Senate Report 94-938 Vol II

8/6/2019 Senate Report 94-938 Vol II

1/921976-3 Vol. 3 C.B. 643 1976

94TH CONGR,ESS }led Session SENATE { R E P T . M -938P a r t 2

(Numerals at top of page indicate official report page numbers.)

T AX R EF OR M ACT O F 1976

S U P P L E M E N T A L R E P O R TOF T H E

COMMITTEE ON F I N A N C EU N I T E D STATES SENATE

ON

A D DI T IO N AL C O MM IT TE E AMENDMENTTO

H.R. 10612

J U L Y 20. 1976

U.S. GOVERNMENT P R IN T IN G O F FI C EW A S H I N G T O N : 1976

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LONG, Louisiana, OhairmanCA RL T . CURTIS, NebraskaPAUL J. FANNIN, ArizonaCLIFFORD P . HANSEN, WyomingROBERT DOLE, KansasBOB PACKWOOD, OregonWILLIAM V. ROTH, JR., DelawareBILL BROCK, Tennessee

Senate Report No. 94-938-Part 2

COMMITTEE ON FINANCERUSSELL B.

HERMAN E. TALMADGE, GeorgiaVANCE HARTKE, IndianaABRAHAM RIBICOFF, ConnecticutHARRY F. BYRD, JR., VirginiaGAYLORD NELSON, Wiscons inWALTER F . MONDALE, MinnesotaMIKE GRAVEL, AlaskaLLOYD BENTSEN, TexasWILLIAM D. HATHAWAY, MaineFLOYD K. HASKELL, Colorado

MICHAIIlL STll:RN, StaD DirectorDONALD V. MOORBlHBlAD, OhiefMinority Ooutlsel

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Senate Report No. 94-938-Part 2

CONTENTSPalCeI. Summary____________________________________________________ 3II . Revenue Estimates u u _ 8

III. Explanation of Additional Committee Amendment to B.R. 10612, AsReported ~ _ _ _ _ _ _ _ _ 13A. Title XXII-Esta te and Gift Taxesu n u_____ 131. Allowance of credit against estate tax_ ___ ____ ___ __ 132. Increase in estate tax marital deduction___________ 143. Valuation for purposes of th e Federal estate ta x ofcertain real property devoted to farming, wood-lands, scenic open spaces, and historic sitesu_____ 144. Extension of time for payment of estate taxn __ ___ _ 17

5. Generation-skipping transfers_u__________________ 196. Gift tax treatment of certain annuities '_ 22B. Title XXIII-Other Amendments________________________ 241. Outdoor advertising displays __ u_________________ 242. Tax treatment of large cigarsn ______ ______ _______ 253. Treatment of gain from sales or exchanges betweenrelated parties u____ 284. Application of section 117 to certain education pro-grams for members of th e uniformed servicesu __ _ 315. Tax counseling for th e elderly ___ 326. Credit for certain expenses incurred in providingeducation____________________________________ 337. Commission on value added taxation_u___________ 358. Interest on certain governmental obligations forhospital construction u _ _ _ _ _ _ _ 379. Group legal services plans u________ 3810. Exchangefunds________________________________ 4111. Distributions by subchapter S corporations__ __ ____ 53C. Title XXIV-International Trade Commission Amendments_ 56D. Title XXV-Miscellaneous Amendments__________________ 621. Sick pay andmilitary, etc., pension exclusion-injuriesresulting from acts of terror ism_________________ 622. Changes in treatment of foreign income u____ 62a. Ordering of foreign tax credit carryover u 62b. Exclusion of income earned abroad_ ________ 63c. Recapture of foreign losses_ ___ __ ___ _______ 63d. Tax treatment of corporations conductingtrade or business in Puerto Rico or posses-sions of th e United States_______________ 643. Treatment of certain individuals employed in fiBhingas self-employed______________________________ 644. Energy related provisions_ ____ __ _____ ____ ___ ____ _ 65a. Special credit for wind-related residentialenergy equipment u u _ 65b. Special inves tment credi t for wind-related

energy equipment used in the production ofelectricity u u _ 685. Sliding-scale inclusion ratio for capital gainsu _____ _ 706. Pensions, ESOP's and related items_______________ 71a. Taxable status of Pension Benefit GuarantyCorporation u u _ _ _ _ _ 71b. Level premium annuity contracts held byH.R. 10 plans u_u u_________ 72c. Employee stock ownership plans u u 73d. Election no t to part icipate in an employeestock ownership plan un_________ 74

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Senate Report No. 94-93&--Part 2 IVIII. Explanation of Additional Committee Amendment to H.R. 10612, AsReported--ContinuedD. Title XXV-Miscellaneous Amendments--Continued7. Tax-exempt organizations and chari table contr ibu- PagetioDS________________________________________ 75

a. Unrelated business income from services pro_vided by a tax-exempt hospital to othertax-exempt hospitals n nnn___ 75b. Hospital laundry facilities__________________ 76c. Donation of government publicationsn_____ 77d. Certain charitahle contributions of inventory _ 78e. Lobbying acti vi ties of public charities_ _____ 79f. Tax liens, etc., no t to constitute "acquisitionindebtedness" n n __ u____ 85g. Extension of private foundation transitionrule for sale of business holdings_________ 87h. Private operating foundations; imputed in-terest_________________________________ 888. Low income allowance n __ n __ un___ 909. Equipment leasing-transitional rule for "at risk"limitation 91

10. Architectural, etc., barriers to handicapped persons-to include the deaf and blind u u __ ____ 92IV. Costs of Car ry ing Out the Bill and Vote of the Committee in Report-ing th e Committee Amendment to H.R. 10612, As Reported_______ 93V. Changes i n Exi st ing Lawn n n______ 95

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Senate Report No. 94938-Part 2

(Numerals at top of page indicate official report page numbers.)INTRODUCTION

Because of time pressure and the committee's desire to ~ e the Ta.xReform Act of 1976, as amended by the Finance CommIttee, to theSenate floor as soon as possible, the committee reported the bill onlywith those a.mendments acted upon by the committee a.t the time thisbill was ordered to be reported. This was to give the staff time to draftthe 1,536-page bill and prepare the report. The repor t (S. Rept. 94938) included the committee's decisions up until the time it ordered thebill reported. Subsequent to this, the committee agreed to the additional amendment to be offered on the floor; the additional amendment is described in this supplemental report.This supplemental report is to be treated as if it were a regularcommittee report with respect to the explanl1tion of the intent of theFinance Committee regarding the amendment.

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'Senate Report No. 94938-Part 2

I . SUMMARYThe summary presented below outlines the principal features ofthe additional amendments agreed to by the committee s u b ~ e q u e n t tothe time the committee's amendment to the Tax Reform BIll of 1976(H.R. 10612) was ordered reported.

Estate and Gift Tax Provisions (Title XXII )1. Estate taaJ credit.-An estate tax credit is provided in lieu of thepresent estate tax exemption. The amount of the credit will be $30,000for decedents dying in 1977 (equivalent to an exemption of $131,000)and will increase by $5,000 per year until 1981 when the credit willbe $50,000 (equivalent to a $197,000 exemption).2. Marital deduction.-The maximum estate tax marital deductionfor property passing from the decedent to his surviving spouse is increased to the greater of $250,000 or one-half of the decedent's adjusted gross estate.3. Valuation of certain real property.-Qualified real property is tobe includable in the decedent's gross estate on the basis of i ts currentuse rather than on the basis of its highest and best use. Real propertythat can qualify for this special treatment will include property usedfor (1) farming, (2) woodland, (3) open pastoral space, or (4) themaintenance of historic values.4. Ea:tension of payment time.-The period for payment of theestate tax attributable to the decedent's interest in a farm or closelyheld business is increased from 10 to 15 years. No part of the estatetax is to be payable fo r the first three years; thereafter, the tax is tobe payable in equal installments over the next 12 years. In addition,a special 6-percent interest rate is to apply to the tax attributable tothe firs t $1 million of farm or other closely held business property.A "reasonable cause" standard for the discretionary 10-year extensionfor the payment of estate tax is to be substituted fo r the existing"undue hardship" standard.5. Generationskipping transfers.-A tax is to be imposed in the caseof a generation-skipping transfer under a trust or similar arrangement upon the distribution of the trust assets to a generation-skippingheir or upon the termination of an intervening interest in the trust .The tax generally is to be paid out of the proceeds of the trust andis to be substantiall;v: equivalent to the estate or ~ i f t tax which wouldhave been imposed I f the property had actually been transferred outright to each successive generation.6. Gift taaJ treatment of certain annuities.-The value of a nonemployee's interest is to be exduded from the taxable ~ i f t s of thesurviving spouse to the extent the value of that interest is attributableto the contributions of the employer and to the extent the value arisessolely by reason of the spouse's interest in the community income ofthe employee under the community property laws of the State.

