February 7,2002 Mr. Mark Weinberger Washington, DC 20220 · February 7,2002 Mr. Mark Weinberger...

February 7,2002

Mr. Mark Weinberger Assistant Secretary - Tax Policy U.S. Department of Treasury 1500 Pennsylvania Avenue, NW Room 1334 MT Washington, DC 20220

a

Dear Mark:

The American Lnstitute of Certified Public Accountants has long been an advocate of simplification of the tax system. We are pleased to have the opportunity to offer the enclosed comments on the Study of the Overall State of the federal Tax System and Recommendations for Simplification issued by the Staff of Joint Committee on Taxation in April 2001.

We congratulate the Joint Committee on Taxation on the study and commend Chief of Staff Lindy Paul1 and the Joint Committee staff for their dedication and efforts. The result of their labors is a study of the highest quality that provides an excellent understanding of both the sources of tax law complexity and its effect on the present system. The simplification recommendations presented are an excellent starting point for addressing complexity problems in the Internal Revenue Code. Even if it is not possible to enact all of the study’s recommendations, the Joint Qnrnittee staff has pointed the way for Congress to bring meaningful relief to many taxpayers by addressing the most troublesome and burdensome sources of complexity in the Code.

We believe the time is )zo\t to take decisive action to simplify the Code. First, Congress should repeal the alternative mimmum tax for both individuals and corporations. Then the inconsistent phase-outs that make tax planning difficult for individuals and result in confusing marginal rates should be eliminated. Fmally,. the definitions and qualifications associated with filing status, dependency exemptions. and credits should be simplified and harmonized. These changes alone - all of w,hlch are described in the Joint Committee study - will make the Code more consistent, rational. farr. and transparent - particularly for low and middle-income taxpayers. In our detailed comments w.e outline addrtional areas where we believe Congress might concentrate simplification efforts to reduce complexit>. for a broad range of taxpayers.

In our response document we have attempted to provide constructive comments on the vast majority of the Joint Committee’s recommendauons. There are, of course, some areas we were unable to address. The Joint Committee staff has proL.ided a clear roadrnap to the task ahead. We urge Congress to follow it and, hence. repeal the hidden tax burden imposed by complexity that ad\.ersely affects all taxpayers.

Sincerely,

(tiz+du pTpLLLIc;Iu

Pamela J. Pec&ich Chair Tax Executive Committee

Enclosqg; p Amencan Ins!Itute of Centhed Pubk Accountants __ ennsvlianla Avenue W Vdasnmg!or DC XOOS-1081 l i2021 737-6600 l fax 12021 638-4512 l w.alcDa.org

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Doc 2002-6154 (74 pgs)TAX ANALYSTS TAX DOCUMENT SERVICE

February 7,2002

Ms. Pamela F. Olson Deputy Assistant Secretary-Tax Policy U.S. Department of Treasury 1500 Pennsylvania Avenue, NW Room 1334 MT Washington, DC 20220

Dear Pam:

The American Institute of Certified Public Accountants has long been.an advocate of simplification of the tax system. We are pleased to have the opportunity to offer the enclosed comments on the Stu+ of rhe Overall State of the Federal Tax $&em and Recommendations for Simplification issued by the Staff of Joint Committee on Taxation in April 2001.

We congratulate the Joint Committee on Taxation on the study and commend Chief of Staff Lindy Paul1 and the Joint Committee staff for their dedication and efforts. The result of their labors is a study of the highest quality that provides an excellent understanding of both the sources of tax law complexity and its effect on the present system. The simplification recommendations presented are an excellent starting point for addressing complexity problems in the Internal Revenue Code. Even if it is not possible to enact all of the study’s recommendations, the Joint Committee staff has pointed the Lvay for Congress to bring meaningful relief to many taxpayers by addressing the most troublesome and burdensome sources of complexity in the Code.

We believe the time is now to take decisive action to simplify the Code. First, Congress should repeal the alternative minimum tax for both individuals and corporations. Then the inconsistent phase-outs that make tax planning difficult for individuals and result in confusing marginal rates should be eliminated. Finally, the definitions and qualifications associated with filing status, dependency exemptions, and credits should be simplified and harmonized. These changes alone - all of uhich are described in the Joint Committee study - will make the Code more consistent, rational, fair, and transparent - particularly for low and middle-income taxpayers. In our detailed comments \ve outline additional areas where we believe Congress might concentrate simplification efforts to reduce complexity for a broad range of taxpayers.

In our response document we have attempted to provide constructive comments on the vast majority of the Joint Committee’s recommendations. There are, of course, some areas we were unable to address. The Joint Committee staff has provided a clear roadmap to the task ahead. We urge Congress to follow it and, hence, repeal the hidden tax burden imposed by complexity that adversely affects all taxpayers.

Sincerely,

(75zdL p.&&Ld

Pamela J. Pecarich Chair Tax Executive Committee

American lnwtute of Certlfled Public Accountants Enclosw5 PennsylvanIa Avenue NVV Washington. DC 20004-IO81 l 1202, 7376600 l fax 12021 63-512 l w.alcoa.org

I\O’/~/O/ clTtt/trd


TAX DIWSIOK OF THE

ARlERlCAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNT.4NTS

COMRIENTS Oh’

RECO!MhlENDATlONS OF THE STAFF OF THE JO13T COhlhIITTEE Oh’ TAXATION

TO SI;11PLIF\’ THE FEDERAL TAX SYSTEM

Februay7.2002


Table of Contents

&g Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11’

IX. ALTERNATIVE MINIMUM TAX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 x. INDIVIDUAL INCOME TAX . . . . . .._..........................._............................_........._..... 1

Filing Status. Personal Exemptions. and Credits . . . . . . . . . . . . . . . . . . . . . . . . . .._........................... 1 Uniform definition of qualifying child . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Dependent care tax benefits . . . . . . . . .._........................................................................ 2 Modifications to the earned income credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . l................,.. 2 Determinations relating to filing status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Income-Based Phase-outs and Phase-ins . . . . . . . . . . . . . .._..................._............................... 3 Taxation of Social Security Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Individual Capital Gains and Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Adopt a uniform percentage deduction for capital gains in lieu of multrple tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Definition of “small business” for capital gain and loss provisions . . . . . . . . . . . . . . . . . . . . . . 4 Two-Percent Floor on Miscellaneous ltemized Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Provisions Relating to Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Definition of qualified higher education expenses . . . . . . . . . . . . . . . . . .._............................ 4 Combine HOPE and Lifetime Learning Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 interaction among provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Deduction for student loan mterest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Exclusion for employer-provrided educational assistance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Taxation of Minor Children . . . . . . . . . . . . . . . . . .._................._........................_..........._............ 6 Xl. INDIVIDUAL RETlREhlENT ARRATCEMENTS. QUALIFIED

RETIREMENT PLANS. AlVD EhlPLOYEE BENEFITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Individual Retirement Arrangements ._._.............................__...................................... 6 Qualified Retirement Plans . . . . . . . . . . . . . . . . . . . . .._........................._....................................... 7

Adopt uniform definition of compensatron for qualified retirement plans . . . . . . .._.. 7 Fvlodifications to mnumum coverage and nondiscrimination rules . . . . . . . . . . . . . . . . . . . . . . . 7 Apply uniform v*esting requirements to all qualified retirement plans . . . . . . . . . . . . . . . . . 7 Conform requirements for SIMPLE IRAs and SIMPLE 401(k) plans .._....._........ 7 Conform definitions of highly compensated employee and owner . . . . . . . . . . . . . . . . . . . . . . 8 Conform contribution limits for tax-sheltered annuities to contribution

limits for qualified retirement plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Simplification of distribution rules applicable to qualified retirement plans........ 8

Simplify minimum disttibution rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..___............._........... 8 Adopt uniform early withdrawal rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Make 401 (k) plans available to all governmental employers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Redraft section 457 to separate requirements for governmental plans and

plans of tax-exempt employers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .._.............. 9 Adopt uniform ownership attribution rules for qualified retirement plan

plan purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Basis Recovery Rules for Qualified Retirement Plans and IRAS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Qualified retirement plans . . . . . . . . . .._........ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10


I

Employee Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Modi& cafeteria plan election requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Employees excluded from application of nondiscrimination requirements........ IO

XII. CORPORATE INCOME TAX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Structural issues Relating to the Corporate Income Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Corporate Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . II Mergers. acquisitions. and related tax-free transactions . . . . . .._............................. 1 I

Eliminate Collapsible Corporation Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Section 355 “Active Business Test” Applied to Chains of Affiliated

Corporations .._................. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 uniform Definition of a Family for Purposes of Applying Attribution Rules . . . . . . . . 12 Limit Application of Section 304 1’ . . . . . . . . . .._................................................................ - Post-Reorganization Transfers of Assets ._............................._.................,............... 12 Redemptions incident to Divorce I 3 . . . . . . . .._.................................................................. Conform Treatment of Boot Recerved in a Reorganization with the Stock

Redemption Rules...... ..,..................................................................... . . . . . . . . . . . . . . 13 XIII. PASS-THROUGH ENTITIES ._...._.__.._.._ . . . . .._._..................................................... 13

Partnership Simplification Recommendations 13 . .._..................................................... Modemrze references to “limited partner” and “general partner” . . . . . . . . . . . . . . . . . . . . . . . 13 Eltmtnate large partnership rules . . . . . . . . . . .._..~...._......._........................................... 16 Conform timing rules for guaranteed payments and other non-panner

payments . . . .._...... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .._........................................... 16 S Corporatton Simplification Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I 7

Excess passive income of S corporations __....._.................................................... 17 Trusts as pemntted shareholders of S corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I9

XI\‘. GEYERAL BUSINESS ISSUES _....__... . 30 . . . . . . . . . . . . . . . . . . . . . . . . . ..*....................................* Sectron 103 1 _...._.........._..._.._....._...._.....__.._.__.._........_................................................. 20

Tax-free rollover of like-kind property ._......................_...................................... 30 Propen> held for use m a trade or busrness or held for invrestment in a

like-kmd exchange . . . . . . . . . . . ..___...._....._...................._._...__....._......._....__.....__..... 2 1 Low-Income Housing Tax Credit . . .._......................._..._....._........_....__..._....._......._.... 2 1 Rehabilitation Tax Credit.. ‘1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..-

Xl’. ACCOL’KTING AF;D COST RECOVER)’ PROVISIONS . . . . . .._..............._..I... 22 Structural Issues Relatmg to Accounting for Capital Expenditures . .._..._................ 22 Cash Method of Accountmg for Small Businesses . . . .._............................................ 22 Amorttzation of Organizatton Expenditures . .._....._...._............................._.....__........ 22 Depreciation - Mid-Quarter Conventton . . .._................. ‘. . . . . . . .._.............._._.__.........._... 23 Additional Accounting and Cost Recovery Provisions for Future Consideration . . . 23

IX. WTERl’iATIONAL TAX . . . . . . . . . . .._....._...._....................._.............._..............._......... 23 .&m-Deferral Regimes Applicable to income Earned Through Foreign

Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Expand Subpart F De Minimis Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Look-Through Rules for Dividends from Noncontrolled Section

902 Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .._............................................ 24 ForeiF Tax Credits Claimed Indirectly Through Partnerships 75 . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...& Conform Sections 30A and 936 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .._..... 25


x.

x11:.

X\‘.

Xi\‘I.

I

Application of Uniform Capitalization Rules for Foreign Persons ......................... .25 Secondap Withholding Tax on Dividends From Foreign Corporations.. .............. .26 Capital and of Certain sonresident Individuals.. ..................................................... 26 U.S. Model Tax Treaties.. ........................................................................................ 2” Older U.S. Tax Treaties .......................................................................................... .I27 TAX-EXEMPT ORGANIZATION PRO\‘ISIONS.. .......................................... 27 Percentage Limits on Grass-Roots Lobbying Expenditures of

Electing Charities.. ‘7 - ............ .................................................................................. . Excise Tax Based on Investment Income.. .............................................................. 28 ESTATE AND GIFT TAX PRO\‘ISION - Conform Certain Family-Owned and Small Busmess Provisions “9 ................................................................................. - ERlPLOYMENT TAX PROVISIONS ....... ‘70 ........................................................... Structural Issues Relating to Worker Classification.. .............................................. 30 Structural Issues Relating to Determination of Individuals Subject to

Self-Employment Tax.. ...................................................................................... 31 CORIPLIANCE AND ADMINISTR4TION PRO1’ISIONS.. .......................... .3 1 Penalties and Interest Overall .................................................................................. 1; 1

Interest.. ............................................................................................................... 32 Estimated Tax.. .................................................................................................... 34 .4ccuracy Related Penalties.. ............................................................................... 135 General Administrative Provisions ..................................................................... 37

X\‘II. DE.4DU’OOD PRO\‘ISIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

.4ppendix .4: AICPA Tan Policy Concept Statement 2 - Guiding Principles for Tax Simplification . . . .._...._........_._...._................._................__.................................................. /10

.4ppendix B: AICPA Simplification Recommendation - Ownership Attribution Rules (April 30. 1997) ._............................_..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . !j7

.4ppendix C: AICP.4 Legislative Proposal Regarding Tax on Self-Employment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..__...._......................................................... !59

.4ppendix D: .4ICPA Testimony Before House Ways and Means Subcommittee on Oversight Concerning Penalty and lnterest Reform Proposals (Januac 27. 2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .._.........._....._........................................ 63

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,

Introduction

The American Institute of Certified Public Accountants (AICPA) has long been an adi.ocate of simplification of the tax system. We are pleased to havre the opportunit>* to offer our comments and feedback on the Study of the Overall State of the Federal Tax System and Recommendations for Simplification prepared by the Staff of Joint Committee on Taxation. issued .4pril 20101.

We congratulate the Joint Committee on Taxation on the stud!, and commend Chief of Staff Lind!, Paul1 and the Joint Committee staff for their dedication and efforts. The result of their labors is a study of the highest quality that provides an excellent understanding of both the sources of tax law complexity and its effect on the present system. The simplification recommendations presented are an excellent starting point for addressing complexit!. problems in the Internal Revenue Code. Even if it is not possible to enact all of the studyr’s recommendations. the Joint Committee staff has pointed the wa!’ for Congress to bring meaningful relief to man!’ taxpayers by addressing the most troublesome and burdensome sources of complexity in the Code.

L1.e believe the time is non. to take decisive action to simplify the Code. First. Congress should repeal the alternative minimum tax for both individuals and corporations. Then the inconsistent phase-outs that make tax planning difficult for individuals and result in confusing margmal rates should be eliminated. Finall>,. the definitions and qualifications associated with filing status. dependent!, exemptions. and credits should be simplified and harmonized. These changes alone - all of which are described in the Joint Committee study - will make the Code more consistent. ranonal. fan. and transparent - panicularl!, for low and middle-income taxpayers.

In addition. the AICPA believes that other areas where Congress mi_eht concentrate stmplificatron efforts to reduce complexIt! for a broad range of taxpayers include: (1) srmplifymg capital gains taxation: (2) rationalizing the estimated tax safe harbors: (311 making expmng provlslons permanent rather than enacting temporary extensions; (4) harmonizing and stmplitjmg education rncenttv’es: (5) clarifvmg the rules for expensing and capitaliza,tion; (6) chanyng the half-year age conventions for retmernent plan distributions to full-years: (7) retbmnng the mintmum distribution rules for retirement plan distributions: (8) replacing the 20- factor common lau. test for determmmg worker classification; (9) harmonizing the attribution rules throughout the Code; ( 10) stmpli&mg the foreign tax credit: (11) simplifying application of subpan F; (17) limiting applicatton of the PFIC rules: and (13) repealing the colllapsible corporation provisions.

To aid Congress as it undertakes this lmponant effort. the AICPA has developed TOX Policy\. Concept Statement $2. Guiding Prlnclples fbr Tax Simplification. The Statement offers recommended guiding princrples to be used in development of simpler tax legislation and regulations (see Appendix A 1.

In the following pages we have attempted to provide constructive comments on the vast majority of the Joint Committee’s recommendations. There are. of course. some areas we were unable to address. The Jomt Committee staff has provided a clear roadmap to the task ahead. We urge Congress to follow it and. hence. repeal the hidden tax burden imposed by complexity that adversely affects all taxpayers.

iv


AICPA COMMENTS ON THE

VOLUME 11: RECOMMENDATIONS OF THE STAFF OF THE JOINT COMMITTEE ON TAXATION

TO SIMPLIFY THE FEDERAL TAX SYSTEM

I. ALTERNATIVE MINIMUM TAX

Individual Alternative Minimum Tax (JCT page 7)

The Joint Committee staff recommends that the individual alternative minimum tax should be eliminated.

The AICPA suppons the proposal to eliminate the individual alternative minimum tax. We strongly agree that it no longer serves the purposes for which it was intended. Further. 1egisiativ.e changes since its enactment have been effective in more closely conforming the regular tax base for individual taxpayers to the AMT base.

Corporate Alternative hlinimum Tax (JCT page 10)

The corporate alternative mmimum tax imposes a tax on corporations. based upon the corporation’s taxable mcome. adjusted for certain preference items. e.g.. accelerated depreciation. The Joint Committee staff recommends the repeal of the corporate alternative mmimum tax. The AICPA supports this decision as a significant reduction in complexity,.

II. INDIL’IDUAL INCOME TAX

Filing Status. Personal Exemptions. and Credits

Uniform definition of quaiifving child (JCT page 44) The Joint Committee staff recommends that a uniform definition of qualifying child should be adopted for purposes of determining eligibility for the dependency exemption. the earned mcome credit. the child credit. the dependent care credit. and head-of-household filing status. Under the uniform definition. a child would be a qualifying child of a taxpayer if the child has the same principal place of abode as the taxpayer for more than one half the taxable year. A child would be defined as an individual with a specified relationship to the taxpayer and who is less than a specified age. A tie-breaking rule would apply if more than one taxpayer claims a child as a quaiifving child. Under the tie-breaking rule. the child generally would be treated as a qualifying child of the custodial parent.

The AICPA supports the recommendatton with the following modifications. We suggest that the law allow the parties involved in a divorce proceeding to allocate the exemption as is allowed currently. Allowing the parties involved to make the election is a negotiating tool. In addition. we suggest any law change include a transition rule for existing divorce decrees.

1


I

Dependent care tax benefits (JCT page 67) The Joint Committee staff recommends that the dependent care credit should be conformed to the exclusion for employer-provided dependent care assistance by: (1) providing that the maximum amount of expenses eligible for the credit is $5.000 regardless of the number of qualifying individuals: (2) eliminating the reduction of the credit based on adjusted gross income: and (3) providing that married taxpayers filing separate returns are eligible to claim up to one half of the otherwise allowable credit.

The AICPA supports the recommendation. The proposal provides that all taxpayers will be treated the same regardless of whether or not there is an employer plan. The AlCPA suggests that the JCT consider an additional stmplification of combining the child care credit. child credit. and exemption allowances into a single provision.

Modifications to the earned income credit (JCT page 69) The Joint Committee staff recommends that the definition of qualifying child for purposes of the earned income credit should be conformed to the recommended uniform definition of qualifying child. including the tie-breaking rule. In addition. the Joint Committee staff recommends that earned income should be defined to include wages. salaries. tips. and other employee compensation to the extent mcluded In gross income for the taxable year. plus net earnings from self employment.

The AlCPA supports the recommendations. The earned income credit calculation is quite complex. The instructtons for claiming the credit include complicated questions and several worksheets. Simplifying the definition of qualifying child would eliminate some of the complexIt>,. The second recommendanon was included in the Economic Growth and Tax Relief Reconciltation .4ct of 2001. but we suggest that this provision be made permanent.

Determmations relatn-g to filing status (JCT page ?5) The lornt CommIttee staff recommends that head-of-household filing status should be available wrth respect to a child only, if the child qualifies as a dependent of the taxpayer under the recommended uniform definition of qualifying child. An additional recommendation is that the sumivmg spouse status should, be available only for one year and that the requirement that the surviving spouse have a dependent be eliminated.

