(40) -- become a party to the transaction and the Secretary later determines the transaction to be a listed.

The excise tax would be increased if the tax-exempt entity knew or had reason to know that the transaction was a prohibited tax shelter transaction at the time the entity became a party to the transaction. This increased tax amount would be the greater of (1) 100% of the entity’s net income (after taking into account any tax imposed with respect to the transaction) that is attributable to the transaction, or (2) 75% of the proceeds received by the entity that are attributable to the transaction. The provision would not apply to any transaction that the tax-exempt entity entered into on or before the date of enactment.

The tax would be in addition to any other tax, addition to tax, or penalty imposed on the entity.

The Conference Agreement would require the tax-exempt entity to disclose to the IRS its participation in each prohibited tax shelter transaction and to disclose other known parties to the transaction. The penalty for failure to disclose would be imposed on the entity (or entity manager, in the case of qualified pension plans and similar tax-favored retirement arrangements) at $100 per day while the failure continues, not to exceed $50,000 for any one disclosure. In addition, the Secretary could make a written demand to the entity or entity manager subject to the penalty specifying a future reasonable date for compliance with the disclosure. Failure to comply with the demand would subject the entity or manager to a $100 penalty for each day after the specified date, not to exceed $10,000 for any one disclosure.

Entity Manager

If an entity manager of a tax-exempt entity approved (or otherwise caused) the entity to become a party to a prohibited tax shelter transaction and knew (or had reason to know) that the transaction was a prohibited tax shelter, the entity manager would pay a tax of $20,000 for each approval (or other act causing participation). More than one entity manager could be subject to this tax.

For purposes of the provision, an “entity manager,” for an entity described in section 501(c), section 501(d), or section 170(c) (not including the United States), or an Indian tribal government under section 7701(a)(40), would be a person with authority or responsibility similar to that exercised by an officer, director, or trustee of an organization and, with respect to any act, a person having authority or responsibility for the act. For a non-exempt trust described in section 4979(e)(1)-(3), a qualified tuition program described in section 529, an eligible deferred compensation plan described in section 457(b) maintained by an employer described in section 4457(e)(1)(A), and certain tax-favored accounts and annuities described in section 4973, an entity manager would be the person who approved or otherwise caused the entity to be a party to the prohibited tax shelter transaction.

Taxable Parties Entering Into Prohibited Tax Shelter Transactions

The Conference Agreement would require that a taxable party to a prohibited tax shelter transaction disclose to the tax-exempt entity that the transaction is a prohibited tax shelter transaction. Failure to make such disclosure would be subject to the present-law penalty for failure to disclose a reportable transaction under section 6707A. Thus the penalty would be $10,000 in the case of a natural person or $50,000 in any other case, except that, if the transaction is a listed transaction, the penalty would be increased to $100,000 in the case of a natural person and $200,000 in any other case.

Code (sec. 4956 with amendments to sections 6011, 6033, and 6652)
Act (sec. 516)           Conference Report (p. 107)