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Senate Report No. 94-938-Part 2 4Other Amendments (Title XXll l )1. Outdoor advertising displays.-Taxpayers are to have the election to treat outdoor adver tising displays as real property undercertain circumstances.2. Large cigars.-The excise tax on large cigars is changed from II-bracket system based on the intended retai l price to an ad valoremtax of 8112 percent of the wholesale price.3. Gain from sales or exchanges between related parties.-Qrdinaryincome tax treatment is extended to gains from sales of depreciableproperty between two corporations that are controlled by the samemdividual and his family. In addition, the amendment makes certainrules of constructive ownership apply in this situation.4. "Extemion of Uniformed /::iervices scholarship excl'U8ion.-Theexclusion from income tor amounts reCeived a:; :;choiarship:; under theArmed Forces Health Professions :::kholarship Program {or ailY substantially similar program) is extended to cover the year 1976.5. Tam coumeling for the elderly.-Provision is to be made for a volunteer tax counseling program for theelderly.6. Taw CTf:,di.t /01 ' Ut;/,Ut.1L eduuatwlL eWJ.lf:,ltses.-A tax credit is to beprovided for certain expenses relating to higher eduction.7. Oommission on Value Added l'amation.-A 20-member NationalCommission on Value Added Taxation is to be established to make astudy of the value added tax and its effects on savings, consumption,capital formation, international trade poli..:y, uml general ~ o v e l ' U ment finance, as well as its potential use as an alternative source offinancing the social security system. A report is to be made to the President and to the Congress by December 31, 1977.

~ 1ndustrial de'vel0J!'lnL'ltt bunds J01 ' uertain hospital CO'fl..8truction.An exception to the small' issues limitation on industrial development bonds is'to be provided for the construction of private hospitalswhere the bond issue does no t exceed $20 million and the hospital hasbeen certified as necessary in their communities by the appropriateState health agency.9. Group legal services plans.-An exclusion from an employee'sgross income is provided for amounts contributed or service or reimbursements provided by an employer under a qualified group legalservices plan fo r the benefit of the employee, his spouse, or hisdependents.10. ExchaJnge funds.-Generally, amounts contributed to partnership exchange funds (so-called "swap funds"), as well as the mergerof certain investment companies, are to be treated as taxable t r a n s a c ~tions where a taxpayer's principal interest is to diversify his investments without current payment of tax.11. Subchapter S corporation distributiom.-An amendment wasadopted modifying the rules pertaining to the number of shareholdersof a subchapter S corporation. 'International Trade Commission (Title XXIV)

The v o t i n ~ procedures of The International Trade Commission inimport relief cases are changed to insure that the Congress will havean opportunity to override import relief decisions of the Presidentunder sections 201 and 406 of the Trade Act of 1974. The Commission660


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5 Senate Report No. 94-938-Part 2membership is to be increased from six to seven members, and certainot.her procedural and organizational changes are to be made with respect to the Commission.Miscellaneous Amendments (Title XXV)

1. DiBability payments e(l)cl'UBion.-An exclusion from gross incomeis provided for disability payments received by U.S. Government employees on account of personal injuries occurring outside of the UnitedStates as a result of a terrorist attack.2. Ohatnges in treatment of foreign irwOrM.-The foreign tax creditswhich are to be allowed an additional2-year carryover under the committee's amendment to H.R. 10612, as reported, are to be applied on afirst-in-first-out (FIFO) basis.Individuals are to have the option of claiming a foreign tax crediton income earned abroad in lieu of the $20,000 (or $25,000) exclusionfrom income.In addition, any loss from a foreign subsidiary is not to be subjectto foreign loss recapture to the extent that it is attributable to a deficitin earnings and profits as of December 31, 1976, where the loss is sustained prior to J anua,ry 1, 1979.Further, foreign source income derived by a possessions corporationis entitled to the possessions tax credit if earned before October 1,1976, without regard to the requirement of i ts being earned in thepossession in which the t rade or business providing the funds is beingconducted.3. Treatment of certain individuals employed in fishing as selfempZoyed.-Crewmen on boats engaged in taking fish (or other formsof aquatic animal life) with an operating crew of fewer than 10 are tobe treated as self-employed for Federal tax purposes in certain instances. (This modifies an earlier committee provision pertaining toboat crewmen.)4. Energy-related proviBions.-A special credit for wind-relatedresidential energy equipment is provided where it is installed to generate electricity to heat or cool residences or to provide hot water forthem.A special investment credi t is provided for wind-related energyequipment installed for use in the trade or business of producing theelectricity or the generation of electricity for use in a trade orbusiness.5. Sliding-scale inclusion ratio for capital gains.-The 50-percentcapital gains exclusion for capital gains is increased for assets heldmore than 5 years by one percentage point for each year an asset isheld in excess of 5 years, but with a mmimum inclusion of 30 percent(after 25 years) .

6. Pe7l8UYn8, ESOP's and rel-ated items.-The Pension Benefit Guaranty Corporation is to be exempt from all Federal taxat ion excepttaxes imposed under the Federal Insurance Contributions Act (socialsecurity taxes) and the Federal Unemployment Tax Act (unemployment taxes) .In addition, unincorporated businesses are to be allowed to makecontributions to tax-qualified pension plans (an H.R. 10 plan) onbehalf of an owner of a business, under the usual H.R. 10 rules for

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Senate Report No. 94-938--Part 2 6plans funded with annuity contracts, without disqualifying the planunder the overall limitations on benefits and contributions under taxqualified plans.With respect to Employee Stock Ownership Plans (ESOP's), twoprovisions previously.agreed to by the c 0 " : l m i ~ t e e are to be d e l e t ~ d .These (1) would requIre ESOP's funded wIth Investment tax credItsto provide for broader employee participation, and (2) would end thetreatment of ESOP's as employee pension or welfare plans underFederallaw (other than tax law) .In addition, an amendment was adopted permitting employees toelect out of an ESOP funded with investment tax credits.7. Tam-exempt organizations and charitable contributions.-Taxexempt hospitals are to be permitted to provide laundry services tosmall tax-exempt hospitals for a fee without the income from theseservices being subject to the unrelated business income tax.Laundry and clinical services are to be tax-exempt when cooperatively operated by a service organization created by tax-exempt

hospItals.United StatesGovernment publications received by taxpayers without charge or at a reduced price are no longer treated as capital assetsand as a result a charitable contributions deduction will no longer beavailable when they are contributed to charity.Corporations (other than a subchapter S corporation) are to beallowed a deduction for up to one-half of the appreciation on certaintypes of ordinary income property contributed to a public charity orprivate operating foundation for use in car rying on it s exemptpurpose.Public charities (other than a church, an organization affiliatedwith a church, or certain support organizations), are to be permittedto elect to have their lobbying activities measured by an "expenditures" test rather than the "substantiality" test of present law.In t ax ing the income of an exempt organization, to the extentthe income is derived from "debt-financed property", the term"acquisition indebtedness" is not to include taxes and special assessments imposed by State or local governmental units until those taxesor special assessments become due and payable and the organizationhas had an opportunity to pay them in accordance with State law.The expiratIOn date of a private foundation transitional rule contained in the Tax Reform Act of 1969 is extended to January 1, 1977.In general, this extension applies to a rule which exempts f rom theself-dealing rules, certain sales. exchanges, or other dispositions ofcertain "nonexcess" business holdings by a private foundation to adiEl'lualified person so long as the private foundation receives at leastfaii- market value.The minimum distribution requirement for private operating foundations is generally reduced to 3 percent. Also imputed interest income on pre-1970 installment payments is excluded from the distribution requirements applicable to private foundations. Final ly , thisamendment exempts libraries and mt:seums, where they elect this general 5 percent payout rule from the net tax on investment incomeapplicable to pnvate foundations. .

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7 Senate Report No. 94-93&-Part 28. LO'/J)-income allowance.-An amendment was adopted increasingthe low-income allowance to $1,850 for single returns and $2,400 forjoint returns for the calendar year 1977, with the increase to be re

flected in lower withholding- d u r i n ~ the last 6 months of 1977. For1978 and future years, the low-income allowance is to be $2,000 forsingle returns and $2,700 for joint returns. (Without this change thelow income allowance would be $1,700 for single returns and $2,100for joint returns.)9. Equirment leasitng-tranBitional ruk /or "at ri8k" limitation.A transitIonal rule to the committee's "at r isk" provision was provided for equipment leasing so that this rule will not apply to lossesincurred under a lease in effect on December 31, 1975.10. Architectural, etc., 'barriers to handicapped persons-to includethe deaf and 'blind.-A clarification of the previous committee provisions provides that the current deduction for the removal of barriersto handicapped and elderly persons is to include the removal of barriers prOVIded for blind and deaf people within the definition ofhandicapped persons.

II-Revenue estimates (pages 712) omitted.

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Senate Report No. 94-938--Part 2

III. EXPLANATION OF ADDITIONAL COMMITTEEAMENDMENT TO H.R. 10612, AS REPORTED

A. TITLE XXII-ESTATE AND GIFT TAXES1. Allowance of Credit Against Estate Tax (sec. 2201(a) of the billand sec. 2010 of the Code)

Present lawUnder present law, the estate of each decedent who was a resident ora citizen IS entitled to an exemption of $60,000 fo r estate tax purposes.