The AlCPA agrees that a uniform defimtton of child would eliminate some complexity in the tax laws (see comments above). We support the position that 811 other aspects of qualification for head-of-household status remain the same. We support the change to surviving spouse filing status. Changing the requirement from two years to one and eliminating the need to have a qualifymg child will expand the usefulness of the provision and will add simplicity to the tax law,.


Income-Based Phase-outs and Phase-ins (JCT page 79)

The Joint Committee staff recommends eliminating the following phase-outs:

0 The ovrerall limitation on itemized deductions (sometimes referred to as the “PEASE limit”). The phase-out of personal exemptions (sometimes referred to as PEP). The phase-out of the child tax credit. The partial phase-out of the dependent care tax credit. The phase-outs relating to individual retirement arrangements (IRAs). The phase-out of HOPE and Lifetime Learning credits. The phase-out of the deduction for student loan interest. The phase-out of the exclusion for interest on education savings bonds. and The phase-out of the adoption credit and exclusion.

The AICPA supports the recommendation. The overall limitation on itemized deductions and the phase-out of personal exemptions are to be eliminated after 2009 as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. However, the provisions will be reinstated after 2010. W’e suggest that the provisions be made permanent. Eliminating the phase-outs will simplify, the tax law, and eliminate some of the current law’s marriage penalties. This position is consistent w,rth our pre\pious positions as stated in the Joint 2000 ABA/AlCPATEl Tax Simplification Recommendations and the 1998 AICPA Testimony before the House Ways and Aleans Committee on February 4. 1998. Our previous positions were more expansive and suggested that simpiictty could be achieved by (1) eliminating all phase-outs: (2) substituting cliffs for phase-outs: or (3) providing consistency in the measure of income. the range of phase- out. and the method of phase-out.

Taxation of Social Security Benefits (JCT page 92)

The Joint Committee staff recommends that the amount of Social Security benefits included in gross mcome should be a fixed percentage of benefits for ail taxpayers. The Joint Committee staff further recommends that the percentage of included benefits should be such that the amount of benefits excludable from income approximates individuals’ portion of Social Security ‘taxes.

The AICPA supports the position that a fixed percentage of the social security benefits be taxable. We recommend that the fixed percentage not exceed 50%. the percentage approxtmately equal to the portion paid by the recipient. Making this change will simplify the tax law. Currently. taxpayers who rece1v.e social security benefits must complete a complicated worksheet to determine the taxable ponion of benefits.

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Individual Capital Gains and Losses

Adopt a uniform percentage deduction for capital .gains in lieu of multiple tax rates (JCT page 97) The Joint Committee staff recommends that the current rate system for capital gains should be replaced with a deduction equal to a fixed percentage of the net capital gain. The deductron would be avpailable to individuals whether itemized deductions or the standard deduction IS claimed.

The AICPA supports simplification of capital gains taxation. However. we believe a preferable approach is reflected in the Joint 2000 ABA/AlCPA’TEl Tax Simplification Recommendations. which would simplify capital gains taxation by establishing a single preferential rate and a single long term holding period for all types of capital assets.

Definition of “small business” for capital gain and loss provisions (JCT page 109) The Joint Committee staff recommends that. for purposes of ordinary loss treatment under sections 1242 and 1244. the definition of “small business” should be conformed to the definition of “small business” under section 1202. regardless of the date of issuance of the stock.

The AICPA suppons the proposal. There should be a concerted effort to eliminate other inconsistencies in existing lam. Further. as new law is drafted, lawmakers should strive for consistency in both concepts and definittons.

Two-Percent Floor on 3liscellaneous ltemized Deductions (JCT page I 11)

The Joint Commntee staff recommends that the two-percent floor on miscellaneous itemized deductions should be elrmmated.

The AICPPI supports the proposal. The two-percent floor was added to the 1986 Act to prevent taxpayers from ha\.tng to keep extenst1.e records for small expenditures such as employee busmess expenses. m\‘estment expenses. and other miscellaneous itemized deductions. In addition. the intent was to remove some of the administrative problems for the IRS. However. we support the. proposal because: (I ) ail business expenses would receive similar treatment (deductible without limitation); (2) attorney’s fees for damage awards would be fully deductible: and (3) it would resolve the Issue of the deductibility of investment advice. Currently. there are two conflicting court cases regarding the deductrbility of investment advice mcurred by a trust, which are considered individuals for the two-percent floor limitation.

Provisions Relating to Education

Definition of qualified higher educatron expenses (JCT page 122) The Joint Committee staff recommends that a uniform definition of qualifying higher education expenses should be adopted, The uniform definition would include expenses for tuition, books, fees. supplies. and equipment requtred for enrollment or attendance. It would not include expenses with respect to any course or other education relating to sports, games. or hobbies other

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than as part of a degree program. The recommendation would retain the current treatment ot room and board expenses under the separate education tax incentives.

The AICPA supports the proposal. which would simplify the tax Ian,. We suggest that the qualifying higher education expenses include room and board even though thi,s would significantly expand the scope of the current education tax incentives that do not cover these expenses. Because qualified tuition must be reduced by scholarships and like items. Imcluding room and board as a qualified higher education expense would make the education tax incentives more broadly available. Further study could be devoted to combining the education incenri\‘es for additional simplification.

Combine HOPE and Lifetime Leamine Credits (JCT page 126) The Joint Committee staff recommends that the HOPE credit and Lifetime Learning credits should be combined into a single credit. This single credit would: (1) utilize the present-la\\ credit rate of the Lifetime Learning credit; (2) apply on a per-student basis; and (3) apply to eligible students as defined under the Lifetime Learning credit.

The AICPA supports the proposal. Combining the credits would simplify the tax benefits and would remove the dupllcatlve provislons of the credits relating to higher education expenses. This position is conslstent with the Joint 2000 ABA/AICPA,TEI Tax Simplification Recommendations.

Interaction among provisions (JCT page 130) The Jomt Committee staff recommends that restrictions on using education tax incentives based on the use of other education tax incentives should be eliininated and replaced with a hmitation that the same expenses could not qualifv under more than one provision.

The .AlCPA supports this proposal. The Economic Growth and Tax Relief Reconciliation Act of 2001 Included the pro\,lsion that al1on.s taxpayers 10 exclude from income withdrawals from an education IR4 In the same year that a HOPE or Lifetime Learning credit is claimed. This is pro\,lded that the exclusion IS not used for the same expenses for which the credits were claimed. We suggest that this provIsIon be made permanent. The Joint Committee staff also recommended that taxpayers b,e allowed fo fund an Education IRA in the same year that a contribution to a 529 plan was made on the taxpayer’s behalf. We support these provisions because they will simplify the education incentives.

Deductlon for student loan interest (JCT page 132) ,

The Joint Committee staff recommends that the 60-month limit on deductibility of student loan interest should be eliminated.

The AICPA supports this position. The Economic Growth and Tax Relief Reconciliation Act of 2001 mcluded the temporarv repeal of the 60-month rule. We suggest that this provision be I made permanent because it simplifies the requirements for an interest deduction.

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Exclusion for emplover-provided educational assistance (JCT page 133) The Joint Committee staff recommends that the exclusion for employer-provided educational assistance should be made permanent.

We support this position. The Economic Growth and Tax Relief Reconciliation Act of 2001 made the exclusion for employer-provided educational assistance permanent. However. because all provisions of the 2001 Act will be repealed effective January 1. 2011. we suggest that this provision be made permanent beyond 201 1. This will: provide certaintv to taxpayers wishing to take advantage of the exclusion: provide certainty to employers interested in providing educational incentives to their employees: and eliminate administrative problems.

Taxation of 3linor Children (JCT page 144)

The Joint Committee staff recommends that the tax rate schedule applicable to trusts should be applied with respect to the net unearned income of a child under age 14. The Joint Commir Y staff also recommends that the parental election to include a child’s income on the parer. s return should be a\railable irrespective of ( 1) the amount and type of the child’s income; and (2) b*hether there withholding or estimated tax payments were made with respect to the child’s income.

The AICPA belle\,es slmplificatlon could be better achieved by eliminating the special rules for taxing the net unearned income of a child under age 14 at the parents’ tax rate. The current rules are L’en complicated. We further be1ieL.e that the tax revenue generated is not significant when compared to the complexrtv created by these provisions.

111. ISDl\‘IDUAL RETIREMENT ARRANGEMENTS, QUALIFIED RETIREMElVT PLANS. AND EMPLOYEE BENEFITS

Individual Retirement Arrangements (JCT page 149)

The Joint CommIttee staff recommends that the Income limits on eligibility to make deductible IRA contributions. Roth IRA contributions. and conversions of traditional IRAs to Roth IRAs should be eliminated. Further. the Jomt Committee staff recommends that the ability to make nondeductible conttibutions to traditional IRAs should be eliminated. The Joint Committee staff also recommends that the age restnctlons on eligibility to m,ake IRA contributions should be the same for all IRAs.

The AICPA suppons the proposals. The recommendations will reduce the number of IRA optlons and conform eligibility cntena for remaining IRAs, therefore simplifying the savings options for taxpayers without reducing benefits. Taxpayers will no longer need to apply various’ rules to determine eligibility. Instead. taxpayers will be able to focus on which tax-favored savings Lrehicle. if any. they consider most appropriate for their circumstances.

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Qualified Retirement Plans (JCT page 155)

Adopt uniform definition of compensation for qualified retirement plans (JCT page 166) The Joint Committee staff recommends using a single definition of compensation for all qualified retirement plan purposes. including determining plan benefits. The uniform definition would be all compensation provided to an employee by the emplover for which the employer is required to furnish the employee a wntten statement on Form W-2. plus elective contributions.

The AICPA supports the current flexibility for a small business owner to make contributions to a retirement plan based on basic wages without considering extraordinary compensation. Usmg a single definition of compensation may unduly add cost to small employers. Because all payroll data is becoming electronic. segregating the elements of employee compensation is not a burden. However. the ability to create a retirement plan that excludes some types of compensation 1s important to small business. Benefit plans should match the employer’s budgetary constraints and benefits philosoph>,. Including or excluding certain elements of compensation helps to achieve this goal. We do not support adoption of this recommendation because it will hinder the ability of small employers to fund plans for all employees.

Modifications to minimum coveraee and nondiscrimination rules (JCT page 173) The Joint Committee staff recommends that the ratio percentage test under the minimum col’erage rules should be modified to allow more plans to use the test. In addition. the Joint Committee staff recommends that excludable employees should be disregarded in applying the minimum coverage and general nondlscrimination rules. Finally. the Joint Committee staff recommends that the extent to which cross-testing may be used should be specified in the Code.

The AICPA conditionall>. suppons these recommendations as part of simplification of the employee benefit rules. W’e support the recommendation to codify the cross-testing rules to the extent that any such codification is consistent with the regulations as currently written.

Apply, uniform vestine requirements to all qualified retirement plans (JCT page 183) The Jomt Committee staff recommends that the vestmg requirements for all qualified retirement plans should be made uniform by applymg the top-heavy vesting schedules to all plans.

The AICPA opposes adopting this vesting recommendation. The recommendation would eliminate an incentive that small employers rely upon to retain employees. Determining a participant’s vesting amount is not undul!, complex. even if the plan becomes top heavy. If a plan is not top heavy. we believe the seven-year vesting &hedule should remain available !o employers. However. the AICPA does recommend that, once a plan becomes top he:avy, the plan may not revert to the seven-year vesting schedule if it later is not top heavy. This modification will achieve the desired slmpiification.

Conform requirements for SIMPLE IRAs and SIMPLE 401 (k) plans (JCT page 185) The Joint Committee staff recommends that the rules relating to SIMPLE IIUs and SIMPLE 401 (k) plans should be conformed by: (1) allowing state and local government employers to adopt SIMPLE 401(k) plans; (2) applymg the same contribution rules to SIMPLE IIiAs and

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SIMPLE 401(k) plans: and (3) applying the employee eligibility rules for SIMPLE IR4s to SIMPLE 401 (k) plans.

The AICPA supports this recommendation. However. we also recommend eliminating the SIMPLE 401 (k) plan, because it largely duplicates the Safe Harbor 401 (k) rules. Eliminating the SIMPLE 401(k) plan would minimize complexity in choosing an appropriate plan form that meets employer objectives without removing benefits for small business. The SIMPLE IRA and the Safe Harbor 40 1 (k) can satisfy the diverse needs of small business ovvners.

Conform definitions of highlv compensated emplovee and owner (JCT page 188) The Joint Committee staff recommends that uniform definitions of highly compensated employee and owner should be used for all qualified retirement plan and employee benefit purposes. Accordingly. the Joint Committee staff recommends that many of the statutonv terms and definitions be repealed.

The AICPA supports the recommendation to conform the definition of owner and highly compensated employee as a simplification. Requiring an employer to apply different definitions and criteria for different employee benefit purposes makes compliance excessively burdensome. In many respects the vparious definitions and criteria overlap or contain only minor differences and. therefore. produce complexity without meaningful policy distinctions.

Conform contribution limits for tax-sheltered annuities to contribution limits for qualified retirement plans (JCT page 192) The Joint Committee staff recommends that the contribution limits applicable to tax-sheltered annuities should be cont,.,med to the contribution limits applicable to comparable qualified retnemenr plans.

The A1CP.A supports the provision as it offers simplification without reducing benefits. The Jornr CommIttee staff recommendation would repeal the exclusion allowance applicable to cnntributrons to tax-sheltered annuities. Therefore. such annuities would be subject to the contribution limits applicable to qualified retirement plans. The differences between the limits on connibutions to qualified retirement plans and tax-sheltered annuities are largely historical. The qualified retirement plan limits are easier to apply than the present-law section 403(b) limits. Conforming the limits will reduce record-keeping and computational burdens. as well as eliminate the confusion resulting from differences between tax-sheltered annuities and qualified retirement plans. ,

Simplification of distribution rules applicable to qualified retirement plans Simp1if-i. mrnimum distribution rules (JCT page 194) The Joint Committee staff recommends that the minimum distribution rules should be simpiified by providing that: (1) no distributions are required during the life of a participant; (2) if distributions commence during the participant’s lifetime under an annuity form of distribution, the terms of the annuity will govern distributions after the participant’s death; and (3) if distributions either do not commence dtning the participant’s lifetime or commence during the participant’s lifetime under a non-annuity form of distribution, the undistributed accrued benefit

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must be distributed to the participant’s beneficiary or beneficiaries wrthin five years of the participant’s death.

The AICPA supports these proposals. Eliminating the rules that require minimum distributions during the life of the plan participant and establishing a uniform rule for post-death distributions would signifrcantlv simplifil a complex requirement that imposes burdens on plan participants and their beneficiaries. as well as plan sponsors and administrators who assist such individuals in complymg uith the rules.

Adopt uniform earl\, ltithdraM,al rules (JCT page 198) The Joint Commrttee staff recommends that the exceptions to the early withdrawal tax should be uniform for all tax-favored retirement plans and that the applicable age requirements for the earl!, withdralval tax and permissible distributions from section 401(k) plans should be changed from 59- 1 ‘3 to 55.

The AICPA supports the proposal as part of simplification of distributions. Under the recommendation. the earl!! withdrawal tax would not apply to distributions for first-time homebuyer expenses. educational expenses. or health insurance expenses of unamployed indivfiduais. In addition. we support lowering the age requirement for penalty -free withdrawals from age 59-1 ‘2 to age 55.

Make 401(k) plans available to all povemmental emplo~~s (JCT page 201) The Joint Commtttee staff recommends that all state and local governments should be permitted to maintam 30 1 (k ) plans.

The AICP.4 supports thts provision. The recommendation will reduce complexity by eliminating meaningless distmcttons between the types of plans that may be offered by different types of emplo!,ers. The recommendation will also mcrease the fairness of the tax laws: there is no clear pollc>. reason wh> some go\remmental employers. including the federal government. may adopt a 301 (k) plan. but other governmental employers may not.

Redraft section -15’ to separate requirements for governmental plans and plans of tax-exempt emplovers (JCT page 202) The Jornt Committee staff recommends that the statutory provisions dealing with eligible deferred compensatton plans should be redrafted to separate the provisions that apply to plans mamtamed b>, state and local governments from those that, apply to plans maintained by tax- exempt organizations.

The AICPA supports this recommendation in conjunction with other simplification proposals in this area. B\, separating these provistons. employers and practitioners could more readily identi@ the requirements that apply to each type of plan. For example, an employer con.sidering’ whether to establish an eligible deferred compensation plan would have to review only the requirements that would apply to its type of plan. This would make it easier for employers to understand and comply with the requirements. In addition. statutory amendments th,at affect only one type of employer would not cause confusion for the other type of employer. The new

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statutory structure would also reflect the differences in operation between the two different types of plan.

Adopt uniform ownership attribution rules for qualified retirement plan purposes (JCT page 204) The Joint Committee staff recommends that the attribution rules used in determining controlled group status under section 1563 should be used in determining ownership for all qualified retirement plan purposes.

The AICPA supports this recommendation. Uniform attribution rules would enable the employer to perform a single ownership analysis for both preventing multiple tax benefits and for all relevant qualified retirement plan purposes.

Basis Recover-y Rules for Qualified Retirement Plans and IRA

Qualified retirement plans (JCT page 2 I 1) The Joint Committee staff recommends that a uniform basis recovery rule should apply to distributions from qualified retirement plans and IRAs. Under this uniform rule. distributions would be treated as attributable to basis first. until the entire amount of basis has been recovered.

The AICPA supports this proposal. Under current Ian!. an individual must not only keep track of his or her basis (the amount of after-tax contributions) as distributions are made. but also perform a \*at-iety of calculations depending on which basis recovery rule applies. The proposal would eliminate the need to calculate the amount of any distribution attributable to basis: instead. the individual would only need to keep track of his or her basis. This would provide significant stmplification for recipients of distributtons from qualified retirement plans and IFUs. In addition. by providing a uniform rule for all tax-preferred retirement savrings vehicles. the proposal would eliminate potential mistakes due to taxpayers mistaking which rules apply in any parncular case.

Employee B nefits

Modifv cafetena plan election requirements (JCT Page 221) The Joint Committee staff recommends that the frequency with which employees may make. revoke. or change elections under cafeteria plans should be determined under rules similar to those applicable to elections under qualified cash or deferred arrangements.

The AICPA conditionally suppons the recommendation. V?e applaud this effort as long as any employee election changes are not measured by comparing benefits paid prior to the change with benefits paid after the change. Any such prerequisite for an employee election change will increase complexity for both the employee and the employer.

Emplovees excluded from application of nondiscrimination requirements (JCT page 22 1) The Joint Committee staff recommends that a uniform definition of employees who may be excluded for purposes of the application of the nondiscrimination requirements relating to group- term life insurance. self-insured medical reimbursement plans, educational assistance programs,

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miscellaneous fringe benefits. and voluntary employees’ beneficiaq associations should be adopted.

The AICPA supports this recommendation. A uniform definition of excludable employees would eliminate the need to determine different groups to be considered in testing different benefits. therefore. making nondiscrimination testing easier. Making the exclusion of these employees automatic. rather than elective. eliminates the need for an employer to test on both bases to determine which approach is advantageous.

I\‘. CORPORATE INCOME TAX

Structural issues Relating to the Corporate Income Tax

Corporate Integration (JCT page 229) The Joint Committee staff provides a detailed discussion of how the tax system could be improved by taxing corporate income once. otherwise known as integrating the corporate and shareholder-level taxes on corporate income. The study also details a number of meth,ods that * could be used to achieve full or partial Integration. each of which has associated policy and administrative considerations.

The AICPA supports corporate integration m concept. (See AICPA Statement of Tax Policy 10: Integration of the Corporate and Shareholder Tax Systems. 1993.) However, the JCT staff does not make a specific recommendation in this area.

Mergers. acquisittons. and related tax-free transactions (JCT page 238) The Joint Committee staff does an excellent job of explaining the tax law complexities associated with mergers. acquisitions. and related tax-free transactions and describes proposals for stmplititng the lau.. and the associated policy issues. Because adopting any of the proposals ii.ould involve policy implications. the JCT staff concluded that no specific legislative simplification recommendation would be made with respect to these issues.