In the case of an estate of a nonresident alien, the exemption is $30,000.Reas0n8 for ahangeThe present amount of th e estate tax exemption was set in 1942.Since that date, the purchasing power of th e dollar has decreasedto less than one-third of it s value in 1942. To some extent this effecthas been mitigated by the addition of a provision for a marital deduction in 1948. Despite thi s the inflation which has occurred means thatthe estate tax now has a much broader impact than was originallycontemplated.In addition, since the present estate tax exemption is a deductionin determining the taxable estate, it results in a greater reduction atthe estate's highest estate tax brackets. However, a credit in lieu of anexemption will have the effect of reducing the estate tax at the estate's

lower estate tax brackets since a tax credit is applied as a dollar-fordollar reduction of the amount otherwise due. Thus, at a given levelof revenue cost, a tax credit tends to confer more tax savings on smalland medium-sized estates, whereas a deduction tends to confer moretax savings on larger estates. The committee believes it would be moreequitable if the exemption were replaced with a credit rather than adeduction.Explanation of p1'ovision

The committee amendment provides for a credit in lieu of the presentexemption for estate tax purposes. The amount of the credi t wil l be$30,000 for decedents dying in 1977 and increases $5,000 each yearuntil 1981 when the credi t will be $50,000. 'Vhen fully effective, the~ 5 0 , 0 0 0 credit is approximately equivalent to a tax exemption on thefirst $197,000 of the decedent's taxable estate. Thus, in 1981 an estateof $197,000 or less will be exempt from estate tax. The committeeamendment also makes comparable changes in the treatment of estatesof nonresident aliens.

Effective dateThis amendment is effective for estates of decedents dying afterDecember 31, 1976. (13)

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senate Report No. 94938-Part 2 142. Increase in Estate Tax Marital Deduction (sec. 2201(b) of thebill and sec. 2056(c) of the Code)

Present lawUnder present law, an estate of a decedent is granted a deductionfor estatlil tax purposes for property passing from the decedent tothe surviving spouse. The maximum allowable deduction is 50percent of the adjusted gross estate of the decedent. The marital deduction generally equates the treatment of common law propertywith the treatment given to community property. The decedent'sshare of community proper ty passing to a spouse is not eligible forthe marital deduction because only the decedent's sha.re is included inthe gross estate as his or her property in the first instance.

Reasons for changeThe committee believes that a decedent with a small- or mediumsized estate should be able to leave sufficient property directly to thesurviving spouse for support during the lifetime of the spouse without the imposition of an estate tax. In addition, in practice it often isdifficult to determine under present law whose efforts are responsiblefo r the property.

Explanation of provisionThe committee amendment would increase the maximum estate taxmarital deduction for property passin'g from the decedent to the surviving spouse to the 'greater of $250,000 or one-half of the decedent'sadjusted gross estate. In addition, the amendment contains rules whichadjust the $250,000 amount where the decedent owns community property, at death so that the parity provided under present law betweencommon law property states and community property law states iscontinued.

Effective dateThe committee amendment is to be effective for estates of decedentsdying after December 31, 1976.3. Valuation fo r Purposes of the Federal Estate Tax of CertainReal Property Devoted to Farming, Woodlands, Scenic OpenSpaces, and Historic Sites (sec. 2201(c) of the bill and secs.2032A, 6324B of the Code)

Present lawUnder present law, the value of property included in the gross estateof the decedent is the fair market value of the property interest at thedate of the decedent's death (or at the alternate valuation date ifelected by the executor or administrator). T h fair market value is

the price at which the property would change hands between a willingbuyer and a willing seller, neither being under any compulsion to buyor to sell and both having reasonable knowledge of relevant facts. Oneof the most important factors used in determining the fair marketvalue of land is the "highest and best use" to which the property canbe put.In some c a ~ , the use of land for farming, woodlands, scenic orhistorical purposes may be its "highest and best use." However,656


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15 Senate Report No. 94938--Part 2in other cases, land which is used fo r such purposes might be worthsignificantly more if it were sold and converted to other uses, such asresidential or commercial pU9;>oses. Thus, where land is used for farmi n ~ , woodlands, or scenic or hIstorical purposes, the value of the landbased on actual use may be substantially less than the value of theland if it were to beconverted to its highest and best use.

Reasons for changeThe committee believes that, when land is actually used for farming, woodlands, scenic or historic purposes (both before and after thedecedent's death), it is inappropriate to value the land on the basis ofits potential "highest and best use." Valuation on the basis of highestand best use rather than actual use may resul t in the imposition ofsubstantially higher estate taxes. In some cases, the greater estate taxburden makes continuation of farming, etc., activities not feasible because the income potential from these activities is insufficient to service extended tux payments or loans obtained to pay the tax. Thus, theheirs may be forced to sell the land for development purposes.On the other hand, the committee recognizes that it would be a windfall to the beneficiaries of an estate to allow such property to bevalued for estate tax purposes a,t a value other than its highest andbest use value unless the beneficiaries continue to use the property fora reasonable period as the decedent did before death. As a result, thecommittee amendment provides a recapture provision where the landis prematurely sold or IS converted for nonqualifying purposes.

Explanation of provisionThe c o m m i t ~ e amendment provides that, if certain conditions aremet, the executor may elect to value qualified real pz:operty includedin the decedent's gross estate on the basis of the property's value inits current use, rather than on the basis of its fair market value in itshighest and best use. However, this special valuation may not reducethe value of the decedent's gross estate by more than $1 million.Real property qualifies for this use valuation only if it is realproperty used for (1) farming, (2) woodland, (3) open pastoralspace, or (4) the maintenance of historic values. For property to beincluded in the last category, it must be listed in the National Register of Historic Places either separately or as part of a listed district.To qualify for this special valuation. the following conditions mustbe met: (1) the assets in the decedent's estate devoted to qualifyinguses, including both real property and personal property, must be atleast 50 percent of the decedent's gross estate (reduced by debts); (2)at least 25 percent of the adjusted value of the gross estate must bequalified real property; (3) such property must pass to a qualifiedheir; and (4) the real property must have been owned by the decedent


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Senate Report No. 94-938-Part 2 16of the real property to a nonqualifying use are to be disregarded.Thus, for example, in valuing qualified real property used as a farm,the committee intends that the following factors be taken into account:

(1) The capitalization of income that the land can be expectedto yield for farming purposes over a reasonable period of timeunder prudent management using traditional cropping patternsfor the area, taking into account soil capacity, terrain configura-tion, and similar factors;(2) The capitaliz!lition of thp- fair rental value of the land forf a r m i n ~ purposes;(3) Assessed land values in a State which provides a differ-ential or use value assessment law for farmland;. (4) Comparable sales of other farm land in the same geograph-ical area fa r enough removed from a metropolitan or resort areaso that nonagricultural use is not a significant factor in the salesprices; and .(5) Any other factor which fairly reflects ,the farm use valueof the property.The committee amendment provides that i f, within 10 years afterthe death of the decedent, the property is disposed of to nonfamilymembers or ceases to be used fo r qualified uses,l the tax benefits ob-tained by virtue of the reduced valuation 'are to be recaptured. Thecommittee amendment also requires that any executor electing thespecial valuation provision file an agreement signed by each personwho has an interest in the specially valned property, consenting to theapplication of the recapture provision.Full recapture is provided for during the first 24 months with aphaseout beginning I I I the 25th month, The amount to be recapturedafter the 24th month is 80 percent of the total tax benefit allowed be-cause of this special valuation. Thereafter, the recapture amount socomputed is reduced on a monthly pro rata basis over 96 months (8

years). However, the potential liability fo r recapture would cease ifthe qualified heir dies without having disposed of the property or con-verted it to a nonqualified use.The committee amendment provides for a special l ien on all quali-fied real property with respect to which the special valuation is elected.The lien continues until the potential fo r recapture is eliminated eitherbecause the tax benefit is recaptured, the qualified heir dies, or a periodof 10 years from the decedent's death lapses. This new section alsoallows the Treasury Depar tment to promulgate regulations underwhich other security can be substituted for the lien on real property.Effective date

These provisions apply to the estates of decedents dying after De-cember 31, 1976.1 Property ceases to be used for qualified uses no t only If an actual cbange to a non-quallfled use occurs, bu t also If the prope rty is rezoned at the request of the owner topermit a nonqualifying use. In the case o f property which Is qualified solely because ofI ts h is to ric values, ces sa tion of thl' qual l fylng use occurs If the property Is removed fromth e :"


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17 Senate Report No. 94938--Part 24. Extensions of Time for Payment of Estate Tax (see. 2201(d)of the bill and sees. 6161, 6163, 6166, 6503, 6601, and 6324A of theCode)

Pr68ent UwJGenerally, an estate tax return is due nine months after the deced-ent's death. Except in certain specified situations, payment of theestate tax is required to bemadeWIth the return.However, present law contains two provisions which permit theestate tax to be paid over a period of up to ten years after the duedate of the return. First, the Secretary of the Treasury may extendthe time for payment of tax up to ten years if he finds that a currentpayment of the tax will result In undue hardship to the estate. Second,an executor may elect to pay the estate tax in installments over twoto ten years where the estate consists largely of interests in a closelyheld business (or businesses).In order to qualify under the first provision, the executor mustshow that the payment of the estate tax on the due date would causeundue ha.rdship. The term "undue hardship" requires more than ashowing of reasonable cause or inconvenience to the estate. In general,undue hardship can be established in a case where the assets in thegross esta.te which must be liquida.ted to pay the estate tax can onlybe sold at a sacrifice price. Further, undue hardship can be estab-lished where a farm or other closely held business could be sold tounrelated persons at a price equal to its fa.ir market value, but theexecutor seeks an extension of time to raise other funds for the pay-ment of the estate tax.Under the second provision, an executor may elect to pa.y the estatetax attributable to an interest in a farm or other closely held busi-ness in installments over a. period not to exceed 10 years. In orderto qualify under this proVlSion, the value of the interest in theclosely he1d business must exceed 35 percent of the value of the grossestate or 50 percent of the taxable estate of the decedent. For thispurpose, the term "interest in a closely held business" means an interestas sole proprietor in a trnde or buemess; an interest as a 'partner ina partnership having not more than 10 partners, or in whICh the de-cedent owned 20 percent or more of the capital; or ownership of stockin a corporation having not more than 10 shareholders, Or in which thedecedent owned 20 percent or more of the voting stock.Under either of these provisions, the Internal Revenue Service may,if it deems it necessary, require the executor to furnish a bond for thE>payment of the tax in an amount not more than double the amountof the tax for which extension is granted. In addition, the executor ispersonally liable for the payment of the tax unless he is d i s c h a r ~ e dupon payment of the tax due and upon furnishing any bond whIchmay required for the tax which is not presently due ~ u s e of anextenSIOn of time for payment.

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Senate Report No. 94-93&-Part 2 18Reaa01UJ for change

The present provisions have proved inadequate to deal with theliquidity problems experienced by estates in which a substantial portion of the assets consists of a closely held business or other illiquidassets. In many cases, the executor is forced to sell the decedent'sinterest in the fa rm or other closely held business in order to pay theestate tax. This may occur even where the estate qualifies for the 10year extension provided for closely held businesses. In this case, it maytake several years before the business can regain sufficient financialstrength to ~ e n e r a t e enough cash to pay estate taxes after the loss ofone of its prmcipal owners. Moreover, some businesses are no t so profitable that they can yield enough to pay both the estate tax and interestwhere the interest rate is high.'Where a substantial portion of the estate consists of illiquid assetsother than a farm or other closely held business, it has been extremelydifficult to obtain an extension on the grounds of "undue hardship"because the Internal Revenue Service generally takes a restrictive approach toward granting such extensions. In addition, many executorshave found it both difficult and expensive to obtain a bond to satisfythe extended payment requirements. Therefore, many executors refuseto elect the extended payment provisions because they must remainpersonally liable for tax for the entire length of the extension.The committee believes that additional relief should be providedto estates with liquidity problems arising because a substantial portionof the estate consists of an interest in a closely held business or otherilliquid assets. Moreover, the committee believes that the provisionsshould be modified so that more estates have the opportunity to takea.dvantage of the extended payment provisions.

Ewplanation of provisionThe committee amendment would permit the executor to elect to

extend the payment of the estate tax attributable to the decedent's interest in a farm or other closely held business over a 15-year period.Under the committee amendment, the executor could defer this entireestate tax for a period of 3 years (Le., until 3 years, 9 months afterthe decedent's death) and thereaf ter pay the tax in equal installments'over the next 12 years. Interest would be due annually, includingthe 3-year period during which no tax need be paid.The committee amendment provides a special 6-percent interestrate on the tax attributable to the first $1 million of farm or otherclosely held business property. Interest on the tax attributable to farmor other closely held business property in excess of $1 million is to bearinterest at the regular rate for mterest on deferred payments (currently 7 percent).The committee amendment also substitutes a "reasonable cause"standard for the discretionary extension of estate tax payments inplace of the existing "undue hardship" standard.' The concept of "reasonable cause" is one already found in existing law and the committeeintends to adopt those standards for this purpose. Interest on amounts

1 This "reasonable cause" standard Is to replace the "undue hardship" standard tor discretionary extensions of time to r payment of estate tax attributable to a reversionary orremainder Interest (sec. 6163(b as well as for discretionary extensions ot time to r pay.ment ot es ta te tax In other circumstances (sec. 6161).

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19 Senate Report No. 94938-Part 2deferred under this provision will continue to bear interest at the regula r rate (currently 7 percent) .The committee amendment also provides a special lien on propertyfor payment of the deferred taxes attributable to a closely held business. Where this l ien procedure is followed and a party is designatedto make estate tax payments and receive and transmit notices to orfrom the Internal Revenue Service, the executor is to be dischargedfrom personal liability and will not be required to post a bond equal totwice the amount of the tax deferred.

Effective dateThese provisions are to apply to estates of decedents dying afterDecember 31, 1976.5. Generation-Skipping Transfers (sec. 2202 of the bill and secs.2601, 2602, 2603, 2611, 2612, 2613, 2614, 2621, and 2622 of theCode)

Present lawUnder present law, a Federal gift or estate tax is generally imposedupon the transfer of property by gift or by reason of death. However,the termination of an interest of a beneficiary (who is not the grantor)in a trust, life estate, or similar arrangement is not a taxable eventunless the beneficiary under the trust has a general power of appointment with respect to the trust property.This result (nontaxability) occurs even when the beneficiary underthe trust has: (1) the right to receive the income from the trust; (2)the power to invade the principal of the trust, if this power is subjectto an ascertainable standard relating to health, education, support,or maintenance; (3) a power (in each beneficiary) to draw down annually from his share of the principal the greater of 5 percent of

its value or $5,000; (4) a power, exercisable during life or by will, toappoint any or all of his share of the principal to anyone other thanhimself, his creditors, his estate or the creditors of his estate; or (5)the right to manaEe the trust property by serving as trustee.Currently, all States (except WisconSIn and Idaho) have a ruleagainst perpetuities which limits the duration of a t rust . While therules of the different Sta tes are not completely uniform, in general,such laws require that the ownership of property held in t rust mustvest in the beneficiaries not later than the period of the lifetime of any"life. in being" on the date of the t ransfer , plus 21 years (and 9months) thereafter.ReQ80'n8 /01' change

The purpose of the Federal estate and gift taxes is no t only toraise revenue, but also to do so in a manner which has as nearly as possiblea uniform effect, generation by generation (taking into accountas the progressive rate structure does, the differences in the utility ofassets according to the value held). These policies of revenue raisingand equal treatment are best served where the transfer taxes (estateand gift) are imposed, on the average, at reasonably uniform intervals.Likewise, such policies are frustrated where the imposition of suchtaxes is deferred for very long intervals, as is possible, under presentlaw, through the use of generation-skipping trusts.

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Senate Report No. 94938-Part 2 20Present law imposes transfer taxes every generation in the case offamilies where property passes directly from parent to child, and thenfrom child to grandchild. However, where a generation-skipping trust

is used, no tax is imposed upon the death of the child, even where ~ h child has an income interest in the trust , and substantial powers wIthrespect to the use, management, and disposition of the trust assets.While the tax advantages of generation-skipping trusts are theoretically available to all, in actual practice these devices are more valuable(in terms of tax savings) to wealthier families. Thus, generationskipping trusts are used more often by the wealthy.Generation skipping results in inequities in the case of transfertaxes by enabling some families to pay these taxes only once everyseveral generations, whereas most families must pay these taxes everygeneration. Generation skipping also reduces the progressive effectof the transfer taxes, since families with moderate levels of accumulated wealth may pay as much or more in cumulative transfer taxesas wealthier families who utilize generation-skipping devices.The committee recognizes that there are many legit imate nontaxpurposes for establishing trusts. However, the committee also believesthat the tax laws should be neutral and that there should be no taxadvantage available in setting up trusts. Consequently, the committeeamendment provides that property passing from one generation tosuccessive generations in trust form should, for estate tax purposes,be treated substantially the same as property which is transferredoutright from one generation to a successive generation.