Accordingly,. the AICPA takes no position at this time. However, because of the vast alnd well- developed body of law dealmg with corporate reorganizations. we believe that any changes in this area should be made usmg an incremental approach (e.g.. conforming the defimtion of voting versus non-voting stock) rather than on a comprehensive basis.

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Eliminate Collapsible Corporation Provisions (JCT page 249)

The collapsible corporation provisions were enacted in the 1950s in order to prevent the use of cenam corporations to avoid ordinary income treatment for the corporation’s in’dividual shareholders. At that time, Iiquidatmg distributions of appreciated property were generally tax- free to the distributing corporation. with the individual shareholders claiming capital gain treatment thereon. The collapsible corporation provisions imposed ordinary income treatment on the individual shareholders receiving these distributions. The repeal of the General Utilities doctrine in the Tax Reform Act of 1986 eliminated the tax-free treatment of liquidating

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distributions of appreciated property. thus rendering the collapsible corporation proiisions unnecessary to the prevention of tax avoidance. The Joint Committee staff recommends the repeal of the collapsible corporation provisions as deadwood.

The AICPA supports this decision as a long overdue step in the reduction of complexity.

Section 355 “Active Business Test” Applied to Chains of Affiliated Corporations (JCT page 251)

Current law imposes an unjustifiable burden on certain holding companies seeking to make tax- free distributions under section 355. These holding companies must engage in certain preliminanr transactions -- e.g.. liquidations or reorganizations of affiliates -- to satis& the “active business” test of section 355. Under present law. this test is imposed on a separate company basis. The Joint Committee staff recommends the test be made on an affiliated group basis.

The AICP.4 supports this decision as a meaningful step in reducing complexity because it would eliminate the need to undertake the uneconomic preliminary transactions described above.

Uniform Definition of a Farnil!, for Purposes of Applying Attribution Rules (JCT page 253)

The Joint Committee staff notes that the code contains 13 different definitions of “family” for purpose of attributing stock ownership. and recommends adopting a uniform definition.

The AlCP.4 supports this decision. and notes that it has previously recommended an even more expanst\‘e defimtion. (See Appendix B: AICPA Tax Simplification Recommendations. April 30. 1997. OwnershIp Attribution Rules.)

Limit Application of Section 304 (JCT page 259)

The Joint Committee staff notes that section 304 was enacted as an anti-abuse provision largely to pre\‘ent lndl~idual shareholders from converting ordinary income into capital gains. The JCT seems to believe that section 304 has been manipulated by non-individual shareholders.

The AlCP.4 respectfully disagrees with this analysis. However. regardless of which analysis is more correct. we believe that modifvmg the application of section 304 for non-individual shareholders IS a policy initiative that adds nothing to the &use of simplification. Accordingly, the .41CP.4 opposes this recommendation.

Post-Reorganization Transfers of Assets (JCT page 261)

The Joint Committee staff notes that there has long been uncertainty over whether the Code permits a post-reorganization transfer of assets following a Type D or F reorganization (the so- called “D with a drop” issue). The Joint Committee staff finds no policy justification for inhibiting such transfers, and accordingly recommends the explicit sanctioning of such asset dropdowns.

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The AICPA supports this decision as a meaningful reduction in complexity by elimmating an

unwarranted stricture.

Redemptions Incident to Divorce (JCT page 263)

The Joint Committee staff notes that complexity and uncertainty prevail under present law. about

whether the stock redemption incident to divorce by one spouse should be treated as a di\fidend to the other spouse. The Joint Committee staff recommends adopting a smgle standard for making this determination. while allowing the parties to fashion a mutually acceptable result.

The AICPA supports this recommendation as a useful step in reducing complexit!. in this increasingly frequent situation. The IRS and Treasury issued proposed regulations in this area in August 2001 (REG-107151-00. 66 Fed. Reg. 40659 (8/03/01)).

Conform Treatment of Boot Received in a Reorganization with the Stock Redemption Rules (JCT page 267)

The Joint Committee staff makes note of certain discontinuities in the treatment of boot received in a redemption versus in a reorganization. The Joint Committee staff recommends adopting the current redemption treatment as the uniform treatment for boot in both settings.

The AICP.4 believes that the recommended treatment is one-sided. and tends to result .in more expanstve dividend treatment. Accordingly. the AICPA opposes this recommendaltion as resemblmg a policy mitiatlve more than a stmplification proposal.

I‘. PASS-THROUGH ENTITIES

Partnership Simplification Recommendations

Modemize references to “limited partner” and “general partner” (JCT page 277) The Joint Committee staff notes that Code section references to general and limited partners generally pre-date the widespread use of limited liability companies (LLC) and are based on distinctions made under state law. It further notes that the distinctions are difficult to interpret when applied to LLC owners. and the Federal statutes must. therefore, be modemized to accommodate persons who are partners under Federal tax law but not under state law.

The AJCPA applauds their efforts and agree both that the references need to be modemized and that. to be consistent with the underlying tax policy considerations, a separate provision-by- provision modification is appropriate. To the extent that specific Code sections do not adequately convey a clear meaning of these terms, we suggest that a general definition should be enacted under section 7701 to govern in the absence of section-specific applications.

We agree that the relevant characteristic in modifying the references to general and limited panners is such person’s participation in the management of the business of the entity. However,

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we are concerned with the general recommendation to substitute the term “limited partner” \vtth a reference to “a person whose participation in the management of the business activtt!, of the entity is limited under applicable state iaM,. ” Alternatively. the JCT staff suggests. on page 286. an approach based on actual performance of services. rather than on whether those senices are allowable under state law. We believe that actual participation is a more appropriate measure for some of the provisions discussed (sections 736 and 1402). than participation allowable under state law,. However. our objections to the actual participation approach center on the complications related to using an “hours-per-year” method to measure whether or not the person should be given limited or general partner status. We suggest that these areas of complexity can be overcome (and in some cases eliminated) by ignoring a de minimis level of senflces m determining whether or not the person is a “limited” or a “general” partner for Federal tax la\+-.

The following summarizes our obsenpations and suggestions on the references to general and limited partners in the Code.

Recommended Statutoqr Default Definitions of Limited and General Partner under Section 7701 (a)(2): (A) General Partner - PI person not treated as a limited partner shall be considered a general partner.

(B) Limited Partner -- A person shall be considered a limited partner whose participation m the management or business activity of the entity is limited under either applicable state law or by the controlling partnership or operating agreement.

General Recommendation: The AICPA recommends adoptlon of and reference to its proposed statutory definition under section 7701(a)(2) for the following code provisions:

1. .41-nsk rules (section 465(c)(l)(D)(ii)(I));

’ Special -. valuation ruler for generation-skipping transfer tax (section 1701 (b)(Z)(B)(ii)):

3. Concept of “limited partner or limited ent&preneur” (sections 464(c)(l)(B) and (e)(2)(A): 1256 (e)(3)(B) and CC). and (e)(4)(A); and 1258(d)(5)(C));

4. Material participation and active panicipation u’nder the passive loss rules (section 469(h)( 2)); and

q -. Ejecting large partnership rules (section 772(f)).

Payments to Retiring Partners (Section 736(b)(3)(B): The Jomt Committee staffs recommendation substituting the requirement that the retiring panner be a general partner with a requirement that the retiring partner must be subject to tax on self-employment income from the partnership causes us concern and is

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partially inconsistent with an existing AICPA proposal (previously submitted to the Congress and attached as Appendix C).

Although the structural issues related to determining whether or not a panner is subject to self-employment tax are discussed (with references to the, AlCPA’s proposal for modemizing the self-employment tax references to limited partners in section 1402). the JCT staff made no recommendations.

We believe that incorporating references to income subject to self-employment tax in section 736(b)(3)(B) is not appropriate at this time. Until the issue is clarified. we suggest that actual participation by the partner be the measure of “general partner” status (rather than the extent of participation allowed under state law). However. once clarification is achieved under section 1402. the concept of self-employment income as the measure may be appropriate.

Foreign Currency Transactions (Section 988(c)(l)(E)(v)(I): .4 section 988 transaction includes entering into or acquiring any forward contract. futures contract. option. or similar financial instrument. but does not apply to a qualified fund. which is defined as a partnership meeting certain requirements and making an election. One of the requirements is that a partnership have at least 20 partners and that no partner have more than a 20-percent capital and profits interest in the partnership, A general partner will not be treated as failing the 20-percent ownership test if it has no ordinaF Income from a section 988 transaction that is foreign currency gain or loss.

The AICPA recommends maintaining usage of the term general partner as defined in the AICPA’s proposed statutory definition under section 7701(a)(2). Section 988 uses the term general partner without modifying the general usage of that term and. as such. a standard definition would be approptiate.

1982 .4ct Partnership .4udit Rules (Section 623 1 (a)(7)): In the context of general and limited pannerships. we accept the Joint Committee staff recommendation.

In the context of a limited liabilie company. the AICPA recommends that the statute reflect the term general partner as used in existing reg. section 301.6231(a.)(7)-(2). According to this regulation. general partners are the,member-manager(s). If no rnember- managers are designated. than any member can be designated as the tax matters panner. In accord with this regulation. member-managers should be defined as the member vested with the exclusive authority to make management decisions to conduct the business for which the organization was formed.

Reponing Rules for Large Pannerships (Section 772(f)): While we agree with the Joint Committee staffs general recommendation to keep section 772(f) in conformity with section 469. the AICPA recommends retaining the elective large partnership reporting and auditing rules (see below), and therefore, also recommends that our proposed statutory definition under section 7701 (a)(2) be adopted.

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Self-employment Tax Rules (Section 1402(a)( 13)): The Joint Committee staff did not make any’ recommendations to section 1402. The AICPA recommends that the JCT staff consider simplification recommendations in this area as part of any future study or legislation. Attached as Appendix C is the AICPA legislative proposal regarding tax on self-employment income under section 1402.

Eliminate lar.ee partnership rules (JCT page 287) The Joint Committee staff recommends that the special reporting and audit rules for electing large partnerships (ELP) should be eliminated and that large partnerships should be subject to the general rules applicable to partnerships. The AICPA recommends that these rules not be repealed for the following reasons:

The ELP rules are elective. thereby providing large partnerships with alternatives with respect to pannership reporting and audits. Partnerships that qualify are generally sophisticated in nature. These partnerships generally prefer flexibility. even if it results in a certain amount of complexity.

The ELP rules were intended to simplify reporting for ELPs. Partners of ELPs benefit from the simplified reportmg provided by these rules.

Eliminating the ELP rules would seem to add temporary complexity for ELPs that have already established a system for partnership reporting under the current rules.

Eliminating the ELP rules does not provide simplification to most partnerships that are not ELPs. except that they no longer need to evaluate a separate regime.

The JCT staff speculates that. because the rules have not been widely elected by pannershlps. the benefits probably do not outweigh the disadvantages and suggests that complexity IS. at least m pan. a reason for the few number of ELPs. The AICPA believes that the fact that few partnershrps use these rules does not. by itself. create complexity in the tax system for the much larger populatton of partnerships that either are not eligible to make the election or. tf eligible. choose not to make the election. Indeed. for those partnerships that elect these provtstons. the rules facilitate simplicity by significant]> reducing their tax compltance burdens. Funher, the small number of existing ELPs is more likely due to market factors Many of the partnerships that might have become ELPs instead became corporattons In an effort to raisd capital more effectively.

Conform timing rules for guaranteed pavments and other non-partner pavments (JCT page 291) The Joint Committee staff proposes treatmg all payments and transactions between partnerships and their partners as transactions occumng between related parties with respect to the timing of such payments. Specifically, the proposal would conform the timing rule for reporting partnership payments to partners in transactions where they are nor acting in their capacity as partners to the timing rule for reporting guaranteed payments made to partners acting in their capacity as panners.

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I

The AICPA opposes adopting this recommendation. It would result in the partnership’s accounting methods and tax year controlling the time for the reponing of payments made to the partners. In the case of payments made for the partners’ performance of services. panners must include payments from the partnership based on the tax year in which the partnership deducts or capitalizes such payments under its method of accounting rather than the tax year in v;hich the partners would have recognized the income under their own accounting methods. as currentl! required by section 707(a). This proposal would adopt the “aggregate” concept of partnership taxation by taxing the partnership’s payments to the partners in the same manner as their distributive shares of partnership income. As a consequence. partners with different tax year- ends from the partnership’s year-end could experience either an acceleration or deferral of income relative to the current rules.

,4lthough the “aggregate” concept of pannership taxation is appropriate for guaranteed payments and distributive shares of pannership income that are made to partners as partners). we believe that the current “entity” concept of partnership taxation is the more appropriate approach lo determining the tax treatment of payments made to partners who are noI acting in their partner capacity.

For valid business reasons. partners may engage in certain transactions with a partnershlip on an independent. third-pan? basis unrelated to their status as partners. Distinguishing between partners acting as partners and partners acting as third panies is comparable to shareholders of C and S corporations who are permitted to engage in similar transactions with their corporations on an independent. third-party basis and are bound by specific tax rules requiring them to be treated as “outsiders.” The “matching” rules of section 267 provide sufficient safeguards against attempts to improperI>, defer income in related party transactions. We are concerned that adopting the JCT staffs proposal would not preserve the integrity of the “entity” concept for determining the tax treatment of partners when they act as independent. third parties in their dealings with the partnership. Accordingly. the AICPA does not recommend adoption.

The explanarlon m the JCT proposal cites the complexity of current law regarding transactions between partners and partnerships involving the performance of services. We are concerned that this proposal could extend conformit>, of timing rules to transactions involving leases alnd sales of property and lending transactions that might create unwarranted tax results. We are also concerned about unintended Impacts on Code sections outside Subchapter K; for example. determining whether to classi& a distribution right as a qualified payment for estate and gift tax purposes under the special valuation rules of section 2701. The impact on these types of payments and transactions needs to be addressed before ado$ing a rule to conform the timing of payments to panners to the time the partnership takes the payment into account.

S Corporation Simplification Recommendations

Excess passive income of S corporations (JCT page 295) The AICPA supports the Joint Committee staffs two-part proposal; however, we also recommend expanding the proposal to: ( 1) exclude gain from the sale of a controlled subsidiary from the definition of passive investment income; and (2) provide relief for a corporation whose

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S election terminated as a result of excess passive investment income. These proposals are discussed below.

Exclude Gain from the Sale ofa Controlled Subsidian. from the Definition of Passive Investment income Dividends fi-om controlled subsidiaries are generally excluded from excess passive income unaer section 1362(d)(3)(E). We recommend a similar exclusion for gain on the sale of such subsidiaries. because the policy reasons for excluding dividends from controlled subsidiaries from the definition of passive investment income are equally applicable to pains from the sale of controlled subsidiaries and adoption of this provision would eliminate a trap for the unwac.

Pro\-idc Relief for Corporatrons Whose S Elections Terminated as a Result of Excess Passha Investment income We strongly support the Joint Committee staffs proposal eliminating excess passive investment income as a terminating event. In conjunction with this proposal. we suggest the following:

1. A corporation that lost its S status as a result of excess passive investment income should be gl\‘en an automatic wai\fer of the five-year waiting period to re-elect S status under section 1362(g).

If a corporanon has filed a C corporation return because its S election terminated as a result of excess passive investment income and the statute of limitations is open for all years m which the corporation filed a C corporation return. an autclmatic waiver of the tennlnstion of the corporation’s S election should be granted under section 1362(f), if: ( I ) the corporation and all its shareholders file amended returns consistent with the corporation’s S election remainmg m effect; and (2) the corporation pays any passive m\festment income tax owed with such amended returns (and properly paid any passive Ini’estment Income tax owed with S corporation returns previously filed).

3. If‘ a corporanon has not filed a C corporation return because it failed to discover that its S electjon terminated as a result of excess passive investment income. upon discovery of the termmating event the corporation should be g-ranted an automatic waiver of the mad\,enent termination of its S election under section 1362(f), if: (1) it files amended returns to pay any passive investment income tax owed; and (2) all its shareholders file returns consistent with the corporanon’s S election remaining in effect. If the statute of llmltatlons IS closed for the year In which the terminating event occurred or for a year in which tax under section 1375 was due but not paid. the corporation would not qualify for an automatic waiver. but could request a waiver by a filing a private letter ruling request with the IRS National Office.

lmplementatlon of these provisions would result in a more equitable treatment of corporations whose S elections have terminated as a result of excess passive investment income.

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Trusts as permitted shareholders of S corporations (JCT 296)

Proposal to eliminate QSSTs The AICPA opposes eliminating qualified Subchapter S trusts (QSSTs). The Joint Committee staffs recommendation implies that QSST elections would not be available prospectiveI>,. Thus. it appears that existing QSSTs would be “grandfathered.” In this case. current rules relating to QSSTs would have to be retained indefinitely and simplification would not result, Furthermore. eliminating the QSST rules for all trusts. including existing QSSTs. could advrersel:!. impact existing QSSTs and their beneficiaries and. for the following reasons. may not result in the desired simplification.

1.

9 -.

3.

3.

The current QSST rules. enacted in 1982. are generally well understood by tax practitioners and attorneys involved in drafting trust agreements. Many existing trust agreements mclude provisions that would allow the trust to qualify as a QSST if it acquires S corporation stock. These ageements specifically’ authorize the trustee to make a QSST election. but do not specifically authorize an electing small business trust (ESBT) election. Eliminating QSSTs as eligible S corporation shareholders would require that these trusts be reviewed and possibly revised. a time-consuming and costly process.

The taxation of S corporation income allocated to stock held by a QSST is straightforward. All income is taxed to the trust’s sole beneficiary. Determining how to tax this income at the trust level under Subchapter J could be much more complex. For example, there is significant uncertainty! about how the passive activity loss rules apply in the trust context.

Frequently S corporation stock is the only asset a QSST holds. QSSTs are commonly used to hold a child’s Interest m a family-owned S corporation, Eliminating the QSST rules and subjectmg the trust to the Subchapter J rules could result in a much more complex trust return.

S corporation income allocated to shares of stock held by a QSST is taxed at the individual beneficiap, level and. as a result. frequently is not subject to tax at the highest individual mcome tax rate. Trust mcome. on the other hand. is subject to the highest individual1 rate of tax once it. exceeds a de minimis amount. If the provision eliminating QSSTs on a prospective basis is enacted, yet the rules relating to the taxation of an ESBT remain unchanged (see discussion below). an increased tax, burden on S corporation income allocated to a shareholder trust would result.

Simplification of ESB T rules The AICPA supports the proposal to stmplifv the electing small business trust (ESBT) rules with modifications. The Joint Comrmttee staffs recommendation to subject the ESBT to the general rules of subchapter J would reduce the complexity inherent in utilizing this type of trust. However. it is important to understand that most of the complexity relating to ESBTs results from the ESBT eligibility requirements. and not from their taxation. Accordingly, we: believe that the primary focus of simplification effons should be on the eligibility requirements.

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In support of simplification. without creating opportunities for abuse. we favor the current rules regarding the taxation of ESBTs (other than the IRS’s position in proposed regulations. which provides that the grantor portion of an ESBT holding S corporation stock should be treated as a separate trust). and recommend the following changes:

1.

3 -.

3.

4.

The concept of potential current beneficiaries should be eliminated. Because all S corporation items allocated to stock held by an ESBT are taxed at the trust level at the highest individual income tax rate. there is no significant policy reason for retaining two classes of beneficiaries -- potential current beneficiaries and beneficiaries.

If the concept of potential current beneficiaries is not eliminated. unexercised powers of appointment should not cause any person in whose favor the power could be exercised to be a potential current beneficiary until such power is actually exercised in his or her favor.

In determining the number of eligible shareholders. only the ESBT should be treated as a shareholder.

If a trustee elects ESBT status. taxation of the “S pottion” should be governed by section 641(c). even if some or all of the S portion is also a grantor trust under Subpart E. This would eliminate uncertainty about the taxation of S corporation items when an ESBT election is made. The proposed regulations treat the grantor portion of an ESBT as a separate trust subJect to taxatton under sections 671-678. This creates uncertainty about the proper taxation of S corporation items when it is not clear if the trust is a grantor trust. A common example IS H,hen a grantor retains the right to substitute property of equivalent vralue. and it is unclear whether this power may be exercised in a fiduciary or non-fiduciary capacity.