E replanation of provisionThe committee amendment imposes a tax in the case of generationskipping transfers under a trust or similar arrangement (such as a lifeestate) upon the distribution of the trust assets to a generation

skippmg heir (for example, a grandchild of the transferor) or uponthe termination of an intervening interest in the trust (for example,the termination of an interest held by the transferor's child).The tax would be substantially equivalent to the estate or gift taxwhich would have been imposed if the property had actually beentransferred outright to each successive generation. For example, wherea trust is created for the benefit of the grantor's child, with remainderto the grandchild, then, upon the death of the child, the tax would becomputed by adding the child's port ion of the trust assets to thechild's estate, and computing the tax at the child's marginal estate taxrate.Thus, under the committee amendment, the child would be treatedas a "deemed transferor" of the trust property. The child's estate taxbrackets are used as a measuring rod for purposes of determining thetax imposed on the generation-skipping transfer, but the child's estateis not lIable for the payment of the tax. Instead, the tax would generallybe paid out of the proceeds of the trust property. However, the trustwould be entitled to any unused portion of the estate tax credit for thechild's .estate, and to the benefit of any increased marital deductionallowed to the estate as a result. of the transfer. In addition, the charitable deduction would be allowable if part of the trust property wereleft to charity. The previously taxed property credit would also be

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21/921976-3 Vol. 3 C.B. 663 1976

21 Senate Report No. 94938-Part 2allowable where an estate tax had been imposed with respect to thecreation of the trust a.nd, within a 10-year period thereafter, the generation-skipping tax is imposed u,pon the death of the child.The committee amendment proVldes that the tax would be imposedwhenever the child, 01' other member of an intervening generation, hadan income interest in the trust, or a power to invade corpus for hisown benefit. The tax would not be imposed, however, where the child(as trustee for his children, for example) had n o t h i n ~ more than aright of management over the trust assets or a limIted power ofappointment among grandchildren or more remote descendants of thegrantor.Alsol under the committee amendment, the tax would not be imposed m the case of an outright transfer from a parent to a grandchild (because the intervening generation receives no direct benefitfrom such a transfer). Likewise, a trust established for the benefit ofthe grantor 's spouse, with the remainder outright to the grandchildren, would not be subject to the tax because the interveninggeneration has no interest in the trHst. In addition (as a rule of administrative convenience), tax WOUld not be imposed in the case ofdistributions of accounting income from a generation-skipping trustto a. grandchild ofthe grantor. -TIe tax under these rules would be imposed only once each generation. Generally, a generation would be determined along family lines,where possible (i.e.,.the grantor, his wife, and his brothers and sisterswould be one generation; their children would be a second generation;the ~ n d c h i l d t e n would be the third generation, etc.) .Where generation-skipping transfers are made outside the family,generations would bemeasured from the grantor. Individuals notmorethan 12% years younger than the grantor would be treated as members of his generation; individuals more than 12% years younger thanthe grantor, but not more than 37 th years younger, would be considered members of his children's ~ e n e r a t i o n , etc. In cases wheregeneration-skipping transfers aremade outside the family, the deemedtransferor (that is, this base for purposes of d e t e r m i n i n ~ the tax)would be the estate of the person h a v i n ~ the closest relationship to thewantor or the person h a v i n ~ the intervening life interest or power(generally, the personnamed in the grantor'swill or trust instrument) .

Effective dateIn general, these provisions are to apply to generation-skippingt.ransfers which occur after April 30, 1977. However under a tran-sitional rule provided by the committee amendment, the tax is not to00 imposed for a 10-year period (unti l January 1, 1987) in the caseof transfers: (a) under irrevocable inter vivos trusts in existence onApril 30, 1977 (except to the extent that transfers are made from suchtrusts out of assets added to the trust after April 30, 1977, or (b) inthe case of decedents dying before January 1, 1978, pursuant to a will(or ~ o c a b l e trust) which was in existence on May 1, 1977, and whichwas not amended or revoked at any time after that date. The purposeof this transition rule is to give beneficiaries under trusts whICh mayhave been created in reliance on existing law a 10-year grace periodin which to relinquish their interests in the trust, if they wish to do

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Ie.,.. Report No. 94-938-P8rt 2 22so, thereby eliminating th e generation-skipping aspect of th e trustwithout liabili ty for the ta x Imposed under these provisions (o r forgift tax in the event of such a relinquisIIment) .. In addition, the postponement of the effective date allows the committee to conduct furtherhearings to reexamine th e provision.6. Gift T ax T re at me nt o f Certain Annuities (sec. 2203 of the billan d sec. 2517 of the Code)

Present lawFor estate ta x purposes, an exclusion is provided fo r the portion ofthe value of a survivor benefit (e.g., an annuity) under a qualifiedplan that is attributable to contributions made by the employer. Aparallel exclusion is provided for gift ta x purposes.In 1972, the estate ta x provisIOn was amended to ensure that noportion of the employer contributions was includible in the gross estateof the employee's spouse if the spouse predeceased the employee andth e couple h a resided in a community property State. This amendm e n ~ was deSIgned to overturn Rev. Rul. 67-278, 1967-2 C.B. 323,which held that, if under community property laws the deceasedspouse ha d a vested interest in one-half of such contributions, thishalf was includible in th e spouse's gross estate an d was no t elIgiblefo r the exclusion because the deceased spouse was not an employeecovered under th e plan.However, no corresponding. amendment has been made to th e gifttax provisions. As a result, the IR S has ruled that , if an employeepredeceases the employee's spouse in a community property State,the surviving Spouse is to be treated as having made a gift of one-halfof any benefits-payable toother beneficiaries. Such a result would no toccur in a non-community property State.

Reaao7UJ for changeTh e committee believes that the treatment described above is discriminatory an d should no t be al'lowed to continue. I t is the viewof the committee that the provisions exempting from the estate andft ta x interests in qualified plans should have uniform application

il l both common law and community property States regardless ofwhich RPOUSe dies first.E::planation of proviBion. ~ n s e q u e n t l y , th e committee has adopted an amendment which provides a gift ta x exclusion fo r the value, to the extent attributable toemployer contributions, of any interest of a spouse in specified employee contracts, or trust or plan payments, where two conditionsexist.

F i r s ~ an employer must have made contributions or payments onbehalf of an employee (o r former employee) under a qualifiedemployee's pension, stock bonus, or profit-sharing plan, or trust whichis qualified as an exempt plan for ta x purposes (under section 401( a , an employee's qualified retirement annuity contract (coveredunder a plan described in section 403 (a ) ), or a retirement annuitycontract purchased for an employee bv an employer which is an educational organization (referred to in sec. 170(b) (1) (A ) (ii) or aI?ublicly-supported educational, charitable, or religious organIzation(referred to in sec. 170(b) (1) (A ) (vi) ) .Second, f or purposes of th e664


23/921976-3 Vol. 3 C.B. 665 1976

23 Senate Report No. 94938-1'8rt 2existing estate tax provision (sec. 2039 (c) ), the amount involved mustnot be considered as contributed by the employee. Where these twoconditions exist, the value of the nonemployee's interest payable toother beneficiaries upon the employer's death is to be excluded fromthe taxable gifts of the surviving spouse to the extent the value of theinterest is attributable to the contributions of the employer and to theextent the value arises solely by reason of the spouse's mterest in thecommunity income of the employee under the community propertylaws of the State.This provision will have the effect of equating the gift tax treatmentthat occurs upon the death of an employee spouse in a communityproperty State with that resulting upon the death of an employee.The amount of benefits payable to other beneficiaries which are attributable to the nonemployee spouse's community interest in the valueof the employer 's contribution to the plan would be excluded fromsuch spouse's taxablegifts for gift tax purposes.This provision does not, in the case of the nonemployee spouse in thecommunity property State, provide any exclusion for a property in-terest in the plan to the extent it is attributable to the contributionsof the employee spouse. Thus, the surviving spouse's community in-terest in the plan which is attributable to contributions made by thedeceased employee spouse could be subject to the gift tax, as underpresent law.

Effective dateThe amendment applies to calendar quarters beginning after De-cember 31, 1976.Revenue effect of estate and gift tax provisions (Items 1 through6)These estate and gift tax provisions are ~ , g t i m a t e d to reduce budget

receipts by $1,042 million in fiscal year 1978, $1,367 million in fiscalyear 1979, and $2,006million in fiscal year 1981.

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Senete Report No. 94-938-hrt 2

B. TITLE XXm-oTHER AMENDMENTS1. Outdoor Advertising Displays (see. 2301 of the bill and see.1033(g) of the Code)

PreBent lawUnder present law, gains from involuntary conversions of property(including casualties and condemnations) are, in general, allowed nonr e c o ~ t i o n treatment where monel realized from the involuntary convermon is reinvested, within a limited period of time, in propert!which is similar or related in service or use to the property converted(sec. 1033). A special rule is provided for condemnatIons of businessor investment real estate (other than inventory property) under whichmore liberal rules are adopted for purposes of determIning whethera purchase of replacement real estate qualifies as similar or relatedin service or use to the p ~ p e r t y converted (sec. 1033(g.The Internal Revenue Service has ruled that outdoor advertisingbillboards and displays are real property for purposes of the investment credit and depreciation recapture.1 However, this. administrative interpretation has been successfully challenged in several courtcases which hold that billboards are tangible personal property (andnot real property) for purposes of the investment credit.I

ReaiJona 101' changeFederal and State highway beautification statutes authorize theGovernment to condemn and purchase privately-owned h i ~ h w a y billboards. Because of continuing restrictions on where hip;hway billboards may be located, the former owners of condemned billboards(particularly small comp'anies) are prevented from using their condemnation awards to buIld and situate replacement billboards; thesetaxpayers have been forced instead to reinvest their awards in othertypes of real property. The committee is concerned that present uncertainties in the property classification of billboards will preventthese reinvestments from qualifying for treatment as involuntary conversion replacement property. It has, therefore, decided to allow taxpayers an election to treat outdoor advertising displays as real property in certain situations.E",planation 01The committee's decision provides an election for taxpayers to treatoutdoor advertising displays as real }?roperty. This electiont oncemade is irrevocable without the permissIon of the Secretal'I to c.nangeit and it applies to all qualifying outdoor advertising displays of the