1’1. GESERAL BUSWESS ISSUES

Section 103 1

Tax-free rollnvrer of like-kind propertv (JCT page 300) The Joint Commtttee staff recommends that a taxpayer should be permitted to elect to “roll over” gam from the disposition of appreciated business or investment property described in section 103 1. if like-kind property is acquired by the taxpayer within 180 days before or after the date of disposition (but not later than the due date of the taxpayer’s income tax return). The detennmation of whether properties are consrdered to be of a like kind would be the same as under present law.

The AlCP.4 supports this position. Allowing rollovers could simplify these transactions and reduce transactron costs by eliminating the qualified intermediaries. The proposal allowing the taxpayer to receive cash from a transactton is consistent with other existing Code provisions such as sections 1033 (involuntary conversions). 1044 (rollover of publicly traded securities gain into specialized small business investment companies), and 1045 (Rollover of gain from qualified small business stock to another qualified small business stock). In addition, prior to its repeal, section 1034 allowed taxpayers to receive cash and roll over the gain on the sale of their

20


,

principal residence if the proceeds were used to replace the residence within a certain time period.

Propertv held for use in a trade or business or held for investment in a like-kind exchars (JCT page 303) The Joint Committee staff recommends that. for purposes of determining whether propert?. satisfies the holding requirement under the section 103 1 like-kind exchange rules. a taxpayer’s holding period and use of property should include the transferor’s holding period and use for propert>!: (1) contributed to a corporation or partnership in a section 351 or 721 transaction: (2) acquired by a corporation in connection with reorganization under section 368: (3) distributed b!* a partnership to a panner: or (4) distributed by a corporation in a section 332 transaction. In addition. the Joint Committee staff recommends that property whose use changes should not qualie for like-kind exchange treatment unless it is held for productive use in a trade or .business or investment for a specified period of time.

The AICPA supports this position as eliminating the confusion caused by inconslstent IRS rulings and COW-I cases that are causing considerable uncenainty. The proposal would1 change the focus from the form of holding the property to the use of the propem, and add consistency. The proposal would also require that the property be held for a specified period of time i.f its use changes. Thus n,ould pro\‘ide guidance to taxpayers entering into like-kind transactions.

Low-Income Housing Tax Credit (JCT page 306)

Under current section 42. a taxpayer owning qualified low-income rental housing can rleceive a tax credit that 1s allocated over a payout period of IO-years based on a statutorily prescribed present value calculation. The propen!‘. however. must satisfv the section 42 qualification requirements for at least a Is-year penod ro avoid recaprure of the accelerated portion of the credit. Complexlr>, occurs because of the difference between the payout period and the compliance penod when the-*z is a recapture event. The Joint Committee staff recommends lengthening the credit payout period to 15 years to eliminate the complex recapture rules that occur because of the difference between the payout period and the compliance period. The proposal also recommends changing the calculation of the present value of the tax benefits of the credit over the revised longer payout penod so that the present value of the tax benefits would remain the same despite the longer payout period.

The AICPA supports this recommendation if the current prTsent-value calculation for the credit IS retained and revised as recommended by the JCT.

Rehabilitation Tax Credit (JCT page 307)

The AICPA disagrees with the Joint Committee staffs proposed revision to eliminate the lo- * percent rehabilitation tax credit for rehabilitation expenditures .with respect to buildings first placed in senice before 1936. The rehabilitation credit would only apply to certified historic structures. One reason for the change. as stated by the JCT, is the potential overlap of the two

types of buildings. that is. certified historic buildings versus buildings that are simply old. but not

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certified as historic. Other reasons are the complexity in computation. the additional record- keeping burden. and renovation limitations.

Although the proposal does reduce complexity. it also eliminates a significant policy goal. Enacted in 1978. this credit was intended to address the declining usefulness of existing older buildings throughout the country. The credit allowed for the efficient use of existing buildings by rehabilitation instead of demolition. Existing buildings are now much older than the!, were in 1978 and unless owners go through the complex application process to receive certified historic structure status. they will not qualify for the credit. It is a very time-consuming process to meet the certified historic structure definition. and therefore. many buildings that currently quali@ for the lo-percent credit will not qualify as certified historic structures. If this proposal were enacted. these buildings will be demolished instead of rehabilitated. This does not meet the 1978 policy goal of preserving and maintaining existing building stock.

1’11. ACCOUKTING AND COST RECOVERY PROVISIONS

Structural Issues Relating to Accounting for Capital Expenditures (JCT page 322)

The Joint Committee staff thoroughly examined the issues raised by the tension between capitalizing and deducting expenditures. but made no legislative recommendation on these issues. defemng instead to IRS and Treasup.

The AICPA supports this decision. Although legislative action may be appropriate in the future. it appears that IRS and Treasuq have made significant progress in developing comprehensive guidance on these issues.

Cash ,Ilethod of Accounting for Small Businesses (JCT page 328)

The Joint Committee staff recommends that taxpayer with S5 million in average annual gross receipts be allowed to use the cash method of accou: ng and should not be required to use an accrual method for purchases and sales of merchandise.

The AICPA supports this recommendation. We acknowledge that the IRS issued a proposed revenue procedure in December 2001 that allows the use of the cash method for certain taxpayers with less than 510 million in average annual gross receipts. However, the proposed revenue pJOCedUJe does not apply to most taxpayers that’purchase and sell inventory. The AICPA currently is undertaking its own study of the inventory requirement and expects to submit recommendations to IRS and Treasuv m the near future.

Amortization of Organization Expenditures (JCT page 332)

The Joint Committee staff notes that the provisions regarding the amortization of organizational expenses are separated into two different Code sections: section 248 for corporations and section 709 for partnerships, and recommends combining these provisions in a single Code section.

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The AICPA supports this recommendation as an aid to understanding.

Depreciation - Mid-Quarter Convention (JCT page 334)

The Joint Committee staff notes that the Code provides several different conventions governing when certain property is considered placed in service for purposes of determining the starting and ending points of depreciation. The Joint Committee staff recommends elimmating the mid- quarter convention under which property placed in service during the last quarter of the tax year may. under certain conditions. be treated as having been placed in service (or disposed 011 on the mid-point of that quaner.

The AICPA supports this recommendation.

Additional Accounting and Cost Recovery Provisions for JCT Future Consideration

The AlCPA recommends that the JCT staff consider the following additional tax simplification recommendations as part of any future study or legislation.

Reform tax depreciation lives and methods The number of separate depreciation schedules taxpayers must keep shouid be reduced (For example. 1OOo/0 declining balance for existence of multiple lives. optional election of section 1245/l 250(a). etc.). Also. there is a need to update the current revenue procedure (issued in 1987) to reflect classes and types of assets that were in existence in prior years.

Eliminate section 263A for “small” manufacturers and “small” resellers Section 263A should be eliminated for small manufacturers and small resellers. “Small”’ would be defined as an entity with gross receipts less than SIO million. Thus. the manufacturer or

reseller would be required to capitalize costs based on full absorption (consistent with financial statement requirements). but would not be required to capitalize costs under the current Uniform Capitalization requirements.

IX. IKTERNATIONAL TAX

Anti-Deferral Regimes Applicable to income Earned Through Foreign Corporations (JCT page 398)

,

The Joint Committee staffs proposal would: (1) eliminate the rules applicable to foreign personal holding companies (FPHC) and foreign investment companies; (2) exclude foreign corporations from the personal holding company rules; and (3) include certain personal lservices contract income targeted under the present-law FPHC rules as subpart F foreign personal holding company income.

The AICPA supports this recommendation as it would eliminate complex, redundant, and out- dated anti-deferral regimes. A multitude of anti-deferral regimes have been enacted, w:hich are sometimes overlapping and inconsistent with each other..

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h

The proposed changes would make foreign corporations’ passive income subject to U.S. tax under either the controlled foreign corporation rules or the passive foreign investment cornpan!. (PFIC) rules. As the JCT staff points out. eliminating the other anti-deferral regimes may result in certain gaps in coverage. but the gaps do not represent significant avenues for evading tax on passive foreign income.

Expand Subpart F De Minimis Rule (JCT page 419)

The AICPA strongly supports the Joint Committee staffs proposal to modi@ the subpan F de minimis rule to be the lesser of five percent of gross income or S5 million.

Subpart F contains a set of highly complex rules primarily designed to tax currently the passivre income and other types of highly mobile income (collectively. “foreign base company income”) of controlled foreign corporattons (CFCs). Under the current de minimis rule F. if the gross amount of a CFC’s foreign base company income for the tax year is less than the lesser of five percent of the CFC’s gross mcome or 51 million. then no part of the CFC’s gross income is treated as foreign base company’ income. The Sl million limitation has the effect of applying a smaller percentage of gross income test for those CFCs with gross income in excess of $20 million (because S 1 million is less than five percent of any amount greater than S20 million).

.4ccordinglyf. by increasing the dollar limitation prong of the de minimis rule. the proposal would reduce complexity and filing burdens for taxpavers with CFCs engaged in active businesses and ha\,tng only) a relatively insignificant portion ofthe CFCs’ gross income constituting foreign base company income. This proposal would particularly benefit smaller companies. by sparing them the difficulties and costs of understanding and complying with the subpart F rules.

Look-Through Rules for Dividends from Koncontrolled Section 902 Corporations (JCT page 32 1)

The AICPA strongly supports the Joint Committee staffs proposal to immediately apply the “look through” approach to all dividends paid by a so-called IO!50 company, also known as a “noncontrolled sectton 902 corporation.” This recommendation would also render moot the timing of the accumulation of the earnings and profits out of which the dividend is paid.

The current rules for dividends from IO,50 companies are complex and result in significant compltance burdens for taxpayers. Dt\,tdends paid cun’ently from a IO/50 company are categotized in a separate category (or “basket”) for foreign tax credit purposes. Thus. a U.S. taxpayer with interests m multrple foretgn corporate joint ventures (in which the U.S. taxpayer owns at least 10 percent but no more than 50 percent) must perform multiple foreign tax credit limitation computations,

Kew rules are scheduled to come into effect for dividends paid in a tax year beginning after December 31. 2002. Under these new rules. dividends paid from pre-2003-generated earnings will be categorized in a single IO!50 basket. whereas dividends paid from post-2002-generated

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earnings will be subject to “look through” rules. Thus. the new rules offer some simplification compared to the current rules. but contain some additional complexity of their own.

The JCT recommendation would further simplify taxpayers’ record-keeping requirements by. accelerating and completing the elimination of the separate basket approach.

Foreign Tax Credits Claimed Indirectly through Partnerships (JCT page 423)

The Joint Committee staff recommends that a U.S. corporation should be entitled ‘to claim deemed-paid foreign tax credits under section 902 with respect to a foreign corporation that is held indirectly through a foreign or U.S. partnership. if the U.S. corporation owns (through the partnership) at least 10 percent of the foreign corporation’s voting stock.

The AICPA strongly supports this recommendation as it would clear up an ambiguity created by the IRS’s published statements. Whether U.S. corporations may claim deemed-paid credits through pass-through entities is uncertain. In Rev. Rul. 71-141. the IRS concluded that a U.S. corporate partner in a U.S. general partnership could claim deemed-paid credits with respect to dividends paid by a foreign subsidiary owned through the partnership. However. the preamble to the 1997 final regulations under section 902 indicates that the IRS is unsure whether the principles set forth in Rev. Rul. 71-I 4 1 should apply in other contexts (such as in the case of limited partnerships or foreign pass-through entities). The JCT staff. however. believes that. generally. the same principles should apply in these other situations as well. and we concur.

Conform Sections 30A and 936 (JCT page 428)

This Joint Committee staff proposal would combine the credit computation rules into o’ne Code section and conform the application of :he possessions tax credit across all possessions, should Congress choose to extend the credits past their current scheduled expiration of 2005.

The Section 30A credit is a separate rule applicable only to operations in Puerto Rico. Although this credit is a subset of section 936 and is computed under the same general rules. it is contained in an entirely separate. non-adjacent Code section. This arrangement creates unnecessary complexity for credit claimants in Puerto Rico.

The AICPA supports this recommendation. as well as the renewal of the credits to which it relates. The harmonization of the possessions credit rules’for all possessions should have the effect of rendering neutral the tax considerations of investing in one possession versus another.

Application of Uniform Capitalization Rules for Foreign Persons (JCT page 432)

The Joint Committee staff recommends that U.S. generally accepted accounting principles (GAAP) be used for purposes of determining a foreign person’s earnings and profits (E&P) and Subpart F income. instead of the uniform cost capitalization (Unicap) rules which are used by domestic taxpayers.

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The AICPA supports this proposal. Even in domestic situations. the Unicap rules are high]! complex and burdensome to taxpayers. In our experience. many IRS auditors do not even understand them. Requiring foreign persons to determine their E&P and Subpan F income usmg the Unicap rules is very burdensome given the multiple sets of books that usually must be maintained already (e.g.. for foreign financial accounting purposes. for foreign tax purposes. .for U.S. financial accountmg purposes. for U.S. tax purposes. and for internal reporting purposes).

It is also worth noting that the purpose of the Unicap rules is simply to defer recognition of deductions via the conversion of certain currently deductible period costs into capitalized product costs. Accordingly,. only the timing of the recognition of tax revenues would be affected.

Secondav Withholding Tax on Dividends from Foreign Corporations (JCT page 436)

The Joint Committee staffs proposal would eliminate the secondary withholding tax on dividends paid by certain foreign corporations.

The AICPA supports this recommendation. given the clear redundancy and practical difficulties in administering this tax.

The branch profits tax was enacted as a part of the Tax Reform Act of 1986 and was designed to replace the secondav u+hholding tax. If a foreign corporation is subject to the branch profits tax. then no secondary, Lvithholding tax applies.

Some foreign corporations are not subjecr to the branch profits tax as a result of particular provisions in U.S. tax treaties with certain countries. fiany of these treaties. however, also prevent the imposition of a second-, withholding tax. Thus. the secondary withholding tax applies today only in vev limited situations where a treaty prohibits the application of the branch profits tax rules but not the secondary withholding tax. There are also significant enforcement and momtonng problems u,ith the second? withholding tax in the case of dividends paid by foreign corporations to foreign shareholders.

Capital Gains of Certain lVonresident Individuals (JCT page 440)

The Joint Committee staffs proposal would eliminate section 871(a)(2), which imposes a 30- percent tax on certain U.S.-source capital gains of non-resident individuals.

The AICPA supports this provision given the statutory provision’s very limited application today. Section 871 (a)(2) applies to non-resident aliens who are present in the United States for at least 183 days in a tax year. However. under the “substantial presence test” of section 7701 (b). an individual who is present m the United States for at least 183 days generally is considered to be a residenr. Thus. section 871(a)(2) can apply only if a foreign national spends at least 183 days in the United States but some or all of these days are not taken into account for purposes of section 7701(b) under very limited exceptions that rarely apply. Even where section 871(a)(2) otherwise would apply, in most cases the provisions of U.S. tax treaties would prevent its imposition.

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c’.S. Model Tax Treaties (JCT page 445)

The Joint Committee staff calls for the Treasury Department to update and publish U.S. mode] tax treaties once per Congress.

The AICPA generally supports the concept underlying this recommendation. Regular]!, updated model treaties would provide taxpayers and practitioners with helpful guidance regarding current U.S. tax treaty policy. However. an updated model treaty would be useful only if it contains changes that arise from thoughtful reflection on recent experience with existing treaties.

Moreover. if Treasury were compelled to devote resources to the continual updating of the U.S. model treaty. we are concerned that insufftcient resources would be available to deal with more pressing needs. such as more detailed guidance with respect to existing and newly signed treaties. as n,ell as the expansion of the U.S. treaty network. Thus. the “once per Congress” requirement should be changed to a “once every five years” requirement. to allow sufficrent time for the accumuiatlon of additional experience and for thoughtful reflection. as well as a more approptiate allocation of resources.

Older U.S. Tax Treaties (JCT page 448)

The Joint Committee staff proposes that the Treasury Department should report to Congress on the status of older U.S. tax treaties once per Congress.

The AICPA generally suppons the concept underlying this recommendation. Such a report would provide taxpayers and practitioners with helpful information regarding the status’ of U.S. tax treaty negotiations. and may allow for more informed public commentary on these negottattons. Some information. however. such as the priority given to a particular treaty, would seem to be too politically sensitive to disclose in a public report (e.g., a country given a lower pnonty than it believes tt deserves could be offended). Other information, such as the impact of significant law changes on treaties. would seem to be more appropriately addressed at the time the law change is proposed. rather than m a petiodic Treasury report. Moreover. we belileve that a balance needs to be struck between updating old treaties and dealing with other irnportant treaty!-related matters. such expanding the U.S. treaty network and resolving important issues with respect to recentlv ratified treaties.

x. TAX-EXEMPT ORGANIZATIOJU PROVISIONS

Percentage Limits on Grass-Roots Lobbying Expenditures of Electing Charities (JCT page 351)

The Joint Committee staff recommends that the percentage limitation on grass-roots lobbying expenditures should be eliminated. The purpose of the section 501(h) expenditure test is to ensure. by using bright-line rules. that no substantial part of an electing charity’s activities are lobbying. Accordingly,. section 501(h) caps an electing charity’s permissible overall lobbying expenditures. The separate limit for grass-roots expenditures does not increase or decrease the permitted amount of total lobbying expenditures; rather it limits grass-roots lobbying as a subset

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of total lobbying. Thus. an electing charity can spend up to $1 million on lobbying. but no more than $250.000 of that amount may be for grass-roots lobbying. In the absence of a significant policy rationale supporting the distinction between grass-roots lobbying and direct lobbying. the Joint Commtttee staff believes that the complexity caused by’ the distinction justifies elimination of the grass-roots expenditure limitation.

The AICPA supports the recommendation to eliminate the separate expenditure limitation on grass-roots lobbying by certain tax-exempt organizations. Currently. charities that measure then permissible lobbying activity by makmg the section 501(h) election must distinguish between direct and grass-roots lobbying. Such charities must both understand the difference. then define and allocate expenses for grass-roots lobbying as a subset of total lobbying expenditures. This proposal would eliminate this largely unnecessary. burdensome process of definition and calculation that often results in inexact and incorrect information being provided to the IRS.

Excise Tax Based on Investment Income (JCT page 456)

The Joint Committee staff recommends that the excise tax based on net investment income of private foundations should be eliminated. This excise tax was originally intended as a fee to fund administration of exempt organizattons generally. However. even in its early years. the tax raised considerable more rex’enue that the IRS spent on supervision. Today. the tax continues to generate more revenue than necessary’. In addition. there is no evidence that the amount of excise tax collected affects in any way the amount that is appropriated to the IRS for administration of programs related to exempt organizations. Thus. funds generated by the excise tax are not earmarked for then intended purpose, resulting in a tax on private foundations for purposes of the general treasury. In addition. because the tax counts toward a foundation’s minimum qualified distributtons. elimtnatrng the tax would result in many cases in increased. charitable activity.

The AICPA supports thts proposal. The current two-tier federal excise tax - Imposing a one- percent tax on a foundanon’s annual investment income if it maintains or increases its level of giving. but a two-percent tax if it does not -- 1s complex. misunderstood. and has not necessarily encouraged increased giving. To achieve the lower rate. a foundation must (1) maintain its five- year average histotic giving levfel as a percentage of the value of its current-year investment asset values: and (2) give its tax savmgs to chant! by Increasing its distributions by the one-percent tax reductton. In other words. the foundatton can currently redirect the half of the two- percent excuse tax to charitable recipients.

,

Eliminating the excise tax on investment income would make more money available for private foundatrons’ support of its chatitable grantees and programs. The burden of calculating net mvestment income. making estimated tax payments, and deciding whether to increase or decrease annual charitable distributions based on tax considerations would be eliminated.

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XI\‘. ESTATE AND GIFT TAX PROVISIOI\;

Conform Certain Family-Owned and Small Business Provisions (JCT page 53 1)

The AICPA suppofls the Joint Committee staffs proposal to conform the section 2032A special use rules with similar rules governing the section 2057 family-owned business deduction. This support is conditional on section 2057 expiring in two years. (Note: Both the recommendations and our comments focus on pre-2001 tax law.)