'Bet'. B1I1. 88-82. 1988-1 c.B. 8815. . See, "C 'l AIa t l _ D4lfl1os/!lIftO. et or. T. U..,.. " , . ,. . . GOT F.1d N4 (Ct. C1L 1914) :W1l4teco l_ .. .tr i. . . lftC. 811 'r:,.;. 8M (19111).(24)

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25 Senate Report No. 94-938-Part 2taxpayer. Outdoor advertising displays do not qualify for the electionwhere the taxpayer has previously treated the property as tangiblepersonal property by claIming either the investment credit or additional first-year d ~ p r e c i a t i o n . .This limitation is necessary to. preventabuse of the election by treatmg the same property as tangIble personal property for purposes of the investment credit and as realproperty for purposes of the involuntary conversion replacementproperty and depreciation recapture rules.The term "outdoor a d v e r t i s i n ~ display" includes rigidly assembledoutdoor signs and displays which are attached to the ground, a building, or other permanent structure for purposes of d i s p l a y i n ~ advertismg messages to the public. This term includes highway billboardsattached to the ground with wood or metal poles, pipes or beams, withor without concrete f o o t i n ~ .The amendment also provides that replacement real property willbe considered "like kind" property even though a taxpayer's mterest inthe replacement property is different from the real property interestheld in a qualified outdoor advertising display which was involuntarily converted. This is to enable, for example, purchases of replacement propertv to qualify unqer section 1 0 3 3 ( ~ ) even though a feesimple interest in real estate is acquired to replace in part a billboardowner's leasehold interest in real property on which the billboard waslocated.There is no comparableprovision in theHousebill.

Effective dateThe election under the amendment may be made for purposes ofclassifying replacements of q u a l i f y i n ~ outdoor a d v e r t i s i n ~ displaysin taxable years beginning after 1970. I t is contemplated that the Secretary will allow taxpayers whohave previously made replacements ofqualified outdoor advertising displays during closed taxable years asufti.cient per iod of time to make an election for these closed years.Revenue effectIt. is estimated that this provision will have no effect on budgetreceIpts.2. Tax Treatment of Large Cigars (sec. 2302 of the bill and sees.5701(a), 5702, and 5741 of the Code)

Present lOIwUnder present law (sec. 5701 (a) (2, 'the manufacturers excise taxon large cigars (those weighing more than 3 pounds per thousandcigars) is imposed on the basis of a bracket system with the rate oftax dependent on the retail price of the cigar. The brackets are JI.Sfollows:

Over-Intended retail price per cigar (in cents)

Not over- Tax pert h O u s a D ~D.............................................................................. 2lf2 . . . . . ._. _ _._._.. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . 4

t ~ ~ ~ ~ ~ ~ m ~ m ~ m m m ~ m ~ ~ ~ ~ ~ ~ ~ ~ ~ m m ~ m ~ ~ m m ~ m ~ m m m m m m ..$2.503.004.007S0.15.~ O 667


26/921976-3 Vol. 3 C.B. 668 1976

Senate Report No. 94-938-Part 2 26.The retail price of a cigar is defined for Federal tax purposes as"the ordinary retail price of a single cigar in its principal market."The law provides that any State or local tax imposed on cigars as acommodity is to be excluded when determining the ordinary retailprice.

Re(JJJ01IJJ for changeThe present bracket system is arbitrary in that it produces widelyvarying effective rates of tax depending on the retail price of the cigar.For cigars intended to retail for 20 cents each or less, the effectiverate of tax depends on a combination of the rate of tax for the givenbracket and the point within the bracket that a cigar is intendedto sell for. Thus, in the wide bracket covering cigars intended toretail for over 8 cents and not over 15 cents, the tax rate of $10 pe rthousand varies from a maximum of 12 percent of the intended retailprice (including the tax) for cigars priced at three for 25 cents to aminimum of 6.7 percent for cigars intended to retai l for 15 cents

each. This 6.7-percent minimum effective rate also applies to cigars atthe top of the over 4 cents and not over 6 cents bracket. However, inthe over 6 cents and not over 8 cents bracket, the minimum effectiverate is 8.8 percent. At the very bottom of the tax scale (namely, in thecase of cig-ars intended to J;etail for not more than 2% cents each) , thetax of $2.50 per thousand Imposes an effective rate of 10 percent of theretail price for cigars intended to retail at two for 5 cents.A corollary of the variability of the effective rates of tax is thefact that a shift in the price of a cigar from the top of one bracketto the bottom of the next tax bracket can result ina tax increase disproportionate to the price increase. An example of this is the increase in tax from $4 to $7 per thousand between cigars intended toretail for 6 cents and those intended to retail for more than 6 centsand not over 8 cents. At the 6-cent level, the tax is 6.7 percent of theretail price and lOA percent of the manufacturer's net price (exclusiveof tax). l I f the manufacturer of a 6-cent cigar raised the sta ted retail price to three for 20 cents, the effective rate of tax would increaseto 10.5 percent of the retail price and 17.5 percent of the manufacturer's net price. The manufacturer would net onfy $1.70 more perthousand cigars although consumers would pay $6.67 additional. Thisbracket system not only discriminoates among producers depending onthe price at which they sell their cigars within a bracket but alsoprevents manufacturers from freely adjusting pdces to meet costchanges.There is no way to determine precisely how the burden of the c i ~ rtax is distributed between consumers and owners of manufactunngfirms. In either event, however, the present tax is discriminatory. Tothe extent it is borne by consumers, the burden imposed by the taxvaries erratically depending' on the intended retail price of the cigarspurchased. To the extent it is borne by manufacturers, the burden ofthe tax varies depending on the particular price l ~ e s produced by eachmanufacturer. As a pereent of sales, the tax paId Is"least for thosemanufacturers whose production is concentrated in price classeswhere the effective rate of tax is at a minimum.1 This assumes the usual standard markup In determlntng the retan price.

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27 Senate ~ e p o r t No. 94938-Part 2These problems of the bracket system have been recognized for along time by the cigar industry, the Treasury Department, and theCongress. When the ,tax on cigars was collected by means of the purchase of stamps, practical considel'ation favored the use of some typeof bracket system in order to keep toa reasonable level the numberand denomination of stamps that had to be printed. However, the useof stamps as evidence of payment of tax was discontinued in June1959. As a result, there now is no reason why the bracket systemshould no t be elimmated.A change from a tax base of the intended retail price to a base ofthe intended wholesale price will make administration. of the taxeasier and avoid many of the problems associ'ated witb the presenttax base of the intended retail price in the cigar's princi.pal market.Administration of the tax will be facilitated because wholesalers traditionally sell ,a given cigar at the same price to different retailers.Retail prices do no t have this consistency. In addition, verificationthat sales actually take place at the list price will be easier than in the

case of the intended retail price because there are far fewer wholesalers than retailers.With a tax based on the wholesale price rather than the retail price,a rate of 10 percent is required in order to produce the same tax yieldas is produced under present law. However, if a substantial tax increaseis not to result for many cigars, a rate which is lower than this is required. Substitution of an ad valorem rate of tax for the presentbracket system, of necessity, has a differing impact on individual firmswithin the cigarmanufacturing industry.An ad valorem rate set at 10 percent of the wholesale price wouldmean that those firms which have produced cigars which sold at priceswhere the tax rate was relatively low under the bracket system wouldbe faced with a tax increasewith such a rate. Firms producing cigars atprices where the tax rate has been relatively high under the bracketsystem, of course, would obtain some benefit under a 10-percent ratestructure. In a transition of this type, however, in order to prevent atax increase for a large number of lines of cigars, a reduction in theaverage rates of tax is necessary.In addition to the need for a tax rate decrease because of a shiftto an ad valorem system, a decrease in the rate of tax fo r cigars also isjustified for other reasons as well, First, when many excise taxes werereduced or eliminated in 1965, the tax on cigars was nevertheless maintained at p r e e x i s t i n ~ rates. Second, the cigar industry in recent yearshas been experiencing considerable financial difficulty. Sales havedropped dramatically from 9 billion cigars in 1964 to about 6 billionin 1975-a period of rising costs.

E(l)pZanatiun of provisionThis amendment changes the present law tax on large cigars (thoseweighing more than 3 pounds per thousand 2) to a tax of 8% percent ofthe wholesale price, but not more than $20 per thousand cigars.Wholesale price, as defined in this amendment, means the manufacturer's or importer's suggested delivered orice of the cigar to retailers(including in this price this Federal cigar tax). Thig price is to be determined before any trade, cash, or other discounts, or any promotion, Small cigars ar e not taxed on the basis of .prlce. Their tax rate Is 75 cents per thousand.