In its February 2001 “Study on Reform of the Estate and Gifi Tax System.” the AICPA noted that targeted relief provisions like those found in Sections 203 l(c). 2032.4. 205.7 and 6166 provide limited relief to a small number of business owners. land owners. and farmers without providing any benefit to holders of other illiquid and inaccessible assets. including retirement accounts. personal residences and other real estate. installment obligations. stock options. etc.

ConsequentIF. the AICPA does not support increasing targeted relief under sections 203 l(c). 2032A. or 2057. or trving to extend the current liquidity relief measures under section 6166. Targeted relief has ndt been successful in the past. and it treats similarly situated taxpayers different]>,. The AICPA believes it would be difficult to structure targeted relief in a way that will be useful for taxpayers. In addition. the complexities of section 6166 make it unworkable for many taxpayers. Therefore. the AICPA favors implementing a new regime of broadened liquidity/payment relief measures by eliminating current sections 203 l(c). 2032A. 2057. and 6166 and replacing them with broader. simpler provisions available to all taxpayers. If concerned about overuse. the government could limit the attractiveness of such a tax payment deferral regime by adjusting interest rates and the deferral period.

If the current transfer tax svstem is modified (and not repealed in 2010). the AICPA suRfrests the follo~~me:

.4lthough the approptiate increase in the applicable exclusion amount depends on Congress’ specific goals. increasing the exclusion amount to S5 million per taxpayer would eliminate estate tax concerns for 90 to 95 percent of previously taxable estates. Also. the applicable exclusion amount should be indexed annually for inflation.

The applicable exclusion amount should be made portakle (i.e.. $10 million per couple), so that any ponion unused by the first spouse to die could be utilized by the surviving spouse. Although this can be accomplished under current law through effective tax planning, ponability should be made an explicit part of the law.

The applicable exclusion amount should be modified so that it becomes a true exemption.

If the estate tax rate structure is altered. across-the-board rate reductions and fewer brackets are preferable to simply reducing the highest marginal rate. In addition to reducing $the rates affecting smaller estates. the top marginal rate should be reduced to a rate that is no higher than the maxlmum individual income tax rate.

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l The full step-up in income tax basis to fair market value for inherited assets should be ‘retained as under current law.

l The state death tax credit should be retained in its current framework. as a credit instead of a deduction. and any revenue losses to the states should be mimmized.

If the estate and generation skipping transfer taxes are repealed in 2010 as scheduled. the PIICPA suggests the following:

The carryover basis provisions should include a statutory safe-harbor as an alternative method for determinmg the basis of lifetime gifts and transfers at death. In some cases. an executor or beneficiary will not have adequate records to calculate carryover basis of assets held at death. .4 safe-harbor could be tied to inflation rates or other measures of price appreciation. based on historical published prices. or based on a statutorily allowed percentage of fair market value.

Tax professionals. preparers. beneficiaries. and executors who use a “reasonable” method to determine carryover basis uphen adequate records do not exist should not be penalized under a carryover basis regime.

If allou*ances for basis srep-ups are Included in a carryover basis regime. an elective safe- harbor procedure should be Included for allocating the allowable basis s;ep-up pro rata to all assets and ail beneficlaties In a taxable estate.

.4n automatic. long-term holdmg period for all inhtited assets should be provided as under current lau..

X\‘. ERIPLOMIEST TAX PROVISIONS

Structural lssues Relating to W’orker Classification (JCT page 539)

The Joint Committee staff discusses the general issues relating to proposals that would simplify the rules regarding worker classlficatlon but makes no specific recommendation in this area.

. The .4ICPA agrees that this IS an area in need of simplification, and we stand ready to assist the JCT staff n.ith the development of a legislative solution.

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Structural Issues Relating to Determination of Individuals Subject to Self-Employment Tax (JCT page 55 1)

The AICPA recommends that the JCT staff consider simplification recommendations in the section 1402 area as part of any future study or legislation. Attached as Appendix C is the AICPA legislative proposal regarding tax on self-employment income under section 1402.

XVI. COMPLIANCE AND ADMINISTRATIVE PRO\‘ISIONS

Penalties and Interest - Overall (JCT 568-571)

We believe the Joint Committee staffs proposals are an excellent response to the need for a comprehensive look at the Code’s interest and penalty provisions. Our comments are based on consideting the penalty and interest regime in its entirety. Individual comments and suggestions should not be accepted or rejected in a piecemeal fashion since the appropriateness of one prov,ision often depends on the status of another. For a more detailed explanation of the AICPA’s positions regarding the recommendations involving penalties and interest. please refer to the AICPA’s testimony before the House Ways and Means Committee on January 117. 2000. (See Appendix D.)

Provide one interest rate for both indi\*iduals and corporate taxpavers The Joint Committee staff recommends providmg one interest rate for overpayments and underpayments for both individuals and corporations. equal to the short-term applicable federal rate (.4FR) plus 5 percentage points

The AlCPA has qualified support for the proposal. We believe that adopting a single rate for underpay,ments and overpayments of all taxpayers will substantially reduce the administrative difficulties and financial inequities associated with the numerous differentials contained in the current regime. However. the concept of a rate equal to the AFR plus five percent will establish an excessively high rate.

Exclude interest paid bv the IRS from the income of individual taxpavers In an attempt to equalize rates on an after-tax basis for individual taxpayers and corporations. the Joint Committee staff recommends that ov’erpayment interest paid by the IRS to individuals be excludable from income.

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The AICPA believes that the recommendation is a constructive proposal in attempting to provide equivpalent effective interest rates on underpayments and overpayments for individuals. In addition. we believe the proposal should be broadened to clarify the deductibility of deficiency interest attributable to trade or business or investment activities of a non-corporate taxpayer. Thus. section 163(h) should be modified to allow every taxpayer a deduction for interest attributable to a deficiency attributable to trade or business activities, regardless of the form in which the businesses is operated. or to investment activities.

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Convert the present law penaltv for failure to pav estimated tax into an interest prov.ision and certain other estimated tax “reforms” The Joint Committee recommends repealing the individual and corporate estimated tax penalties and replacing them with interest charges.

The AICPA supports the proposal. Converting the estimated tax penalties into interest charges would result in a more accurate characterization because the penalties are essentialI>. fees for the use of money.

Repeal the present-law penaltv for failure to pav tax. and waive the S43.00 fee on installment ameements for taxpavers who agree to an automated withdrawal pavment plan Current law contains a failure-to-pay penalty equal to 0.5% per month (or fraction thereof). up to a maximum of 25%. The Joint Committee staff recommends repealing the penalt!. for failure to pay taxes. noting the repeal would be consistent with a policy initiative begun by the IRS Restructuring and Reform Act of 1998. in which the failure-to-pay penalty rate was reduced. Also. the JCT recommends waiving the $43.00 fee on installment agreements for taxpayers who agree to an automated withdrawal pa-yment plan.

The AICPA supports the proposal. We believe that. because the rate of interest oh under-payments is now tied to the market rate of interest. this penalty is a substitute for interest and should be repealed. Further. we support the provision to waive the installment agreements fee automated withdrawal plans. We believe that this withdrawal will provide an incentive to enter rnto these agreements and better ensure payment of taxes. Some states that offer automated withdrawal payment plans have shown high rates of adherence to installment agreements, We belleve that this provrsron would similarly facilitate a higher rate of adherence to federal insrallment agreements.

lmplementatron of a late pavment service charge for failure to enter into an installment ameement with the IRS bv the fourth month after assessment The Joint Commtttee staff recommends lmposmg an annual 5% late payment service charge on taxpayers who do not enter into an installment agreement within four months after assessment. The sewIce charge would be imposed on the balance remaining unpaid at the end of the four- month penod.

The AICPA opposes the proposal. W:e do not support establishing a service charge for failure to enter into an installment agreement. We believe that such a service charge will penalize taxpayers who already are struggling to pay then tax obligat;ons.

Interest (JCT pages 568-569)

Allow abatement of interest if gross injustice would otherwise result The Joint Committee staff recommends that the IRS be granted the authority to abate interest where necessary to avoid gross injustice.

The AICPA supports the provrrslon. Funher. because the IRS has been reluctant in the past to grant relief in this area. we request that the terms “gross injustice,” “unreasonable,” and

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‘*significant hardship” be adequatel!, defined to provide the IRS Mith clear standards for implementation.

Expand the circumstances in which interest mav be abated to include periods attributable to an\ unreasonable IRS error or dela\ The Joint Committee staff recommends that the IRS be granted the authorit!’ to abate interest for periods attributable to any unreasonable IRS error or delal,. whether or not related to managerial or ministerial acts.

The AICPA supports the provision. Further. because the IRS has been reluctant in the past to grant relief m this area. we request that the terms “gross injustice.” “unreasonable.” and “significant hardship” be adequately defined to provide the IRS with clear standards for implementation.

.4110~. abatement of interest if the taxpaver is repaving an erroneous refund based on IRS calculations w*lthout regard to the size of the refund The Jomt CommIttee staff recommends that the IRS be granted the authority to abate i:nterest in situations where the taxpayer is repaying an excessive refund based on IRS calculations. without regard to the size of the refund.

The AICP.4 supports the provision.

Allnu abaremenr of lnteresf to the extent interest is attributable to the taxpaver’s reliance on it’nrten staremenrs b\, the IRS The Joint CommIttee staff recommends that the IRS be g-ranted the authority to abate interest to the extent the interest 1s attnbutable to taxpayer reliance on a written statement of the IRS.

The AICP.4 suppons the prn\,lsion.

AIIOU taxpavers to deposit amounts in a “dispute reserve account” The Jomr Commlrree staff recommends that taxpayers be allowed to deposit amounts in a “dlspure resen’e account.” 3 special interest-bearing account within the U.S. Treasury. These accounts are Intended to help taxpayers better manage their exposure to underpayment interest Lvlthour requinng them to surrender access to their funds or make a potentially indefknite-term mk’esrmenr In a non-interest bearing account.

The AlCP.4 suppons the proposal in concept. We have sobe concerns about how the account ~,ill operate. but believe the recommendation blends some of the good features of several current Ia\4 approaches to avoid deficiency Interest charges and. thus. merits serious consideration.

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Estimated Tax (JCT page 569)

Repeal the modified safe harbor that applies to individuals with adjusted .gross income in Excess of S 150.000 in the preceding tax vear Section 6654(d)( 1 )(B) states that the required annual pa-yment of estimated taxes by an individual taxpayer shall generally be the lesser of: (1) 90 percent of the tax shown on the return for the taxable year: or (2) 100 percent of the tax shown on the return of the individual for the preceding tax year. However. section 6654(d)( 1 )(C) provides for a modified safe harbor whereby if the individual taxpayer had an adjusted gross income of $150.000 or more for the preceding taxable year. then the applicable percentage in the immediate preceding sentence increases from 100 percent to 112 percent for 2001 (110 percent for 2002) with respect to the percentage of the tax shown on the individual’s return for the preceding year.

The Joint Committee staff recommends repeal of the modified safe harbor for AGIs over S 150.000. letting all taxpayers making estimated payments based on the prior year’s tax to do so based on 100 percent of the prior year’s tax.

The AICPA supports the provision. as we concur that the 90/100 percent tests setout in section 6654(d)( 1 )(B) should generally, apply to all taxpayers. Also. we recommend against arbitrarily increasing or decreasing the percentage test for revenue raising purposes

Provide onlv one interest rate per underpavment period. The Joint Committee staff recommends applying only one interest rate per underpayment period __ the rate applicable on the first day of the quarter in which the payment is due. Currently. if interest rates change while an underpayment is outstanding. separate calculations are required for the periods before and after the interest rate change.

The AICPA suppons the provision. Having only one interest rate apply per underpayment penod would end the potential for multiple interest calculations occurring within an estimated tax underpayment period.

Change the definition of “underpavment” to allow existing underpayment balances to be used in underpavment calculations for succeeding estimated tax payment periods The Jomt Committee staff recommends changing the definition of “‘underpayment” to allow existing underpayment balances to be used m underpaIment calculations for succeeding estimated payment periods, i.e.. making underpayment balances cumulative.

The AICPA supports the provision. as the initiative should result in significant simplification of the computations.

Require taxpavers to use a 365-dav vear for all estimated tax underpayment calculations, regardless of whether the tax vear IS a leap vear The Joint Committee staff recommends establishing a 365-day year for estimated tax penalty calculation purposes. Current IRS procedures require separate calculations when outstanding underpayment balances extend from a leap year through a non-leap year.

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The AICPA supports the provision.

Accuracy-Related Penalties (JCT pages 569-570)

Raise the minimum standards for undisclosed positions for both taxpavers and preparers tinder current lau.. to avoid the substantial understatement penalty with respect to an undisclosed position. a taxpayer must have “substantial authorityV:” for a tax return preparer to avoid a preparer penalty with respect to an undisclosed position. the position must have a “realistic possibility of being sustained on the merits. ” The Joint Committee staff recommends th,at. for an undisclosed position. the taxpayer and the tax return preparer must reasonably believe that the tax treatment is “more likely than not” the correct tax treatment under the Code.

The AICPA opposes the proposal. We believe that the “substantial authority” standard is the more appropriate threshold standard for undisclosed positions. rather than the higher “more likely than not” standard. Currently. the only authorities that can be relied upon to constitute “substantial authority” are those issued by the federal government itself or the judiciap,. Acceptable authorities include the Code and other statutes. regulations. court decisions. and administrative pronouncements (e.g.. revenue rulings and procedures. proposed reg:uIations: notices. and other similar documents published b>* Treasury and the IRS). In addition. the list of authonties includes General Explanations of tax legislation prepared by the Joint Comrnittee on Taxation (the “Blue Book”). Conclusions in treatises.. legal periodicals, legal opinions or opimons of other tax professionals do not qualih, under present IRS rules.

Taxpayers and preparers who take positions relying on the government’s own rules and pronouncements should be able to feel comfortable that their positions are sufficiently accurate so as to free them from the possibility of penalties. A “more likely than not” standard for undisclosed positions would mean disclosure would be required even though the “substantial author+,” threshold is satisfied with respect to a position. Requiring disclosure for items that comport with the government’s own list of authorities would unnecessarily increase taxpayer compliance costs and the IRS’s burden. Further. such an approach would literally inundate the IRS with countless inconsequential disclosures. weakening the overall effectiveness of the disclosure regime. Thus. we believe the standard for undisclosed positions should be “substantial authority.”

Raise the mmlmum standards for disclosed positions for both taxpayers and tax preparers Under current law. to avoid a substantial understatement penalty with respect to a disclosed position. a taxpayer must have a “reasonable basis” for a return position; for a tax return preparer to avoid a preparer penalty with respect to a disclosed position. the position must not have been “fii~~oIous.” The Joint Committee staff recommends raising the minimum standard for taxpayers and tax return preparers to avoid a penalty for a disclosed position, there must be at least “substantial authority” for that position.

The AICPA does not support the proposal. The AlCPA has serious concerns about raising the standard for taxpayers and tax return preparers above the “reasonable basis” standard currently applicable to taxpayers. We are particularly troubled by the proposal to establish “substantial

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authority” as the minimum standard for disclosed positions. Such a high standard ma!- be unworkable. Although taxpayers and tax return preparers may be able to ascertain whether “substantial authority.” exists with regard to some issues. this is not true in all cases. The Federal tax law is forever changing. and as a result. there may be virtually no guidance issued at the time a return is filed. and therefore. virtually no authority with respect to the proper tax treatment of an item. Even if there is some authority. it may nevertheless be extremely difficult for taxpayers and preparers to know the probable correctness of many return positions given the exceedingly. complex nature of the tax law. It is not only unrealistic. but in many cases impossible. to ensure the high degree of accuracy required by the “substantial authority” standard or the “realistic possibility of being sustained on the merits” standard without forcing taxpayers to avoid otherwise meritorious positions on the return.

This problem is compounded by IRS’s failure to adhere to section 6662(d)(2)(D). added to the Code in 1989 to assist taxpayers and preparers in determining whether “substantial authority” is present for a position. Under this section the IRS is required to publish. at least annually. a list of positions for which the IRS believes there is no “substantial authority” and which affect a significant number of taxpayers. To date. the IRS has never issued any such list for any year. If the Service itself cannot determine which positions lack “substantial authority.” it is unreasonable to adopt this threshold as the minimum reporting standard for return positions by taxpayers and return preparers.

In its 1980 civil tax penalty study,. the IRS acknowledged the practical limits on the probable correctness of returns.

While not in and of themselves determinative of the correct standard of behavior, a \,ariety. of factors limit the ability of taxpayers to report positions disclosing a liability that IS probably correct. Perhaps the most significant limitation is the ambiguity inherent in applying a complex and changing set of tax rules to an infinite variety of factual situations. which may themselves be of ambiguous import. These complexities may result m failure to recognize issues. incorrect conclusions as to the probability that a particular position will prevfail. and differences of opinion regarding probability that are not resolvable short of the courthouse. The complexity of modern financial affairs. when coupled with the legal requirement to file a return by a statutory deadline and the costs of making the best possible assessment of each individual issue may also provide practical limits on the pursuit of a theoretically perfect return. Commissioner’s Study of Civil Penalties. 1989, at VIII- 1 1.

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For these reasons. we believe the standard for disclosed positions should be the “reasonable basis” standard currently applicable to taxpayers.

Chance the preparer penaltv from the current two-tier. flat-dollar penalty. The Jomt Committee staff recommends increasing the amount of tax return preparer penalties. For first-tier violations -- prepanng a return with a position that does not meet the minimum preparer standards -- the JCT staff recommends changing the preparer penalty from a flat $250 per occurrence to the greater of 5250 or 50% of the tax preparer’s fee. For second-tier violations -- understatements that result Tom willfirl or reckless disregard of the rules or regulations -- the

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JCT staff recommends increasing the amount from a flat S 1 .OOO per occurrence to the greater of S 1 .OOO or 1000/b of the preparer’s fee.

The AICPA does not support the proposal. Rather we suppon retaining the two-tier. flat-dollar penalty under current law based on the lack of empirical evidence indicating that the flat-dollar amount is not effective. In our opinion. deterrence for preparers results. not from a dollar penalty. but rather from the possible adverse impact on their abilit?, to practice and on their reputation for integrity and ethical behavior.

General Administrative Provisions (JCT pages 570-571)

Apple a hieher standard of behavior to conduct bv the IRS. similar to that which vrould be imposed on practitioners elsewhere under the JCT Study The Joint Committee staff recommends that standards similar to those that appl;rf to tax practitioners should be imposed on IRS employees.

The AICPA supports the provision but urges that sanctions be specified to encourage enforcement and recommends adding certain other specificity to the recommendation. As a matter of fairness and consrstency. we recommend that. if the standards for tax return preparers are raised as proposed. the standard for IRS revenue agents should be similarly raised to require revenue agents to have concluded that there is at least a “realistic possibility of success” before proposing an adjustment against a taxpayer. (

Require the IRS to publish. annuallv. statistics concerning the number of pavments made and total amount paid out under section 7430 for taxpavers’ reasonable administrative and litigation costs. and certam other stattstrcal information The Joint Committee staff recommends that the IRS be required to publish annually. information regarding paGents made under section 7430 for taxpayers’ administrative and litigation expenses and the admmlstrative issues that resulted in the making of those payments.

The AICPA supports the provtston

Require the IRS to improve the supmisorv review of the imposition and abatement of penalties m order to provide for greater unifommy of administration The Joint Committee staff recommends Improving supervisory review of the imposition and abatement of penalties.

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The AICPA supports the provpision on the theov that such improved review would promote equatable treatment of taxpayers.

Require the IRS to develop better information systems and statistical information on abatements The Joint Committee staff recommends that the IRS improve its method of providing statistical information on abatements and the reasons and criteria for abatements.

The AICPA supports the provtsion.

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Require the IRS to shorten sirmificantlv the current 45dav processing time for address chances The Joint Committee staff recommends that the IRS place a higher priority on improving the processes by which the names and addresses of individual taxpayers are updated in the IRS’s records. such as significantly shortening the current 45day processing time for address changes.

The AICPA suppons the provision.

Require the IRS to establish administrative svstems that assure that the proper representative of a taxpaver receives the proper notice direct]!, from the IRS. The Joint Committee staff recommends that the IRS establish administrative systems to assure that the proper taxpayer’s representative receives the proper notice directly l?om the IRS.

The AICPA supports the provision. In addition. the AICPA recommends that proposed changes in this area be expanded to allow practitioners to discuss a notice, and its related account. with the IRS through the use of a Personal Identification Number (“PIN”) on notices sent to taxpayers.

This proposal would require that a PIK be placed on each notice sent to a taxpayer such that if the taxpayer wants their practitioner to contact the Service on their behalf. the PII\;‘ will authorize the IRS to discuss the matter with that practitioner. This would be particularly important if the practitioner who is asked to resolve the matter is someone other than the preparer of the original return.

Under present law. the IRS has developed a “Third Pq Designee” program that was made effective for tax year 2000 for all 1040 series returns. This program was formerly referred to as the Checkbox Authont), initiative. Under this proFarn, taxpayers may “checks-off’ the Third Party Authorizatlon on their returns: thereby indicating their desire to allow the IRS to discuss the tax return ufith the preparer while the return is being processed. The IRS has announced plans to expand the Third Pan>, Designee Program to include the designation of friends and farnil!, members. and for the program to be expanded and made available with respect to cenain other tax forms.

The AICPA regards the Checkbox Initiative as a good first step. Our experience and IRS records show that the processing of notices dunng the return perfection and processing phase is a significant workload factor. The AICPA believes that the availability of a PIN on a notice would allow a taxpayer to authorize a practltloner to discuss the notice and the related account with the IRS . thereby resulting in workload reductions for taxpayers,‘practitioners. and the IRS.

Require the IRS to consider whether recent technological advances. such as e-mail and facsimile transmissions. permit the utilizatlon of altematlve means of communicating with taxpavers The Joint Committee staff recommends consideration by the IRS of the use of e-mail and fax transmissions instead of regular mail for communicating with taxpayers. The JCT also recommends that the IRS consider proposing legislation to provide for use of an alternative delivery; system where current law requires use of regular mail.

The AICPA suppons the provislon.

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XVII. DEADWOOD PRO\‘ISIONS

Deadwood Provisions (JCT page 579)

The AICPA supports periodic review of the lntemal Revenue Code for “deadu,ood’* pro\Gions that should be withdrawn.

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APPENDIX A

Tax Poliq Concept Statement 2

Guiding Principles for Tax Simplification

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AlCPA Issued by the Tax Division of the American lnstitute of Certified Public Accountants

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NOTICE TO READERS

Tax Policy Concept Statements of the AICPA Tax Division are issued for the general information of those interested in the subject. They present the conclusions of the division. as approved by the Tax Executive Committee. The Tax Executive Committee is the senior technical body of the AICPA authorized to speak for the AICPA in the area of federal income taxation.

Tax Polic), Concept Statements are intended to aid in the development of federal tax legislation in directions that the AICPA believes are in the public interest.

Tax Policy Concept Statements do not establish standards enforceable under the AICPA’s Code of Professional Ethics and are not intended for that purpose.

Copwghr L :OO,’ b>, American Insrirure qf Certified Public Accountants. Inc. .Z’m I.orX-. .j3’ 10036-8 77.5

.dII rrghrs reserved. For informarlon about the procedure$or’requesting permission 10 make copies qf an?’ part qf this H.ork. please call the AICPA Copyright Permissions Horline a[ f201) 938-3245. A Permissions Requesr Form for e-mailing requests is avaiiablc aI \tuu..aicpa.org b! clicking on rhe cop-vright notice of any page. Orhemise, requesrs should be Hwuen and mailed to Permissions Departmenr. AICPA, Harborside Financial Cewer. 201 Plaza Three. Jersey CiF, NJ 07311-3881.

1,‘3456’89OTDO9876543:

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APPENDIX B

AICPA SIMPLIFICATION RECOhfMENDATlONS APRIL 30.1997

OWNERSHIP ATTRIBUTION RULES

Present Law: The purpose of the attribution rules is to identify circumstances where ownership of stock is deemed to exist due to the presumed relationship between the actual owner and the person to whom the stock is being attributed. Since the underlying policy objective is essentially the same for each set of attribution rules. this is an area in which substantial simplification can be accomplished with minimal disruption. CurrentI>,. there are nine IRC sections that contain specific rules for stock attribution. Additionally. there are numerous references to these nine attribution sections elsewhere in the IRC. Many of these re:ferences modi& the nine IRC sections resulting in additional variations of the attribution rules. The proliferation of stock attribution rules has occurred because. frequently. when a new provision has been enacted. the drafters have tried to identie and address the exact relationships that would be covered. Each search for the ideal set of attribution rules seemingly ignored ,the wide variety of already-existing statutoy attribution rules. As each new set of attribution rules became law. its own set of re_rulations. administrative pronouncements. and case law ensued.

Recommended Change: Repeal all existing stock attribution rules. In their place. a single set of stock attribution rules will provide significant simplification and improved administration of the tax law b>‘ both taxpayers and the IRS. The proposal is divided into three primary Iparts: I) family attribution. 2) entitv attribution. and 3) option attribution.

Farnil!, attribution: An individual IS considered to own stock owned b\r his or her spouse. children. grandchildren. parents and grandparents.

Entity attribution: The owner of a pannership. corporation. estate or trust is deemed to own proportionally whatever stock the entity owns. An entity is deemed to own proportionally whatever stock the entit!- owns. An entity is deemed to own proportionally whatever stock IS nuned b\r its shareholders. partners or beneficiaries. In cenain situations. entity attribution does not exist unless the owner owns more than 50 percent of the entic.

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

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Contribution to Simplification: One of the primav goals of a tax system is certaint!. Currenti!. taxpayers and their advisors must deal with so many variations in the attribution rules that man!’ relevant IRC sections must be consulted to ensure proper reporting. Moreover. v+ith so man!’ sections modifying various basic IRC sections. it is difficult to even know if all releirant provisions have been addressed. One recently enacted example of this complexity is the related party definition of section 197(f)(9)(C). This provision states that a person is related to an>. person if the related person bears a relationship to such person specified in sections 367(b) or 707(b)( 1). or the related person and such person are eneaeed in trades or busmesses under c c common control within the meaning of section 31(f)(l)(A) and (B). If the reference to the three different IRC sections is not confusing enough. the provision further states that 120 percent 5 is substituted for 150 percent Z in applying sections 267(b) and 707(b)( 1). Section 267(b)(3 ‘j. in turn. provides that two corporations that are members of a controlled group as defined in section 267(f) are related. Section 267(f). in turn. refers to but modifies section 1563. Does this mean that the substitution of 20 percent for CO percent should be extended to section 267(f). and subsequently to section 1563? The usage of multiple attribution sections makes this provision \%-tually incomprehensible. Such a result is unnecessary and not good tax polic\s. Enacting just one set of stock attribution rules would greatly reduce this type of complexity.. The proposed single attribution IRC section would provide for one set of family. entity-to-owner. owner-to- entit). and option attribution rules. Developing one IRC section with one set of attribution rules uill not onlv simplify the IRC. it will provide more certainty for taxpayers and their advisors in the planrung and reporting of transactions. In addition. such a change will provide the IRS with a much more administrable set of rules. A single set of stock attribution rules may not result in the ideal set of relationships for each and even’ situation. The advantage. howe\,er. of a single set of attribution rules is a manageable system that both the government and taxpayers can comprehend. In addition. we believe that it would not compromise any substantial purpose of the rules in the process. This proposal does not introduce complex new concepts. but rather utillzes alread!, established attribution concepts. Likewise. this proposal does not address the definitions of control or related parties. The objective of this proposal is to accomplish simplification and standardization b!, providing a single set of understandable stock attribution rules.


APPENDIX C

February 19. 1998 (Abridged version)

Dear Chairmen Roth and Archer:

The American Institute of Certified Public Accountants is pleased to present for your consideration a legislative proposal regarding tax on self-employment income under Section 1402 of the Internal Revenue Code.

In light of the moratorium placed on the issuance of regulations by Section 935 of the TaxpaJw RelicfAct qf / 997. as well as the perennial difficulty the IRS has had in providing guidance to limited liability company members on self-employment taxation issues. and the immediat’e need by such taxpayers for a workable and realistic long-term solution. the AICPA’s Partnership Taxation Committee has developed the enclosed legislative proposal, which we believe to be fair with regard to all tvpes of relevant taxpayers. The AICPA believes that a timely legislative response to the proposed regulations under Section 1402(a)( 13). in addition to the moratorium. is the best \hray of handling this sensitive area of tax law and will provide much needed guidance to taxpayers more quickly and more equitably than could be accomplished by the Treasury Department subsequent to the expiration of the moratorium. The enclosed proposal was de\,eloped by a working group consisting of members of the following AICPA Committees: Partnership Taxation. S Corporation Taxation. Individual Taxation and Small Business Talxation and has been approved by our Tax Executive Committee.

Specifically,. our proposal would provide an elective means for individual partners and LLC members to receive a fair return on their invested capital before calculating their net earnings from self-employment. It would provide that the value of services that are subject to SE tax ma>,be calculated under a safe harbor test or under a facts and circumstances test if the computed amount falls outside of the safe harbor. Further. to provide for administrative simplicity. we belie1.e a de minrmzs exception is appropriate. Last November. our proposal met with a fa\,orable response when we discussed it with the professional staff members of your Committees. Their suggestions are incorporated in the attached proposal.

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS LEGISLATIVE PROPOSAL REGARDING TAX ON S,ELF-EMPLOYMENT INCOME

IN GENERAL

The AICPA recognizes the unique nature of limited liability companies (LLCs) and partnerships - relative to other forms of business organizations. To the extent that LLCs and partnerships elect or default to partnership status for Federal tax purposes. we believe that general and limited partners and LLC members (hereinafter “partners”) who are individual taxpayers should ble treated in the same manner with respect to determining the amount of their net earnings from

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self-employment under Subtitle A. Chapter 2 of the Internal Revenue Code. Ke also be1iev.e that. within certain limitations noted belon,. sole proprietors should be treated in the same manner.

SPECIFIC PROPOSAL

We propose that every partner be required. except as otherwise provided in $1402(a). to pa>’ self- employment tax under $1401 on the value of the services they perform for or on behalf of the partnership. The valuation of sewices performed would be based on the general standard of reasonableness which would be determined under either 1) facts and circumstances or 3) the safe harbor test described below. Partners who receive a reasonable $707(c) guaranteed payment for semices will not be subject to Q 1401 tax on their distributive share of partnership income under $702( a)( 8). i.e. thev will only be taxed on the guaranteed payment.

.Sgte Harbor Test - We propose that there be a safe harbor calculation for determining the reasonableness of the v*alue of services performed by partners. This test will provide partners with certaint?, regarding a fair return on their invested capital which should not be subject to self- employment taxation and an appropriate valuation of their services which is subject to self- employment taxation. If a partner’s reported self-employment income varies from the safe harbor amount b!, more rhan =I@,, the amount of self-emplo.yment income is subject to reasonableness testing on the basis of facts and circumstances as indicated above. The safe harbor amount is equal to the partner’s distributive share of partnership income or loss under 5702(a)(8) plus $707(c) guaranteed payments for services less a reasonable rate of return on the partner’s capital account at the beginning of the year (which cannot be less than zero), calculated on the same basis as the reponed taxable mcome of the partnership. The rate of return on the partner’s capital account (computed m the same manner as reported by the partnership on Schedule K-l of Form 1065) will be deemed to be reasonable if the rate used is 150% of the AFR at the end of the partnership’s tax year.

DC .ilrnrmls Esception - We propose that there be a de minimis exception provided for partners \t.ho perform sewices for the partnership for less than 100 hours during a twelve month partnership tax year (or for a proportionate number of hours in the case of a short tax year or where a partner joins the partnership dunng the year). This de minimis rule will provide for adm1nistrativ.e simplicity. We recommend that the rule be an affirmative election to enable partners u,ho would like to contribute to the OASDI and HI systems an opportunity to do so. Any mcome reported as a $707(c) guaranteed payment for services will not be available for the election out of the 6 1401 self-employment tax. even when at&-ibutable to services of less than 100 hours.

*Anti-abuse rules - We recognize that specific anti-abuse provisions will be required in at least the following areas:

Aggregation - Aggregation of partnership interests will be mandatory to prevent partners from using the de minimis exception to avoid paying self-employment taxes. Section 267(e)(3) would be made applicable for this purpose.

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Commonlv-Owned Partnerships - If two partnerships are more than 50% owned b>. the

same persons. than both partnerships will be aggregated for the purpose of these calculations.

Provision For Sole Proprietors - We believe that the same concepts should apply to sole proprietors. Because no requirement currently exists for proprietorships to maintain a capital account or to present a balance sheet for tax purposes. we propose that in order for a pro,prietor to use the safe harbor method outlined above. they must be required to report a balance sheet (similar to Schedule L on a partnership return) in addition to Schedule C.

If there are any questions regarding this proposal, please call Mike Koppel (Chair of the Section 1302 Working Group) at (612) 482-l 100. Michael E. Mares (Chair of the Tax Executive Committee) at (757) 873- 1587 or Marc Hyman (Technical Manager - AICPA) at (202) 4*34- 9231.

June 22. 2000 (Abridged version)

Dear Mr. Chairman [Roth]:

In the summer of 1999. the American Bar Association’s Section of Taxation sent to you a legislati\,e recommendation and analysis under section 1402(a)( 13) of the Internal Revenue Code. This recommendation deals with the application of the self-employment tax rules to limited liability company members and other tax partners and recommends that the income of these mdi\fiduals from these pannerships be bifurcated into basically two categories: that: which is attributable to capital and that which is attributable to services. Possible mechanics of such calculations are discussed in the repon. The AICPA had submitted a similar legislative recommendation to Congress in February of 1998 and would now like to express its support for the ABAs 1999 recommendation. The two reports are substantially similar in many ways and both ach1eL.e the same objective albeit through slightly different means. Both submissions are intended to help modernize the self-emplo-yment tax laws and a final reading of either such proposal has room for modification as to methodology.

Guidance is urgently needed on this issue because LLCs are extremely popular. current statutory construction Inadequately addresses today’s business climate. and varying interpretations of the statute yield significantly different tax results for similarly situated taxpayers. The idea of excluding pannership income attributed to capital is deeply ;ooted in our perception of what is fair and we believe these proposals would muumize administrative controversy. We wou.ld appreciate any efforts you could make m sponsoring legislation on this important matter.

PROPOSED SECTION 1402(A)(13) LEGISLATIVE LANGUAGE

Our suggested amendments of Section 1402(a)(13) are as follows (language to be added is underlined and language to be deleted is struck through):

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,

(a) tiet earnings from self-employment.-

The term “net earnings from self employment” means the gross income det-i\,ed by an individual from any trade or business carried on by such individual. less the deductions allowed by this subtitle which are attributable to such trade or business. plus his distributilre share (whether or not distributed) of income or loss described in section 702( a )( 8 ) from ant trade or business carried on by a partnership of which he is a member: except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss -

( 13)(,4) there shall be excluded the distributive share of net M income or of a I;m;tprl panner- attributable to capital. k

t-be-p* Few-m ,’

I B) Safe harbors - For purposes of subparagraph (A). the following amounts shall be treated as income attributable to capital:

(i) the amount. if an).. in excess of what would constitute reasonable compensation for sentices rendered bv such partner to the partnership. or

(ii) an amount equal to a reasonable rate of return on unreturned capital of the partner deterrnmed as of the betinnin,g of the taxable vear.

(C) Definitions. For purposes of subparagraph (B) --

(i) Enreturned Capital. The term ‘-unreturned capital” shall mean the excess of the aggre.eate amount of monev and the fair market value as of the date of contribution of other con deratton (.net of liabilities) contributed bv the partner over the aggregate amount of mot-r:\ and the fair market value as of the date of distribution of other consideration (net of lrabilmes) distributed bv the pannership to the partner. increased or decreased for the partner’s distributrve share of all reportable items as determined in section 702. If the panner acquires a partnershtp interest and the partnership makes an election under section ?%I. the partner’s unreturned capital shall take into account appropriate adjustments under sectron 733. ,

(ii) Reasonable rate of return. A reasonable rate of return on unreturned capital shall equal 150 percent (or such ht.gher rate as is established in regulations) of the highest applrcable federal rate. as deterrnmed under section 1274(d){ l), at the beginning of the partnership’s tax vear.

(D) The Secretary shall prescribe such regulations as maybe necessarv to carry out the purposes of this para.rzraph:

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I

APPENDIX D

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

TAX DIVISION

HOUSE WAYS AND MEANS COMMITTEE

SUBCOMMITTEE ON OVERSIGHT

PUBLIC HEARING ON

PE?;ALT1’ AND INTEREST REFORltl PROPOSALS

January 27,200O

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I

Mr. Chairman and members of this distinguished Subcommittee:

The American Institute of Certified Public Accountants (“AICPA”) offers you these comments on the penalt>* and interest provisions in the Internal Revenue Code (“Code”). The AICPA is the national. professional organization of certified public accountants comprised of more than 330.000 members. Our members advise clients on federal. state and international tax matters and prepare income and other tax returns for millions of Amencans. They, provide sen,ices to individuals. not-for-profit organizations. small and medium-size businesses. as Lye11 as Amenca’s major businesses. including multi-natronal corporations. Many. serve busmesses as employ,ees. it is from this broad base of experience that we offer our comments.

IKTRODUCTIOIV

The AlCP.4 worked with Members of Congress. the Internal Revenue Service. and other tax practitioners and business groups in 1989 in connection with the last major reform of the federal tax penalty, pro\‘tstons. The result of those efforts was the Improved Penaln, .itdministration and Compiiancc Tax .Act qf I989 (“IMPACT”). Since then. questions have been raised regarding the appropriate administration of the interest and penalty provisions. such as the use of penalties as a bargaining tool by, the IRS. Also srnce that time. a number of revisions to the interest and penah!, pro\.isions have been made or proposed. We believe there once again is a need to take a comprehensive look at the interest and penalty provisions and make needed reforms to ensure the pro\.isions are appropriately. and fanI\- applred and are designed to accomplish their purpose. U’e encourage you to do so.

\I’e offer you our assistance mrth such an undertaking. and. as an initial step. provide you with our comments on: the Joint Commtttee on Taxatron’s Stud\. ofPresent-Lalf, Penalty and Interest Pro\xsions as Required b?, Section 3801 of the Internal Revenue Service Restructuring and Rctorm .~CI ot 1998 (Including Provisions Relating to Corporate Tax Shelters) (JCS-3-991. July l1 --. 1999: the Department of the Treasury’s study,. entitled Penale. and lnterest Provlisions qfthc lnrcmal Rc\ CIII~(‘ Code. released October 25. 1999; and the penalty and interest reform pro\‘rstons In the Nattonal Taxpayer Ad\,ocate’s 1999 Annual Report to Congress. released January, 3. 2000.

Our comments regarding penalties arc based on our continued belief in the philosophy embraced b>, ljt1P.4CT. that the purpose of penalties is to encourage compliance. not to raise rcvvenuc. 1j.c urge Congress not to aitcr that phiiosoph?,. MC also urge Congress to adhere IO the phiiosoph?. that interest is not to bc rmposcd as a penal?,. but rather is solely compensation .ior the USE qf mane?..

Our comments arc based on considering the penal?, and interest regime in its entireg. Individual comments and suggestions should not be accepted or rejected in a piecemeal fashion since the appropriateness qf one pro\ulon qtien depends on the status of another.

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PENALA’ PROVISIONS

1. Accuracy-Related and Preparer Penalties

Note: The following discussion relates only to non-tax shelter items.