669

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28/921976-3 Vol. 3 C.B. 670 1976

Senate Report No. 94-938--Part 2 28advertising, display, or similar allowances. Generally, this wholesaleprice is th e traditional manufact.urer's or importer's declared intendedcatalog or list delivered bulk price to retailers. Where th e manufac-t ur er o r importer has no suggested delivered price to retailers for th eparticular cigar in question (as ma y hallpen, fo r example, if he sellsonly at retail, or where th e suggested delivered price to retailers is no tadequately supported by bona fide arm's length sales), th e amendmentprovides that th e wholesale price is to be determined by the TreasuryDepartment on th e basis of th e p ri ce f or which cigars of comparableretail price are sold to retailers in th e ordinary course of trade.In most cases th e wholesale price will be adequately supported bysales b y t he wholesalers to retailers. In only a few situations will it benecessary fo r th e Treasury Department to determine th e wholesaleprice on th e basis of t he p ri ce fo r which cigars of the same or compa-rable retail price' ar e sold to retailers in th e ordinary course of trade.Th e use of the intended wholesale price as th e ta x base will elimi-nate th e troublesome determination of the retail price of a single cigarin it s principal market.Th e wholesale price does no t include State or local taxes imposed oncigars as a commodity. Th e present law exclusion of such taxes fromthe ta x base is continued b y t hi s amendment. I f a manufacturer nor-mally includes State or local taxes in his "wholesale price," he mustshow th e price ne t of an y such taxes in a'manner satisfactory to th eTreasury Department fo r th e purpose of imposing th e ta x providedby this amendment.This amendment also amends th e Code (sec. 5741) to include im-porters a m o n ~ those persons required to keep records prescribed bythe Treasury Department and to provide that th e required records beavailable fo r inspection b y i nt er na l revenue officers during businesshours. Th e existing statutory requirement is extended to i ~ p o r t e r s ino rd er t o avoid any doubt that appropriately prescribed regulationsmay require them to keep records which are needed. This is particu'-larly relevant with th e change in manner of imposition of th e ta x onlarge cigars an d th e added definition of "wholesale price" which willlikely result in a requirement that records be kept by importers.There is no comparable provision in the House bill.

Effective dateTh e effective date of the changes made by this amendment is th efirst da y of th e first month which begins more than 90 days after th edate of enactment. This date provides taxpayers and the Treasury De-partment with sufficient time to make th e required administrativechanges.

Revenue effectThis provision will reduce budget receipts by $7 million in fiscalyear 1977, $7 million in fiscal year 1978, an d $7 million in fiscal year1981.

3. Treatment of Gain f ro m S al es or ExchanJtes Between RelatedParties (sec. 2303 of the bill and sec. 1239 of th e Code)Present law

Under present law, recognized gains from a sale or exchange ofdepreciable p ro pe rty a r e denied c ap ita l g ain tr ea tme nt i f t he t ra ns -670


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29 Senate Report No. 94938-Part 2action is between a husband and wife, or between an individual anda corporation over 80 percent of the value of whose stock is ownedby the individual, his spouse, and his minor children or grandchildren(sec. 1239). This rule applies where the shareholder sells property tohis controlled corporation, and vice versa.Although the present statute covers a sale or exchange "directly orindirectly" between an individual and a controlled corporation, thecourts have held that this language does not reach gain on a sale ofdepreciable property between two corporations each of which is morethan 80 percent controlled by the same individual and his family. Thecourts have refused to follow a ruling by the Internal Rev,}nue Servicethat a sale between two such commonly controlled corpordions is (forpurposes of this provision) "indirectly" a sale between t h l ~ individualand the corporation.1

ReQ.801UJ for changeIn enacting section 1239 (and its predecessors in the 1939 Code),Congress sought to prevent the practice of sell ing a low basis-highvalue depreciable asset to a controlled corporation in order to "stepup" the basis of the asset for depreciation purposes in the hands oftlie corporation at the cost of a capital gain tax to the selling shareholder.2 The corporation's basis would be i ts cost for the property,which in turn wo:uld reflect appreciation in value in the hands of theshareholder.In refusing tQ' interpret "indirectly" to cover commonly controlledcorporations, the courts have not disagreed that corporations undercommon control can a ~ do engage in sales or exchanges with eachother to obtain the tax; benefits which Congress sought to prevent ifthe sale were made directly between the shareholder and the corporation. The courts, however, have generally based their decisions ontechnical factors i n v o l v i n ~ the language of the present statute andsome ambiguity in the leglSlative history of the provision.The potential for abuse is as evident in such cases, however, as insales between a shareholder and his controlled corporation. In bothsituations, the shareholder (or his family) maintains control over theasset while the corporation obtains a higher depreciable basis in theproperty. The committee sees no reason why a sale between corporations controlled by the same individual should be treated differentlyfrom a sale between an individual and his controlled corporationshould be treated differently (under section 1239) a from a sale betweencorporations controlled by the same individual.No rules of constructive ownership are provided in section 1239 forpurposes of determining the ownership of stock under that provision.As a result, a taxpayer may be able to structure a transaction to circumvent the applicability of the section. For example, a taxpayerdesiring to sell depreciable property to a corporation which he wbollyowns may be able to avoid sectIon 1239 by (prior to the sale) contrib-

1 Rev. Rul. 69-109, 1969-1 C.B. 202. H. Rept. 1186,824 Cong., la t Sess. (19111), 19111-1C.B. '3'57, 376. The committee reportstates that this type of transaction may be highly advantageous "when the sale may becarried ou t without lose of control over the asset because the corporation to which the assetIs sold Is control led by the individuals who make the sale." The depreciation recapture rules of sections 12411 and 1250 would have a limited useto prevent this abuse where sales are made between controlled corporations of propertywhich has a low basis but a h igh value. In such cases, sections 12411 and 1250 would recapture as ordinary Income only a relat ively small por tion of the seller 's gain.671


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Senate Report No. 94-938-Part 2 30uting his stock in the corporation to a holding company or by transferring 20 percent of his stock to a trust for the benefit of members ofhis family. Although it can be argued that the taxpayer continues toown the stock "indirectly" and section 1239 therefore should comeinto play, as explained above, the courts have been reluctant to give abroad interpretation to the te rm "indirectly."

Ernplanation of provisionThe committee amendment revises and strengthens section 1239 inseveral ways. First , the amendment adds a rule which brings withinthe scope of this provision a sale or exchange of property betweencommonly-controlled corporations. Second, the amendment makesrules of constructive ownership applicable in determining stock ownership under this provision generally. For this purpose, the presentrules which apply under section 318 are incorporated by reference.Third, the amendment changes the control requirement which bringssection 1239 into effect from over 80 percent to 80 percent or more invalue of a corporwtion's stock. (This latter change follows the conceptof control reflected in' the reorganization rules, where control meansat least 80 percent or greater control (sec. 368 (c) ).Under the first of the changes made by the committee, the treatment

of gain as ordinary income in the case of a sale between commonlycontrolled corporations is to ocCur at the level of the transferor (seller)corporation rather than at the level of theshllreholder. The constructive ownership rules are to'be used to determine whether the 80 percent stock ownership requirement has been met, but (in the commonlycontrolled ~ o l ' p o r a t i o n situation) the actual tax effect of recharacterizing gain ,as ordinary income is to occur at the corporate level.The committee does not intend to prevent section 1239 from beinginvoked to produce ordinary income to a shareholder where a corporation is used as a conduit to make a sale to another controlled.corporation, or where the entity of a corporate transferor is properlydisregarded fo r tax purposes. These situations will result in ordinaryincome to the shareholders.5The incorporation of constructive ownership rules into section 1239applies generally to this section and is not limited to sales betweencommonly controlled corporations. In light of the section 318 rules, theSO-percent requirement of section 1239 will continue to be measuredby reference to the value of the company's outstanding stock; however, the stock which will be grouped together in measuring controlwill include stock considered owned by an individual under the constructive ownership rules. Thus, for example, if a father owns outright 79 percent of the stock (by value) of a closely held corporationand a trust fo r his children owns the remaining '21 percent of thestock, the chi ldren wil l be deemed to own the stock owned for their

I f the transferor corporation Is a subchapter S corporation (I.e. , a corporation whichhas made an election under sections 1371-1379 of p resen t l aw), gain which Is deniedCApital gain treatment by reaso n of t he co mm itt ee amendment will be Included In th ecorporation's undistr ibuted taxable Income which Is taxed to Its shareholders ("pursuantto sec. 1373 o f the Code). The committee 's amendment bring ing sales between cer ta in controlled corporationswithin section 1239 also Is no t Int en ded t o make such sales less subject (than they areunder present law) to allocations of Income between or among the corporations or theirshareholders under'sectlon 482 of present law. Nor Is the amendment Intended to makesuch sales no longer subject to constructive dividend treatment to the c o n t r o l l l D ~ shareholder ( as may occur In appropriate cases under present law).

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31 Senate Report No. 94938-Part 2benefit by the trust in proportion to their actuarial interests in thetrust (sec. 318(a) (2) (B . The father will, in turn, constructivelyown the stock so deemed ,to be owned by his children (sec. 318 (a) (1)(A) (i i . The result will be that the father will be treated as owningall the stock of the corporation, and any gain he would otherwisehave to recognize from selling depreciable property to the corporation would be treated by section 1239 as ordinary income.Also, the constructive ownership rules mean, among otherthings, that if a shareholder holds an option to acquire stock (suchas from another shareholder), he will be treated as owning the stockwhich he could acquire by exercising the option (sec. 318(a) (4.The members of a shareholder's family' are also broadened beyonda spouse, minor children, and grandchIldren to include parents andadult children (sec. 318(a) (1) ).6There is no comparable provision in the House bill.