Standards for Taxpavers and Preparers

Both the JCT staff and Treasury propose modifications to the standards that ‘must be satisfied \vrth respect to a tax return position in order to avoid the accuracy-related penalt>, applicable to taxpayers under section 666, 7 for the substantial understatement of tax and the preparer penalty under section 6694(a) for understatement of a ta.xpayer’s liability, due to an unrealistic position. Under present law. to avoid the substantial understatement penalty. a taxpayer must have “substantial authority” for an undisclosed position and a “reasonable basis” for a disclosed position: for a tax return preparer to avotd the preparer penalty. an undisclosed position must have a “realistic possilbility of bemg sustamed on the ments” and a disclosed position must not be “frivolous,”

Both the JCT staff and Treasup recommend that the same standards apply to taxpayers and tax return preparers. We do not object to that recommendation. but request that in making such a change. Congress clarify in the statutory language that the imposition of a penalty agarnst a taxpayer and the imposition of a penalty against the taxpayer’s return preparer must be based on separate determinations. The imposition of a penalty against one is not evidence that the tmpositton of a penalty agamst the other is appropriate. For example. a taxpa:yer may pa>- a penalty for personal reasons. such as to avoid expending additional time and mloney to contest the Issue ev’en though the taxpayer might have been successful if the matter had been pursued: an automarrc imposition of a penalty against the return preparer in such a case clearI>, w,ould be Inappropriate. An independent review of the applicable authorities and of the facts. Including who had knowledge of specific facts. must be considered in determining n,hether the rmposttion of a penalty agamst a particular party is appropriate.

Standards for Disclosed Positions

Under current law. to avoid a substantial understatement penalty with respect to a drsclosed positton. a taxpayer must have a “reasonable basis” fo; a return position; for a tax return preparer to avoid a preparer penalty with respect to a disclosed position, the position must not have been “frivolous.” The JCT staff recommends raising the minimum standard for taxpayers and tax return preparers regarding disclosed positions such that, to avoid a penalty for a disclosed position. there must be at least “substantial authority.” Treasury recommends raising the minimum standards for taxpayers and tax return preparers regarding d:isclosed positions such that. to avoid a penalty for a disclosed position, there must be at least a “realistic possibility of being sustained on the merits.”

We have serious concerns about raising the standard for taxpayers and tax return preparers above the “reasonable basis” standard currently applicable to taxpayers. We are particularly troubled by the JCT staffs proposal to establish “substantial authority” as the minimum

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standard for diSclosed positions. Such a high standard may be unworkable. While taxpayers and tax return preparers may be able to ascerrain whether “substantial authorit!.” exists u.ith regard to some issues. that is not true m all cases. The Federal tax law is forever changing. and. as a result. there may be \G-tuall> no guidance issued at the time a return is filed. and. therefore. virtually no authority with respect to the proper tax treatment of an item. Further. even if there is some authotit!.. given the exceedingly complex nature of the rax law. ir ma>- nevertheless be extremely difficult for taxpayers and preparers to know the probable correctness of many return positions. It is not only unrealistic. in man!’ cases it is impossible. to ensure such a high degree of accurac?’ as is required by a “substantial, authorit!,” standard or even the “realistic possibility of being sustained on the merits” standard \iithout forcing taxpayers to avoid otherwise meritotious positions on the return.

While taxpayers may be able to ascertain whether “substantial author+,” or “realistic possibility of being sustained on the merits” exists with regard to some issues. that certain]!, is not trJe in all cases. This problem is compounded by the fact that the IRS has failed to adhere :o a provision added to the Internal Revenue Code in 1989 to assist taxpayers and preparers in determining whether “substanrial authority” is present for a position. IMPACT created section 6662(d)(Z)(D) of the Code. requiring the IRS to publish. not less frequentI\, than annuallit. a list of positions for which the IRS believes there is no “substantial authority” and uhlch affect a significant number of taxpayers. To date. the IRS has never issued an!! such list for any year. If the IRS 1s unable itself to determine which positions lack “substanrial authotit?,.” it 1s unreasonable to adopt this threshold as the minimum reporting standard for return positions by taxpayers and tax ret-urn preparers.

In irs 1989 civil tax penalty stud!,. the IRS acknowledged the practical limits on the probable correctness of returns. In the Commlssroner5 SW&~ qf Civil Penafries. 1989. at VI’II-1 1. the IRS noted:

\%%lle not In and of themsel\*es determinative of the correct standard of behavior. a \‘anet>’ of factors limit the abilltb, of taxpayers to report positions disclosing a llabilit>, that IS probably correct. Perhaps the most sipificant limitation is the amblguit>, inherent in applvlng a complex and changing set of tax rules to an InfinIte \.anet!’ of factual sltuatlons. which may themselves be of ambiguous Import. These complexities ma!’ result in failure to recognize issues. incorrect conclusions as to the probablllt> that a particular position will prevail. and differences of opinion regardmg probability that are not resolvable short of the courthouse. The complexity of modem financial affairs, when coupled with the legal requirement to file a return by a statutory deadline and the costs of making the best possible assessment of each individual issue may also provide practical limits on the pursuit of a theoretIcally perfect return.

For these reasons, we believe the standard for disclosed positions should be the “reasonable basis” standard currently applicable to taxpayers.

Standards for Undisclosed Positions

Under current law. to avoid the substantial understatement penalty with respect to an undisclosed position. a taxpayer must have “substantial authority;” for a tax return preparer to

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avoid a preparer penalty with respect to an undisclosed position. the position must ha\,e a “realistic possibility of being sustained on the merits.” The JCT staff recommends that. for an undisclosed position. the taxpayer and the tax return preparer must reasonably believe that the tax treatment is “more likely than not” the correct tax treatment under the Code. In contrast. Treasury does not propose raising the standard for undisclosed positions above the “substantial authority” standard that currently applies to taxpayers: it would appl!, that standard to both taxpayers and tax return preparers.

We agree with Treasury that the “substantial authority” standard is the more approptia.te threshold standard for undisclosed positions. rather than the higher “more likely than not” standard recommended by the JCT staff. Currently. the only authorities that can be relied upon to constitute “substantial authority” are those issued by the government itself or the judician,. PIcceptable authorities include: the Internal Revenue Code and other statuton. provisions. regulatlons. court decisions. and administrative pronouncements (e.g. revenue rulings. revenue procedures. proposed regulations. private letter rulings. technical advice memoranda. actlons on decisions. information releases. notices. and other similar documents published b>’ Treasury or the IRS). In addition. the list of authorities includes General Explanations of tax legislation prepared by the Joint Committee on Taxation (the “Blue Book”). Conclusions m treatises. legal petiodicals. legal opinions or opinions of other tax professionals do not qualify under present IRS rules.

Taxpayers and preparers who take positions relying on the government’s own rules and pronouncements should be able to feel comfortable that their positions are sufficiently accurate so as to free them from the possibility of penalties. A “more likely than not” standard for undisclosed positions would mean disclo&e would be required even though the “substantial authont!,” threshold is satisfied with respect to a position. Having taxpayers disclose items on their returns which compon with the government’s own list of authorities \\,ould unnecessaril!, increase compliance costs for taxpayers and burden for the IRS. Further. such an approach would literally inundate the IRS with countless inconsequential disclosures. u,eakenmg the overall effectiveness of the disclosure regime. Thus. we believe the standard for undisclosed positions should be “substantial authority.”

Reasonable Cause ExceptIon

The JCT staff recommends repeal of the reasonable ,cause exception to the substantial understatement penalty. We disagree. believing that the exception is necessary to provide flexibility needed to watve the penalty m appropriate situations.

.4mount of Preparer Penaltv

The JCT staff recommends increasmg the amount of tax return preparer penalties. For first- tier violations. i.e.. preparation of a return with a position that does not meet the minimum preparer standards. the JCT staff recommends changing the preparer penalty from a flat $250 per occurrence to the greater of S250 or 50% of the tax preparer’s fee. For second-tier violations. i.e.. understatements that result from willful or reckless disregard of the rules or regulations. the JCT staff recommends increasing the amount from a flat $1 .OlOO per occurrence to the greater of S 1 .OOO or 100% of the preparer’s fee.

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,

Treasuy, also recommends increasing the tax return preparer penalties. Treasury

recommends that consideration be given to a,fee-based or other approach that more closets correlates the preparer penalo, to the amount of the under&ing understatement of tax rather than the, flat dollar penal& amount under current 1aM..

l4.c support retaining the tu,o-tier Jar dollar penalt?, under current law. IJc base our recommendation on the lack of empirical evidence indicating that the flat doliav amount is not effective. in our opinion, deterrence, for preparers results not -from a dollar pena/?.. but rather-from the possible adverse impact on the preparer’s abili?. to practice and on hi.s/hcr reputation.for integrin. and ethical behavior.

2. Failure to Fiie Penal0

Rate

The current law contains a failure to tile penalty of 5% of the net tax due. for each month (or portion thereof) the return remains unfiled. up to a maximum of 25%. The JCT staff proposes no change to the current prov*ision. Treasury recommends that the penalty be restructured to elimmate front-loading; tt proposes doing this by lowering the penalty rate in the mittal months and providing for the increase in the rate. up to the 25% maximum. over a longer period of time. The example Treasury presented was charging a rate of 0.5% per month for the first 6 months and 1 ?,o per month thereafter. up to the 25% maximum. Treasury recommends retaining the current rule for fraudulent failure to file.

We agree with Treasuq’s reasoning that the front-loading of the failure to file penalty in the first five months of a filing delinquency does not provide a continuing incentive to correct filmg fatlures and Imposes addittonal financial burdens on taxpayers whose filing lapse may be coupled vvtth payment difficulties. thus, possibly impeding prompt compliance. We also apee w.lth Treasury that the current structure seems especially harsh given the fact. by mereI> requestmg one. a taxpayer IS entitled to an automatic extension for most or all of those fiv’e months. (An individual taxpayer is entitled to an automatic four-month extension; a corporate taxpayer is entitled to an automatic six-month extension.)

Gtven the significance to the tax system of taxpayers fulfilling their filing obligations. the failure to file penalty should be structured to provide a strong incentive for timely complrance. and a continuing incentiv.e to promptly correct any failure to file.

Sen,tce Charge

Under current law. since the late filing penalty is a percentage of the net tax due, no penalty applies with respect to a late-filed return if the return reflects a refund due or no tax due. Treasury recommends imposing a new de minimis service charge for late returns that have a refund or no tax due. at least in situattons where the IRS has already contacted the taxpayer regarding the failure to file the return.

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We do not support this recommendation. We view such an approach as un-iustified. Such an approach is particularly inequitable in situations where the taxpayer has a refund due. since the IRS has had interest-free use of the taxpayer’s money.

Safe Harbor

Treasuns recommends adoption of a provision that would permit the IRS to take into1 account a taxpayer’s compliance history in determining if there is reasonable cause for abatement of the failure to file penah),. Treasury does not support providing automatic relief from the failure to file penalty based on safe harbor rules. however.

Although M’e agree tiith Treasun* that a taxpayer’s compliance histo)?. should be considered in determining the appropriateness qf a penalc., MV recommend a more c.rpansil*c simpi$cation qf the penaltv abatement provisions. To reduce the burden on both ta-\-pal*cr.s and the Service resulting from the imposition of man? inappropriate penaltics. \rT recommend that safe harbor &-ovisions be established for a variee qfpenalties (particular-(\, those that are mechanical in nature. such as the failure to file. -failure to pa>‘ and&lure to deposit penalties) that M,ould be deemed to represent reasonable cause. The object qf these sqfc harbors Mvould be to minimizc the assessment and subsequent abatement sf man?. penalties. Sqfe harbor pro\kons could take the.form SC

l Xo penaltv assessment for an inrtial occurrence,. hoti’ever. the taxpqver should receive a notice that a subsequent error H.ould result in a penal?.:

l .Iutomatic non-assertion q/ a penal?. based upon a record qf a certain number qf periods qf compliance; and or

l 1 blunta?, attendance at an educational seminar on the issue in question. as the basis .for non-assertion or abatement.

Such sqfe harbors rr,ould encourage and create vested interests in compliance. since a histog* qf compliance B.ould result in relic/ .4dditiona&.. the likelihood qcfuture abatements nvouid diminish $ the taxpa.ver has a histoT* qf non-compliance. Furthermore, a system qf automatic abatement would reduce the time spent bj. both the Service and taxpa-vers on proposing an assessment. initlatrnp and responding to correspondence. and on the subsequent abatement. The abilrc, to abate a penaiD*-for-p reasonable cause other than those used for automatic abatements H.ould continue; however, reasonable cause abatements requiring independent evaluation should be reduced.

3. Failure to Pay Penalty

Retention or Repeal

Current law contains a failure to pay penalty equal to 0.5% per month (or fraction thereof), up to a maximum of 25%. This penalty was created in 1969 to respond to the belief that the then-applicable interest rate (a flat 6%) on underpayments was not sufficient to encourage timely payment of tax and to discourage the use of the government as a low-cost lender.

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The JCT staff recommends repealing the penalty for failure to pay taxes. noting the repeal would be consistent with a policy initiative begun by RlU’98. in which the rate of the penalty for failure to pay was reduced. The National Taxpayer Advocate also recommends a repeal of the penalty. Treasury acknowledges that the initial intent of the penalty was to address the fact that the interest rate on under-payments did not take into account the then market rate: nevertheless. it recommends retaining the failure to pay penalt!.. but with a restructured rate. as noted below.

We believfe that. since the rate of interest on under-payments is now tied to the market rate of interest. this penalty. as a substitute for interest. should be repealed. If the penalty is not repealed. we recommend adoption of the mitigation and waiver provisions noted below.

Expansion of Mitigation of Penaltv for Months During Period of lnstallment Agreement

Under current law. the failure to pay penalty for individuals with respect to a timely filed return is reduced from .5% to 2590 for anv month in which an instaliment agreement is in effect. This mitigation provision does not apply to halve the penalty in any case in which a final notice has been issued (at which time the penalty increases to 1% per month).

The National Taxpayer Advocate recommends that this mitigation provision be expanded to include reducing the penalty rate from 1 O/b to 5% in situations (1) when a final notice is issued tn error or as the result of an administrative practice and (2) when a final notice has been Issued. for any month tn which an mstallment agreement is in effect. We agree with the recommendatton.

U’ai\.er of Penaltv When an Installment Agreement is in Effect

The Satlonal Taxpayer Advocate also recommends that the failure to pay penalty be waived for an! month In ivhich an approved installment agreement is in effect. even if the 1% per month penalty, rate otherwise applies. Under the recommendation. however. the failure to pay penah), would be reinstated for the entire period if the taxpayer defaulted pior to completmg the agreement. We agree with that recommendation.

Rate

Treasury, recommends restructuring the calculation of thi failure to pay penalty. The penalty would equal 0.5% per month for the first 6 months and 1% per month thereafter, up to the maximum of 25%. The penalty, would be reduced to 0.25% per month during the first 6 months and 0.590 per month thereatier if the taxpayer makes and adheres to a payment aFeement. As under current law. a higher rate would apply once the IRS takes action to enforce collection.

As noted above. we recommend repealing the failure to pay penalty rather than revising the rate.

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Service Charge

The JCT staff recommends imposing an annual 50/o late payment service charge on taxpayers that do not enter into an installment agreement within 4 months after assessment. The service charge would be imposed on the balance remaining unpaid at the end of the 4-month period.

We do not suppon establishment of a service charge for failure to enter into an mstallment agreement. We believe that such a service charge will penalize taxpayers who alt8ead>, are struggling to pay their tax obligations.

Related Installment Ameement Issues

Waiver of Fee. The JCT staff recommends waiving the installment agTeemenPi fee for taxpayers that agree to the automated withdrawal of each installment payment.

We support the JCT staffs recommendation. We believe that waiving the fee for taxpayers that enter into agreements to pa>’ tax Lfia an automated system of withdrawal will provide an incentltre to enter into these agreements and better ensure payment of taxes. We have heard that some states that offer automated withdrawal payment plans have shown high rates of adherence to installment agreements. We believe that adoption of this provision will similarI!, facilitate a higher rate of adherence to installment agreements for the Federal go\‘emment.

lnstallment Ameement interest Rate. Treasury recommends providing the IRS with the authority to use a fixed rather that a floating interest rate on installment agreements in order to facilitate adherence to such agreements and to avoid possible balloon payments.

Ij’c support Tt-easut? ‘s recommendation to simpliji* the installment interest rate calculation.

4. Estimated Tax Penal?

Status as Penaltv or Interest

The JCT staff recommends repealing the individual and corporate estimated tax penalties and replacing them with interest charges. The National TaFpayer Advocate also recommends eliminating the penalty and allowmg Interest to be automatically asserted, or as an alternative. he calls for simplification of the estimated tax penalty computations. Treasury recommends retaining the individual and corporate estimated tax penalties as penalties.

U’e support the recommendation of the JCT staRand the National Tnxpa-ver Advocate for* converting the estimated tax penalties for individuals and corporations into interest provisions. The conversion of the estimated tax penalties into interest charges would result in a more accurate characterisation since the penalties are essentiallv fees for the use of monel‘.

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Deductibilih, ofhteresr

The JCT staff recommends that interest on under-pa-yments of estimated tax b!. indileidual taxpayers be nondeductible personal interest. whereas interest paid on under-pa-ments of estimated tax by corporate taxpayers be deductible. We recommend that deficient!. interest be deductible bv individual taxpayers to the extent the deficient!, to which the interest relates is attributable to the taxpayer’s trade or business or invrestment activ.ities.

S 1 .OOO Threshold for Individuals

The JCT staff recommends increasing to S2.000 the threshold below which individuals are not subject to the estimated tax penalty. Currently the threshold amount is Sl .OOO afier reduction for withheld taxes. The JCT staff also recommends that the calculation of the threshold be modified to take into account certain estimated tax payments. i.e.. estimated taxes paid in four equal installments on or before their due date. Accordingly. for qualifying indivridual taxpayers. no interest on underdeposits of estimated tax would be imposed if the tax shown on the tax return. reduced by withholding and certain estimated tax payments. is less than $2.000.

Treasu? recommends retaining the current 51,000 threshold. but allowing estimated tax payments to be considered under a proposed simplified averaging method in determining whether the threshold is satisfied.

U.e support increasing to S3.000 the threshold below which individuals are not subject to the estrmated tax penalty. We also support allowing estimated tax pa,yments to be considered under a simplified averaging method in determining if the threshold is satisfied. Both recommendations should simplify the computations required to calculate estimated tax payments and the interest (JCT) or penalty (Treasury) on underpayments.

Safe Harbnrs

The JCT staff recommends repealing the modified safe harbor that is applicable to individual taxpayers u,hose adjusted gross income for the preceding taxable year exceeded $150.000. Under the JCT staffs proposal. all taxpayers making estimated payments based on the prior year’s tax would do so based on 1000/o of the prior year’s tax.

We support this JCT staff recommendation for simplifi&ion of the safe harbor provisions.

Rate

The JCT staff recommends applying only one interest rate per underpayment period - the rate applicable on the first day of the quaner in which the payment is due. Currently, if interest rates change while an underpayment IS outstanding, separate calculations are required for the periods before and after the interest rate change. Having only one interest rate apply per underpayment period would end the potential for multiple interest calculations occurring within one estimated tax underpayment period.

We support this JCT staff recommendation for simplification of the computations.

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Einderpavment Balances

The JCT staff recommends changing the definition qf “underpa?*ment ” to alloH, existing underpayment balances to be used in underpayment calculations -for succeeding estimated pa?*ment periods. i.e.. making underpa!menr balances cumulative.’ C’nder the proposal. ta\-pqvers M*ould no longer be required to track each outstanding underpaj*menr balance until the earlier sf the date paid or the.foliowing April Ijth. We support this JCT staff recommendation for simplification of the computations.

Leap l’ear lssue

The JCT staff recommends establishment of a 365day year for estimated tax penah!. calculation purposes. Current IRS procedures require separate calculations when out.standin_r underpaJVment balances extend from a leap year through a non-leap year.

W.e support this JCT staff recommendation for simplification of the computations.

First-Time Offender

Trcasttr?. recommends providing a reasonable cause H.aiver of the estimated tax penal03 for lndi\iduals that arc $rst-time pqr.ers sf estimated tax. The proposed M*aiver M.*ouid be arfailabic onI!. if the balance due is belou, a certain amount and is paid M*ith a timelv-filed return. Current 1aM. does not provide a general reasonable cause rzsaiver for-failure to pa!* rstlmatcd tat- for lndrviduals.

Although we do not support Treasury’s position on retaining the estimated tax penalty, if the penalt), IS continued. we do support the recommendation for a reasonable cause waiver of the penalty for Individuals that are first-time offenders.

Penaltv k!‘alver

Treasun, recommends waiving the estimated tax penalty if the penalty is below a certain de minimIs amount - e.g.. S IO to 520. There is no current statutory authority permitting, the IRS to Ls’al\‘e estimated tax penalties below a dc mrnimis amount:

.Ilrhough we do not support Treasu?, ‘s position on reta&ing the estimated tax penal’&, if the penale, is continued, we support the recommendationfor establishing a de minimis’ waiver, but recommend a higher de minlmls amount.

Safe Harbor for Corporations

We recommend increasing the taxable income cut off point from $1 million to $10 million for defining a “large corporation*’ for purposes of the Section 6655(d)( l)(B)(ii) safe harbor.

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3. Failure to Deposit Pena@

Recentlv Enacted Provisions

Both the JCT staff and Treasury recommend that no major changes be made to the failure to deposit penalty provisions. to allow time for recent changes in these rules to be implemented and evaluated.

We support the recommendations that no major changes be made to the new rules until the provisions have been in effect long enough to be evaluated. but we encourage the introduction of any minor changes that add to the simplification of the failure to deposit penalty.

Deposit Schedule

The JCT staff recommends that Treasury consider revisions to the deposit regulations. particularI!, the change in deposit schedule. to change in a later calendar quarter.

We support the JCT staffs recommendation as a simplification of the failure to deposit provisions.

Penah\- for Wr0n.e Method of Deposit

Treasury recommends that it be provided with the authority to reduce the penalty for use of the wrong deposit method From 10% to - ‘o/b. Currently. taxpayers who use the wrong deposit method may be subject to the penalty rate of 109; and. thus. may be treated as harshly as if the>- did not make the deposit at all.

W’e support Treasuy’s recommendation: the lower rate would not be unduly harsh and would accomplish the same objecuve of encouraging payment by the proper method.

Svstemic Problems of Pavroll S-ices

The JCT staff and Treasury recommend that the IRS work with payroll services to resolve systemic errors. rather that deal with individual employers on a case by case basis.

We support the JCT staff and Treasq,‘s recommendations. Such an approach could greatly simpli& the resolution of such problems.

6. Pension Benefit Penalties

The JCT staff recommends consolidating the IRS and ERISA penalties for failure to file timely and complete Form 5500. and reducing from three to one the number of governmental agencies authorized to assess, waive. and reduce penalties for failure to file Form 5500. The JCT staff recommends designating the IRS as the agency responsible for enforcement of

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reporting. The JCT staff also recommends repealing the separate penalties for failure to file Schedules SSA and B and for failure to provide notification of changes in plan status. The JCT staff recommends treating these situations as a failure to file a complete Form 5500.

Treasury recommends consolidating the penalty for failure to file Form 5500 into a single penalty that will not exceed a specified dollar amount per day or a monetm cap per return. Treasun, proposes that the single penalty would be waived upon a showing of reasonable cause. Welfare and fringe benefit plans would be subject to a similar single penalt!. under Treasury’s proposal. Treasury recommends designating the Department of Labor as the agency responsible for enforcement of reponing. The Department of Labor’s DFC‘C voluntary compliance program would continue to provide relief from late filing or failure to file penalties for Form 5500 under the proposed single penalty.

Although w’e do not have comments on the specific recommendations. we do encourage proposals such as these that promote simplification.

7. Liniformip of Administration

Statistical Information

The JCT staff and Treasury, recommend that the IRS improve its method of providing stattstical information on abatements and the reasons and criteria for abatements. We support this recommendation.

Supen4sons Review

The JCT staff and Treasury recommend improving the supervisory review of the imposition and abatement of penaltres. We support this recommendation on the theory that such improved review would promote equitable treatment of taxpayers.

Abatement

The JCT staff recommends consideration by the IRS of establishing a penalty oversight commtttee similar to the Transfer Pncmg Penalty Oversight Committee.

We support the JCT staffs recommendation as a mean: to promote equitable treatment of taxpayers. Previously. the AlCPA has recommended the creation of a database regarding the imposition and abatement of penaltres and the establishment of a coordinator of penalty admn-nstration to promote conststent applrcation.

INTEREST PRO1’ISIONS

Detennining the amount of interest owed to or by taxpayers in connection with their Federal tax liabilities is governed by a rather complicated set of interest and procedural provisions in the internal Revenue Code. We believe simplification of the interest regime is in order and commend the JCT staff for proposing the establishment of a single interest rate applicable to both underpayments and overpayments of all taxpayers and the abatement of interest in various

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instances. We agree that these proposals will greatly simplify; interest computations and are disappointed that Treasuv essentially recommends maintaining the current interest regtme. including interest rate differentials for corporate taxpayers. We think the recommendanons made by the JCT staff. coupled with our proposed modifications. will result in a fairer. simpler. more administrable interest regime. We also believe that the JCT staffs interest simplification recommendations. with our modifications. should be adopted in their entirety because the benefits of each component necessarily depends upon the enactment of the others.

Like both the JCT staff and Treasury. we believe the Internal Revenue Code’s interest provisions should provide for compensation to the government for the time that the taxpayer has use of the govemment’s. tax dollars and to the taxpayer for the time the government has use of the taxpayer’s mane?‘. Interest is fundamentally a charge or compensation for the use or forbearance of another’s mane!’ - it is not a penah),. The interest provisions should not be used to financial]\. punish taxpayers.

1. Interest Rate

The JCT staff recommends providing one interest rate for overpayments and underpayments for both rndi\,iduals and corporations. equal to the short-term applicable federal rate (“AFR”) plus 5 percentage potnts. Treasun, recommends a uniform interest rate in the range of AFR plus 7 to 5 percentage points except in the case of large corporate over-pa-yments or underpayments. for whrch Treasury recommends retaining the current rate differential. includmg “hot interest.”

W’e strongI>, be1reL.e that adopting a single rate for underpayments and overpayments of all taxpayers w?ll substanrtall~ reduce the administrative difficulties and financial inequities assocrated w,tth the numerous differentials contained in the current regime. We. therefore, support the JCT staffs stngle rate recommendation.

Establrshrng one rate for every taxpayer necessarily entails blending the various market rates applrcable to all taxpayers: howe\,er. we are concerned that the JCT staffs proposal may establrsh an excessrL,el>, high interest rate. At current market rates. raising the overpayment and underpayment rates to AFR-5 percentage points would result in a 10 percent rate; that would be the highest rate of interest for ordinary underpayments in more than a decade. Indi\.ldual taxpayers would see then underpayment rate jump from 8% to 1096 and the mlnrmum rate that would apply, to corporate taxpayers would be equal to the current “hot interest” rate. We concur with Treasury that the appropriate rate should be in the range of the AFR plus 2 to 5 percentage pomts and should reflect typical market rates.

1 Interest Abatement a.

.4dditronal Causes for Abatement

The JCT staff recommends that the IRS be granted the authority to abate interest: (1) where necessary to avoid FOSS injustice; (2) for periods attributable to any unreasonable IRS error or delay. whether or not related to managerial or ministerial acts; (3) in situations where the taxpayer is repaying an excessive refund based on IRS calculations, without regard to the size of the refund: and. (4) to the extent the interest is attributable to taxpayer reliance on a

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written statement of the IRS. Treasury agrees to abatement of interest when the taxpayer has reasonably relied on erroneous written advice from the IRS. but does not recommend further legislative expansion of abatement of interest. arguing that current law provides sufficient relief. The National Taxpayer Advocate recommends abatement when the taxpayer is experiencing significant hardship.

We support the recommendations of the JCT staff and the National Taxpayer Advocate and strongly encourage their adoption. Further. because the IRS has been reluctant in the past to grant relief in this area. we request that the terms “gross injustice.” “unreasonable” and “significant hardship” be adequately defined to provide the IRS with clear stand,ards for implementation.

.4pplicatiorl of Abatement Attributable to Errors and Delal*s to Nondeficiencl- Federa,’ Taws

The current law provision allowing abatement based on errors or delays by the IRS is, limited to interest on income. estate, gift, generation skipping, and certain excise taxes. The National Taxpayer Advocate recommends that the abatement provision be expanded to apply to interest on employment taxes. the remainder of excise taxes. and certain other taxies. We agree with that recommendation.

3. Suspension of lnterest Where IRS Fails to Contact Taxpayer

heither Treasury nor the JCT staff make any recommendations with regard to the interest suspension provision. enacted as part of the Internal Revenue Service Restructuring and Reform .4ct gf/998. that suspends the accrual of deficiency interest for individual taxpayers In all cases where the IRS fails to noti@ the taxpayer within 18 months (1 year beginning in 2003). specificallv stating the taxpaver’s liabilitv and the basis for that liability. Under use of money pnncrples. interest is charged solely as compensation for the use of another’s money. While there ma>’ be some situations in which use of money principles should give way to more compellmg objecttves. such as in the abatement context, we believe such an automatic suspension provision is an unnecessav feature for a single-rate interest regime with broad interest abatement authorities. An expanded interest abatement provision should provide adequate relief for those taxpayers subjected to excessive interest charges. We, therefore. recommend that this provision be repealed and that any resulting savings to the government be applied to lowering the proposed single-rate amount.

4. Interest IVetting ,

Treasury argues that. given the recent enactment of global interest netting, it is premature to adjust interest rates to eliminate all interest differentials. On the other hand, the JCT staff notes that establishing a single rate of interest will simplify tax administration and “limit” the need for interest netting on a going-forward basis. We believe that restoring interest rate harmony will mitigate (but not eliminate) the need for interest netting in most cases, hecause the rate at which interest is paid by a taxpayer to the IRS with respect to any underpayment of tax will be the same rate paid by the IRS to a taxpayer who overpays a tax liability. Unfortunately. the Internal Revenue Code contains several special rules providing for interest-free periods whereby taxpayers and the government are given grace periods to take certain actions without accruing additional interest charges. For example, the government is

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given 45 days to process refund claims and taxpayers are afforded 21 calendar days to pa! demand notices (10 business days if the amount exceeds $100.000). Thus. even with the single-rate interest regime advocated by JCT staff. there would continue to be some situations where taxpayers could be charged interest on periods of underpayment that run concurrently with a non-interest bearing overpayment period for the taxpayer.

We support JCT’s proposed single rate regime but believe that interest netting still would be appropriate in some circumstances. to ensure that taxpayers are not charged interest on amounts where no true liability actually exists. Extending interest netting to interest-free periods would be consistent with use of money principles and would not harm the government since during these periods of time. neither the taxpayer nor the government are actually indebted to one another. In our judgment. taxpayers do not object to interest-free periods: they recognize the imponance of administrative convenience. to allow, the gov’emment sufficient time to process claims for refund. Taxpayers. however. do resent the imposition of interest on equivalent outstanding amounts under the pretext that a true liabilit!, exists where none does. Absent netting. the problem will become more acute if the interest rates are equalized at a higher level. as the JCT staff is proposing.

The JCT report states that limiting the availability of netting to situations in which the taxpayer both owes and is owed interest for the same period preserves the inte_grity of the rule requiring the suspension of interest where the IRS fails to contact an individual taxpayer. The JCT staff seems to be saying that taxpayers should be required to pay interest during some periods of mutual indebtedness when they clearly are not indebted to their government in order to preserve the concept of suspending interest for taxpayers who have admittedly underpaid their taxes. Logic dictates that taxpayers who owe tax should pay interest and those who owe no tax should not pa>* interest.

In summa?.. we belieL,e that a new single-rate interest regime should contain an interest netting component whereby taxpayers can identify periods of mutual indebtedness involving interest-free penods and request the IRS to have their interest charges recalculated in accordance with procedures similar to those set forth in Rev. Proc. 99-19.

5. Interest and Look-Back Rules

The JCT staff recommends that the single interest rate also apply to the Code sections that reference the underpayment or overpayment rate under present law. The Treasury report does not address this issue. There are several provisions’that allow taxpayers to re-determine their tax liability based on facts determined after the filing date of the return without requiiing an amended return to be filed-the so-called “look-back” provisions. As we indicated above. we believe that a smgle interest rate should be applicable to the underpayments and overpayments of all taxpayers, but question the amount of the rate increase proposed by JCT. We are concerned that, in the context of these sections, under JCT staffs proposed rate structure. most taxpayers would face a significant increase in the amount of interest.

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..-.& .‘jZ

6. Exclusion of Individual Overpayment Interest from Income/Denial of Deduction.

In an attempt to equalize rates on an afier-tax basis for individual taxpayers and corporations. the JCT staff recommends that overpayment interest paid by the IRS to individuals be excludable from income. While acknowledging that the same rate and same tax treatment with regard to deficiency interest would provide equivalent effective interest rates for individual and corporate taxpayers. Treasury does not propose an exclusion for interest and believes a deduction for deficiency interest for individuals is not warranted.

While JCT’s recommendation is one way to provide equivalent effective interest rates on underpayments and overpayments for individuals. the proposal is incomplete because it fails to clarifjv the deductibility of deficiency interest attributable to trade or business or investment acti\‘ities of a non-corporate taxpayer. Section 163(h)(2) provides that. in the case of a taxpayer other than a corporation. no deduction shall be allowed for personal Interest paid or accrued during the taxable year. The term “personal interest” does not include interest paid or accrued on indebtedness properly allocable to a trade or business. Temporan, regulations section 1.16- 7-9T(b)(2)(i)(A) provides. however. that interest relating to taxes is personal interest regardless of the source of the income generating the tax liability. This interpretation of the statute has generated considerable litigation and two ‘different standards for the deductibility of interest on deficiencies incurred in a trade or business-a corporation filing a F0m-1 1 120 is clearly entitled to deduct deficiency interest while an indi\,idual operating an unincorporated trade or business reporting income on a Form 1040 return is denied the interest deduction. We believe section 163(h) should be modified to alloH e\‘en’ taxpayer a deduction for interest attributable to a deficiency attributable to trade or business actlvltles. regardless of the form in which the businesses is operated, or to investment actl\*ities.

7. Dispute Resen,e Accounts

The JCT staff recommends that taxpayers be allowed to deposit amounts in a “dispute reseT7.e account.” a special interest-beanng account within the U.S. Treasury. These accounts are intended to help taxpayers better manage their exposure to underpayment Interest wlthout requiring them to surrender access to-their funds or requiring them to make a potentialI>, indefinite-term investment in a non-interest bearing account. The Treasury report does not contain similar relief.

\Ve have some concerns about hou the dispute reserve account system will operate. For example, will the IRS be pernutted to use the offset provisions against amounts deposited into these accounts? Nevertheless. we believe the JCT staffs recommendation blends the good features of several current-law approaches to avoid deficiency interest charges and ments serious consideration.

8. Interest-Free Periods

Treasup recommends that. when administratively feasible. the 45day rule restricting overpayment interest on reknds should be applied, in the case of early-filed returns, to the

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date the return was received. rather than the last day prescribed for filing the return. The JCT report does not recommend any changes with regard to these so-called rules of convpenience.

Under the Code. taxpayers are given a 2 1 -day interest-free grace period to pay tax liabilities (I 0 business days if the underpa-yment is in excess of 5 100.000) while the government is given 45days to make tax refunds. In addition. overpayment interest accrues on an overpayment from the later of the due date of the return or the date the payment is made. until a date not more than 30 days before the date of the refund check.

Nuances associated with these special rules contribute to the complexity of interest computations. We believe that in the context of comprehensive interest reform. consideration should be given to reviewing and adjusting the application of these rules. The lengths of the grace periods were established years ago and may no longer reflect the actual length of time it takes to complete the assigned task (e.g.. transmit data. issue refund checks. remit payment). On the surface. it seems patently unfair to give the IRS 45 days from the due date of a return to process a refund check while allowing some taxpayers only IO business days to respond to an IRS bill. We beheve that these rules should be updated. with a view toward simplification.

9. Application of Compound Interest Only to the Underlying Tax

The Xational Taxpayer .4dvocate recommends that compound interest apply only to the tax liabilit!, and that simple interest apply to penalties and/or additions to tax.

We disagree with that recommendation. lnterest computations already are extremely complex: thus proposal u,ould add to that complexity. Further. such an approach would be lnconststent nrlth the use of money principles on which interest is based.

10. Limitation on the Total Amount of Interest that Can Accumulate

The Nattonal Taxpayer Advocate recommends that the total amount of interest that can accumulate on a liability should be limited to 200% of the underlying tax liability.

We dtsagree with that recommendanon as being inconsistent with the use of money principles on which interest IS based.

STANDARDS APPLICABLE TO IRS

1. Standards

The JCT staff recommends that standards similar to those that apply to tax practitioners should be imposed on IRS employees.

We support the JCT staffs recommendation. but urge that sanctions be specified to encourage enforcement. As a matter of fairness and consistency, we recommend that, under

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current law. the IRS require revenue agents to have concluded that there is at least a “realistic possibility of success” before proposing an adjustment against a taxpayer. (If. as is proposed. the standards for tax return preparers are raised. the standard for IRS revenue agents should be raised similarly.) One method of ensuring that a position contained in a Revenue Agent Report has satisfied the standard could be to require that each Report be signed. evidencing supervisory approval. by an individual at the group manager or higher level. attesting to the fact that the proposed adjustments set forth therein meet the applicable standard. Implementing a policy such as this would be consistent with tax administration principles for the IRS set forth in ReL*. Proc. 64-,,. 7’ 1964-l C.B. 689. Rev. Proc. 64-22 requires that the Service apply and administer the law in a reasonable and practical manner. and that issues only be raised by examining officers when they have merit. and never arbitrarily, or for trading purposes.

2. Awards of Costs and Fees

Section 7430 of the Code currently requires the IRS to pay the reasonable administrative and litigation expenses of a taxpayer in certain circumstances if the IRS does not show that its position was “substantiallv iustified.” Such awards are not available. however. to taxpayers hav%-ig a net worth above i-certain dollar amount.

We recommend that recovery of such expenses under section 7430 be available to all taxpayers. regardless of their net worth. The IRS should be held accountable to all taxpayers and responsible for reimbursing a taxpayer for expenses it unduly causes the taxpayer to incur.

3. hlonitoring and Reporting

The JCT staff recommends that the IRS be required to publish annually. information regarding payments made under section 7330 for taxpayers’ administrative and litigation expenses and the administrative issues that resulted in the making of those payments.

Treasury recommends that. on an ongoing basis. the IRS undertake review of cases involving awards of attorney’s fees and cases where penalties have not been judicially sustained, in order to enhance quality review of the administrative process.

We support the JCT staffs recommendation. ,

CO.~ML’NiCATlO,IvS BETWEEdy IRS .4.VD TAXPAYERS

1. Communications with Individuals

The JCT staff recommends that the IRS place a higher priority on improving the processes by which the names and addresses of individual taxpayers are updated in the IRS’s records.

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Yreasunr recommends that on an ongoing basis the IRS improve the quality of its notices and communications to taxpayers regarding the basis for penalty and interest assessments and the abatement procedures. Treasury also recommends that the IRS institute procedures to reduce the burdensome nature of the current abatement process.

We support these recommendations.

2. Method of Communicating

The JCT staff recommends consideration by the IRS of the use of e-mail and fax instead of regular mail for communicating with taxpayers. The JCT staff also recommends that the IRS consider proposing legislation to provide for use of an alternative deliven, system where current la\%, requires use of regular mail.

U’e support the JCT staffs recommendations.

CONCLUSlON

‘4s stated earlier. we believe there is a need for a comprehensive review of the penalty and interest provisions in the Code and reforms to those provisions to ensure they are appropriately and fairly applied and are designed to accomplish their purpose. We welcome the opportunity to u,ork with you now and in the future on such an undertaking.

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February 7,2002 Mr. Mark Weinberger Washington, DC 20220 · February 7,2002 Mr. Mark Weinberger...

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