Effective dateThis provision applies to gain recognized ona sale or exchangemade ,after the date of enactment of ,the amendment. A transitionrule is also .provided under which the new rules will no t apply to asale or exchange after the date of enactment but occurring pursuantto a binding contract entered into before the date of enactment.

Revenue elfect8I t is estimated that this provision will result in an increase in budgetreceipts of less than $5 million annually.

4. Application of Section 117 to Certain Education Programs forMembers of the Uniformed Services (sec. 2304 of the bill andsec. 117 of the Code)P1'e8ent lUJw

Amounts received by an individual as a scholarship or fellowshipgrant for study, research, etc., at a qualified educational institution(as defined in sec. 151(e) (4 are generally excluded from grossincome (sec. 117 (a) ). However, such amounts are not excludible fromgross income if they represent compensation fo r past, present, or future employment services, or if the studies or research are primarilyfor the benefit of the grantor or are under the direction or supervisionof the grantor (Treas. Regs. 1.117-4 (c) ) .D u r i n ~ oolendar years 1973, 1974, and 1975, amounts received fromapproprIated funds as a scholarship ( including the value of contributed services and accommodations) by a member of a uniformedservice 1 who was receiving training under the Armed Forces Health As 1UI0ther example of the elrect of the stock attribution rules, aBsume that a shareholder owns 80 percent of corporations A and B. The shareholder attempts to plan aroundtbe rule In th e amendment bringing sales between controlled corporations within section1239 by contributing bls stock In corporation B to newly formed !loldlng compan1' 0,which th e sbareholder wholly owns, and then hav ingA sell depreciable propertY to B. Wltbou t attribution, this sale might be found (under present law ) not to be covered by sec tion1239. However, the attribution rules under tbe amendment wlll treat th e shareholder asowning tb e B stock owned by holding company 0, so that A's gain on t he sale will beordinary IncomeFor purposes o f sec tion 1239, a tt ribution to a shareholder of stock owned by a corporation, or vice versa , I s to occur without regard to tb e 5().percent limitation containedIn sections 318(a) (2) (C) and 318( a) (3) (C).lAlJdeflned under 37 U.S.C., See. 101(8).

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,Senate Report No. 94938-Part 2 3'2Professions Scholarship Program 2 (or any other similar program, asdetermined by the Secretary of the Treasury) were specifically excluded from gross income by congressional action.s This exclusion wasavailable whether the member was receiving training while on activeduty or in an off-duty or inactive status, and without regard towhether a period of active duty was required of the member as a condition of receiving those payments.

ReatJ0'n8 lor changeThe Internal Revenue Service has ruled (Rev. Rul. 76-99) that,without further legislation, all amounts received under the ArmedForces Health Professions Scholarship Program will be t reated ascompensation and therefore includible in gross income for calendaryears 1976 and thereafter. In view of the Congressional and executiveconcern regarding the need for these health professions scholarshipsfor the uniformed services, the committee concluded that those scholarships should continue to be excluded from gross income pending &

thorough staff review of the appropriate tax treatment of the grantsin view of the overall national policy toward the military (and otheruniformed service) health professions program.Erplanation 01 provision

The committee amendment extends the prior law exclusion fromgross income (under P.L. 93-483) for amounts received under theArmed Forces Health Professions Scholarship Program (or substantially similar programs) fo r one more year (1976). This will givethe committee additional time to determine the appropriate tax treatment of those scholarship programs. The House bill contains no similarprovision; however, the House Committee R e ~ o r t on H.R. 10612 statesthat the Committee on Ways and Means, WIth the assistance of theInternal Revenue Service,. will s tudy the tax treatment of scholarships and fellowships.Effective date

This provision is effective for amounts received during calendaryear 1976.Revenue effect

I t is estimated that this provision will decrease budget receipts by$2 million in the transition quarter and $3 million in fiscal year 1977.5. Tax Counseling for the Elderly (sec. 2305 of the bill and sec.7803(a) of the Code)

Pre8entlawPresent law provides a number of tax benefits for elderly or retired

individuals; however, it contains no provision dealing with tax counseling for the,elderly.ReatJ0'n8 for change

Preparation of a t ax return is frequently a difficult task for theelderly. UIJon reaching retirement age, taxpayers are often confronted Author ized by the Untforli 'ed Services Health ProfesaloD8 RevitaUzatlon Ac t of 1912(10 U.S.C. seCS. 2120-2127). Publlc Law 93-4,83 (H.B. 12035; 93rd CongrBss. 1s t S88S.), October 24, 1974.

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33 Senate Report No. 94938-Part 2with new provisions and complex forms to contend with. They oftenmust complete a retirement income credit schedule, d e t e ~ m e thetaxable f0rtion of their annuities, or compute the taxable gam whenthey sel their residences. For an untrained elderly individual, whohas perhaps had no experience with the preparation of tax returnsother than the short form 104M, this change in circumstances mayresult in overpayment of tax.

E0planation of p1'O'ViBionThe amendment authorizes the Secretary of the Treasury, throughthe Internal Revenue Service, to enter into training and technicalassistance agreements with private or public nonprofit agencies andorganizations to prepare volunteers to provide tax counseling assist-ance for elderly individuals in the preparation of the ir Federal in-come tax returns. I t permits the Service to provide reimbursementto volunteers for transportation, meals, and other expenses incurredby them in training or p r o v i d i n ~ counseling assistance. The amountsreceived by the volunteer as reImbursement fo r these expenses areto be exempt from income and social security taxes, except to the extentthat a charitable contribution or other deduction is claimed for theseexpenses. The Secretary is authorized to provide the volunteers withpreferential access to Internal Revenue Service taxpayer service repre-sentatives and make available technical information and materialneeded for their use.The amendment also authorizes the Secretary to hire retired formerInternal Revenue Service employees who could, under this committeeamendment, work up to 720 hours a year without losing their pensions.These temporary employees would primarily be used to provide taxassistance services, but the Service is also given authority to use theseindividuals to administer and enforce the tax laws. Additionally, theamendment provides that, from time to time, the IRS is to direct theattention of elderly individuals c o n c e r n i n ~ tax measures of particu-lar interest to the elderly, such as the retIrement income credit. An"elderly individual" is defined as a person who has reached the ageof 60 as of the close of a taxable year.Appropriations to carry out these provisions are authorized by theamendment in the amounts of $2 million for fiscal 1978 and $3 millionfor fiscal 1979.The House bill contains no comparable provision.

Effectwe dateThis provision is to be effective on the date of enactment.

Revenue effectI t is estimated that this provision will have little effect on Federal

revenues, but will involve expenditures of up to $2 million for fiscalyear 1978 and up to $3 million for fiscal year 1979.6. Credit fo r Certain Expenses Incurred in Providing Education(sec. 2306 of the bill and sec. 44D of the Code)

Present lawUnder present law, there is no tax credit or deduction for personaleducational expenses. However. a deduction may be taken for certain

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iSenate Report No. 94938-Part 2 34educational expensee which qualify ae trade or business expenses undersection 162. In addition, individuals may generally exclude from grossincome amounts received as scholarships or fellowships (sec. 117).

Reasom for changeThe cost of a college education has increased dramatically in recentyears. The committee is concerned about the growing number of qualified students who are prevented from obtaining a higher educationbecause of the increasing costs. The escalating costs are making it increasingly difficult fo r many parents to provide their dependents witha higher education. The impact of rising college education costs hasbeen particularly hard on middle-income families. Low-income families are eligible for the various Government programs providing direct grants, work-study programs, and guaranteed or low-interestloans, while high-income families are generally able to afford collegeexpenses. The committee believes that tax assistance is necessary tohelp assure a greater access to a higher education.Explanation of provisionThe amendment provides a nonrefundable tax credit fo r certaineducation expenses paid by an individual, for himself , his sJ?ouse, orhis dependents. The amount of the credit for each student IS not toexceed $100 fo r expenses paid in 1977 and increases by $50 each yearuntil it reaches a limit of $250 fo r expenses paid in 1980 and subsequent years. Subject to this limitation, the credit is allowed for 100percent of the eligible educational expenses. There is no comparableprovision in the Hotlse bill.The education expenses which are eligible for the credit are thetuition and fees required for the enrollment or attendance of a studentat an eligible educational institution and the fees, books, supplies,and equipment required fo r courses of instruction at an eligible educational institution. The credit is not available for any amount paid directly or indirectly for meals, lodging, or other personal, living, orfamily expenses.To be eligible for the credit, the education expenses must be paidwith respect to an individual who is, for at least 4 months duringthe calendar year, a ful l- time student above the secondary level at aninstitution of higher education (as described in the Higher Education Act of 1965) or at a vocat ional school (as defined in the Vocational Education Act of 1963). The tax credi t is available only foramounts attributable to instruction fo r which course credit is allowedtoward a baccalaureate degr

Senate Report 94-938 Vol II

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